A high-growth firm is expected to have a dividend growth of 10% for the next 2 years. It is then expected to stabilize at 4%. The firm has just paid a dividend of $2 and investors require a rate of return of 14%. The market price of the firm's stock is:
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A. B. C. D.B
Since the dividends do not grow at a constant rate, you cannot directly apply the Dividend Discount Model valuation formula. However, note that 2 years from now, looking into the future, you will see a constant growth rate of 4% and the dividend 3 years from now will be $2 * 1.1^2 * 1.04 = $2.517. Therefore, the stock price 2 years from now, using the required rate of return of 14%, will equal P = 2.517/(14% - 4%) =
$25.17. Thus, the current stock price equals 1.1/1.14 + (1.1/1.14)^2 + 25.17/1.14^2 = $21.26.
Note that you must be very careful about the time line. In the Dividend Discount Model valuation formula, the price at time t uses the dividend paid at time (t+1).
That's the reason we had to use the dividend paid in year 3 to calculate the price at the end of year 2.