A portfolio manager is examining shares of Ottawa Industries to determine if the shares are fairly valued. Ottawa Industries common stock is currently trading at
$70 per share on the New York Stock Exchange. In her analysis, the portfolio manager determines the value of Ottawa Industries common stock using the two- stage dividend growth rate model. Due to the release of several important new products, the Company is anticipated to grow at a rate of 16% per year for the next three years. After this supernormal growth rate period, Ottawa Industries is anticipated to return to its long-term growth rate of 12% per year. The Company recently paid an annual dividend of $0.90 per share, and investments of a similar nature have warranted a 13.5% per year rate of return.
Given this information, what is the value of Ottawa Industries common stock? Use the dividend discount model. Additionally, are shares of Ottawa Industries currently overvalued, undervalued, or fairly valued in the stock market?
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A. B. C. D. E. F.Explanation
The multi-stage dividend discount model is a more realistic way of valuing fast-growing companies that pay dividends. With this model, it is necessary to estimate the above-average, or "supernormal," rate of growth, as well as the long-term rate of growth. Once these growth rates have been determined, they are used to calculate the anticipated annual dividends leading up to the "horizon point" at which the growth rate decelerates to the long-run rate of growth.
Incorporating the given information into the two-stage dividend discount model will yield the following
P = {[$0.90 * 1.16) / 1.135] + [($1.044 * 1.16 / 1.28823] + [($1.21104 * 1.16) / 1.46214] + [($1.40481 * 1.12) / (.135 - .12)]/1.46214}
Which can further be developed into:
P = {$0.91982 + $0.94008 + $0.96079 + $71.74} = $74.56
Assuming that the results produced by the multi-stage dividend discount model are accurate, Ottawa industries common stock appears to be undervalued.