A stock has an expected dividend growth rate of 4.4%. The firm has just announced a dividend of $1.9 per share, with an ex dividend date 3 days from now.
Investors expect a rate of return of 9% from the stock and the stock is trading at $31.84. Ignoring stock price uncertainty between now and the ex dividend date and expecting the same growth, the stock is:
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A. B. C. D.B
Ignoring stock price uncertainty between now and the ex dividend date, the stock would have a fair price of Po on the ex dividend date, given by Po = D1/(r-g) =
1.9*1.044/(9% - 4.4%) = $43.12. Therefore,the current fair price of the stock is $43.12 + $1.9 = $45.02, which is much greater than the actual trading price of
$31.84. Thus, the stock is under-priced.
Note that the operative phrase in this example is "ignoring all uncertainty between now and the ex dividend date and expecting the same growth." If the market is expecting some negative information about the firm to be released some time in the near future (not necessarily before ex dividend date) or does not believe that the firm will continue to grow at or more than 4.4%, the actual trading price could be a fair price. Hence, you should never blindly apply the DDM.