Stock Valuation and Dividend Growth Rate Calculation

Expected Dividend Growth Rate, Ex-Dividend Date, and Investor's Rate of Return

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Question

A stock has an expected dividend growth rate of 2.4%. The firm has just announced a dividend of $2.30 per share, with an ex dividend date 3 days from now.

Investors expect a rate of return of 12% from the stock and the stock is trading at $26.12. The stock is:

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A. B. C. D.

B

In the usual notation, the Dividend Discount Model gives Po = D1/(k-g). In this case, g = 2.4%, D1 = Do*(1+g) = 2.3 *1.024 = $2.355, Po = $26.12. Therefore, k = g + D1/Po = 2.4% + 2.355/26.12 = 11.42%. Thus, the rate of return built into the price is less than that required by the investors, implying that the stock is overpriced. Another way of seeing this is to find the price that will give k = 12%. This price equals P = 2.355/(12% - 2.4%) = $24.53. Since the stock is trading at a price higher than this, it is overpriced (by $1.59).

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