Question

Mack Industries just paid a dividend of $1.00 per share. Analysts expect the company's dividend to grow 20% this year and 15% next year. After 2 years the dividend is expected to grow at a constant rate of 5%. The required rate of return on the company's stock is 12%. What is the current price of the company's stock? Also, the stock is currently priced in the market as of today at $20.00 per share. As an investor would you purchase this stock, why?

Answer 1

Year	Dividend	PVF(12%, n)	Present value of dividends
1	1.20	0.893	1.0716
2	1.38	0.797	1.09986
			2.17146

$2.17146 is the present value of dividends expected from the company for the first 2 years.

D₃ = D₂ ( 1 + g )

where,

D₃ = Dividend payable in the third year

D₂ = Dividend payable in the second year

g = Growth rate in dividends

D₃ = 1.38 ( 1 + 0.05)

= 1.38 X 1.05

= $1.449

Price of stock at the end of year 2 will be calculated as under:

P₂ = D₃/(K_e - g)

where,

P₂ = Price of stock at the end of year 2

K_e = Required rate of return

P₂ = 1.449/(0.12 - 0.05)

= 1.449/0.07

= $20.7

Present value of stock = present value of dividends + Present value of stock after 2 years

= 2.17146 + (20.7 x 0.797)

= 2.17146 + 16.4979

= $18.67

Hence, current price of stock is $18.67

If the stock is currently available in the market at $20 per share, it is not advisable to buy the share at this price since stock is over-priced. Expected price of stock as per dividend growth model is $18.67. Since, current market price is more than $18.67, buying share is not a good investment.