Question

1. What are the limitations of the dividend discount model?
2. A stock currently pays a dividend of $4 for the year. Expected dividend growth is 20% for the next three years and then growth is expected to revert to 4% thereafter for an indefinite amount of time. The appropriate required rate of return is 10%. What is this stock’s intrinsic value?
3. What is the rate of return on an investment that costs $500 and is sold after 1 year for $560?

Answer 1

Limitations:

1. It can be useful only if the company is paying dividend. and not useful for company's nota paying dividend.

2. It uses many assumptions such as growth rate, Tax rate, Required Ret etc.

3. It assumes DIvidends and Earnings are correlated.

4. It ignores buyback of shares.

Stock Intrinsic Value :

= PV of CFs from it.

DIv calculation:

Year	Particulars	CF	Formula	Calculation
1	D1	$      4.80	D0(1+g)	4*1.2
2	D2	$      5.76	D1(1+g)	4.8*1.2
3	D3	$      6.91	D2(1+g)	5.76*1.2
4	D4	$      7.19	D3(1+g)	6.91*1.04

P3 = D4 / [ Ke - g ]

P3 = Price after 3 Years

D4 = Div after 4 Years

Ke = Required Ret

g = Growth Rate

P3 = $ 7.19 / [ 10% -4% ]

= $ 7.19 / 6%

= $ 119.81

P0:

Year	Particulars	CF	PVF @10%	Disc CF
1	D1	$      4.80	0.9091	$      4.36
2	D2	$      5.76	0.8264	$      4.76
3	D3	$      6.91	0.7513	$      5.19
3	P3	$ 119.81	0.7513	$   90.02
Price of stock Today	$ 104.33

Part 2:

Rate of Ret = [ P1/ P0 ] - 1

= [ 560 / 500 ] - 1

= 1.12 - 1

= 0.12 i.e 12%

Pls do rate, if the answer is correct and comment, if any further assistance is required.