Question

Part 1: Consider the Gordon model of constant growth rate assumption. State briefly what this model says about the value of stocks. In 2018, Walmart paid $2.08 in dividends per share. The stock traded for about $96 per share towards the end of the year. Find out a set of inputs to the Gordon growth model (e.g., the assumed growth rate g and the required rate of return r, that make the intrinsic value of the stock equal to the trading price of $96. There can be many combinations; you just need to find out one such combination by trial and error.

Part 2: Suppose you have 10,000 to invest and you can choose up to five companies' stocks (or fewer) to split this investment. Which companies would you choose so that you create a well-diversified portfolio (usually diversification requires more types of investments, but this is a simpler example)? Review the concept of diversification and the role of correlation in Chapter 8. Defend your choice based on chapter 8.

Answer 1

(1): The Gordon model of constant growth states that intrinsic value of a stock = next expected dividend/(required rate of return – growth rate)

In other words: P0 = D1/(r-g)

The model assumes that dividends are paid annually and the growth rate remains constant.

For the given scenario of Walmart P0 = $96, D0 = $2.08 and we have to determine “r” and “g”. Now D1 = D0*(1+g)

So 96 = 2.08*(1+g)/(r-g)

Or 96r – 96g = 2.08+2.08g

Or 96r = 2.08+98.08g

Or r = 1.02166667g + 2.08/96

Now let’s take g as 2% so r = 1.02166667*2 + 2.08/96

Or r = 4.21%

Thus one such combination is r = 4.21% and g = 2%

(2): The companies that I will select are:

(i) Apple, (ii) GE, (iii) P&G, (iv) AMD and (v) HCA Healthcare

The reason for my selection is that the above companies are all in different industries and hence including them in the portfolio will reduce my risk exposure while maximizing my possible returns. The above selection ensures that there is no concentration in any single sector and by combining the best return generating assets from different sectors I will be able to maximize my returns for a selected level of risk.