Question

4. The current dividend on a stock is $2 per share and investors require a rate of return of 12%. Dividends are expected to grow at a rate of 3% in year 1; 6% in year 2; 4% in year 3 and then at a rate of 5% per year forever. Find the intrinsic value of the stock.

Answer 1

The intrinsic value of the stock is $29.44.

What is the intrinsic value of the stock?

The first step is to determine the value of the dividend at the end of each year:

Dividend in Y1 = 2. x 1.03 = 2.06

Dividend in Y2 = 2.06x 1.06 = 2.18

Dividend in Y3 = 2.18 x 1.04 = 2.27

Dividend after year 3 = (2.27 x 1.05) / (0.12 - 0.05) = $34.06

Now, find the present value of these dividends :2.06 / 1.12 + 2.18 / 1.12² + 2.27 / 1.12³ + 34.06 / 1.12³ = $29.44

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