An investor evaluating a company’s common stock has gathered the following information:Current dividend per share $2.40Dividend growth rate expected during Years 1 to 2 20%Dividend growth rate expected from Year 3 onward 4%Company’s weighted average cost of capital 13%Required rate of return on equity 15%The intrinsic value per share of this common stock is closest to:A.$24.86.B.$26.59.C.$29.82.
Question
An investor evaluating a company’s common stock has gathered the following information:Current dividend per share 24.86.B.29.82.
Solution
To calculate the intrinsic value of a stock, we can use the Gordon Growth Model (also known as the Dividend Discount Model). This model is used to determine the intrinsic value of a stock based on a future series of dividends that grow at a constant rate.
Given the information, we first need to calculate the dividends for the first two years and then calculate the price of the stock at the start of the third year.
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Calculate the dividends for the first two years:
- Year 1: 2.88
- Year 2: 3.46
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Calculate the price of the stock at the start of the third year (P2):
- P2 = D3 / (k - g) = 32.04
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Calculate the intrinsic value of the stock today (P0):
- P0 = [D1 / (1 + k)] + [D2 / (1 + k)^2] + [P2 / (1 + k)^2]
- P0 = [3.46 / (1 + 0.15)^2] + [$32.04 / (1 + 0.15)^2]
- P0 = 2.61 + 29.50
So, the intrinsic value per share of this common stock is closest to 29.82.
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