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Dear sir,
Can you please help me in solving the below question: (should I solve through first principles?)
The current dividend on a stock is $2 per share and investors require a rate of return of 12%.
What is the price of the stock if dividends are expected to grow at a rate of 20% per year over the next three years and then at a rate of 5% per year from that point onwards.Thanks,
It is a combination of first principles and using the formula.
The market value is the present value of the future expected dividends.
For the first three years, you know what the dividends are:
2 x 1.2 in 1 year
2 x 1.2^2 in 2 years
2 x 1.2^3 in 3 years
These three you discount at the required return of 12% p.a.For the dividends from time 4 onwards, you need to use the formula (because it is a perpetuity). When using the formula:
Do = 2 x 1.2^3; g = 0.05; and r = 0.12.
However, the formula gives the value now if Do is the dividend now. Because Do here is the dividend in 3 years time, the figure from the formula will be the value in 3 years time. So we need to discount the answer from the formula for 3 years at 12%.Then add this figure to the PV of the first three dividends, and you have your answer 🙂
Dear sir,
Thank you very much for such a explanation. I found this solution very easy.
Previously I was using the third formula in the below website:
https://www.zenwealth.com/businessfinanceonline/SV/StockEquations.htmlSo I think I should use your method as the formula is not given in the formula sheet as it is very complex to remember.
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