Suppose a firm just paid a dividend of 5$ per share.
We expect the firm to grow at a rate of 14% for thee years. after
which it will grow at 8% forever. the required return is 10% and
the current stock price is 100$.
1. What is the intrinsic value (present value) of stock?
2. Should you buy the stock? Why?
1). Stock Price = [{D0 x (1 + gH)} / (1 + r)] + [{D0 x (1 + gH)2} / (1 + r)2] + [{D0 x (1 + gH)3} / (1 + r)3] +
[{D0 x (1 + gH)3 x (1 + gC)} / {(r - gC)(1 + r)3}]
D0 = Current Dividend;
gH = Higher growth rate
gC = Constant growth rate
r = required rate
Stock Price = [{$5 x 1.14} / 1.10] + [{$5 x 1.142} / 1.102] + [{$5 x 1.143} / 1.103] + [{$5 x 1.143 x 1.08} / {(0.10 - 0.08) x 1.103}]
= $5.18 + $5.37 + $5.57 + $300.54 = $316.66
2). As the current price is $100, we should buy the share as it is expected to reach its intrinsic value of $316.66 in the future. Hence, it is a good investment to buy.
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