Question

The company ABC just paid $2 dividend per share, which will grow at 15% for the next three dividends. Afterwards, the dividends will level off and grow at 5% per year forever. If the investors require 7% return on similar investments, what is the price of stock today

Answer 1

Answer:

P0 = $137.2988907 rounded off to $137.30

Explanation:

The two stage growth model of DDM will be used to calculate the price of the stock today. The DDM values a stock based on the present value of the expected future dividends from the stock. The formula for price today under this model is,

P0 = D0 * (1+g1) / (1+r)  +  D0 * (1+g1)^2 / (1+r)^2  +  ...  +  D0 * (1+g1)^n / (1+r)^n  +   [(D0 * (1+g1)^n  *  (1+g2) /  (r - g2))  /  (1+r)^n]

Where,

• g1 is the initial growth rate

• g2 is the constant growth rate

• D0 is the dividend paid today or most recently

• r is the required rate of return

P0 = 2 * (1+0.15) / (1+0.07)  +  2 * (1+0.15)^2 / (1+0.07)^2  +

2 * (1+0.15)^3 / (1+0.07)^3  +  

[(2 * (1+0.15)^3 * (1+0.05) / (0.07 - 0.05))  /  (1+0.07)^3]

P0 = $137.2988907 rounded off to $137.30