Question

Storico Co. just paid a dividend of $2.45 per share. The company will increase its dividend by 20 percent next year and will then reduce its dividend growth rate by 5 percentage points per year until it reaches the industry average of 5 percent dividend growth, after which the company will keep a constant growth rate forever. If the required return on Storico stock is 11 percent, what will a share of stock sell for today?

Answer 1

We can find the price of the stock in Year 3 since the dividend growth rate is constant after the third dividend. The price of the stock in Year 3 will be the dividend in Year 4, divided by the required return minus the constant dividend growth rate. So, the price in Year 3 will be:

P3 = $2.45(1.20)(1.15)(1.10)(1.05) / (.11 – .05) = $65.08

The price of the stock today will be the PV of the first three dividends, plus the PV of the stock price in Year 3, so:

P0 = $2.45(1.20)/(1.11) + $2.45(1.20)(1.15)/1.11^2 + $2.45(1.20)(1.15)(1.10)/1.11^3 + $65.08/1.11^3

P0 = $55.70