Question

Stetson Inc just paid a dividend of D0 = $1.23. Analysts expect the company's dividend to grow by 25% this year, by 20% in Year 2, 12% in Year 3 and at a constant rate of 5% in Year 4 and thereafter. The required return on this low-risk stock is 9.00%. What is the best estimate of the stock's current market value?

Answer 1

Current Dividend = D0 = $1.23

Dividend for year 1 = D1 = D0 x (1+growth rate) = $1.23 x (1+25%) = 1.23 x 1.25 = 1.5375 = 1.54 (rounded to two decimal places)

Dividend in year 2 = D2 = D1 x (1+growth rate) = 1.54 x (1 + 20%) = 1.54 x 1.20 = 1.8480 = 1.85 (rounded to two decimal places)

Dividend in year 3 = D3 = D2 x (1+growth rate) = 1.85 x (1 + 12%) = 1.85 x 1.12 = 2.0720 = 2.07 (rounded to two decimal places)

Dividend in year 4 = D4 = D3 x (1+growth rate) = 2.07 x (1 + 5%) = 2.07 x 1.05 = 2.1735 = 2.17 (rounded to two decimal places)

Now Required rate of return on stock = r = 9%, Growth rate of dividends after year 3 = 5%

P3 = Terminal value of stock at end of year 3

Then according to constant growth rate model.

P3 = D4 / (r - g) = 2.17 / (9% - 5%) = 2.17 / 4% = 54.25

Now P0 = Current market price of stock

P0 = D1/(1+r) + D2/(1+r)² + D3/(1+r)³ + P3/(1+r)³

P0 = 1.54/(1+9%) + 1.85/(1+9%)² + 2.07/(1+9%)³ + 54.25/(1+9%)³

P0 = 1.4128 + 1.5571 + 1.5984 + 41.8909 = 46.4592 = 46.46 (rounded to two decimal places)

Hence, best estimate of the stock's current market value = $46.46