Question

You’ve collected the following information from your favorite financial website.

52-Week Price		Stock (Cur div)	Div Yld %	PE Ratio	Close Price	Net Chg
Hi	Lo
77.40	10.43	Palm Coal .36	2.6	6	13.90	–.24
55.81	33.42	Lake Lead Grp 1.54	3.8	10	40.43	–.01
131.06	70.15	SIR 2.65	3.0	10	89.10	3.07
50.24	13.95	DR Dime .80	5.2	6	15.43	–.26
35.00	20.74	Candy Galore .32	1.5	28	??	.18

According to your research, the growth rate in dividends for SIR for the next five years is expected to be 20 percent. Suppose SIR meets this growth rate in dividends for the next five years and then the dividend growth rate falls to 5.25 percent indefinitely. Assume investors require a return of 14 percent on SIR stock.

According to the dividend growth model, what should the stock price be today? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)
  
Current stock price            $

Based on these assumptions, is the stock currently overvalued, undervalued, or correctly valued?

  

Answer 1

With supernormal dividends, we find the price of the stock when the dividends level off at a constant growth rate, and then find the present value of the future stock price, plus the present value of all dividends during the supernormal growth period. Since the first dividend with constant growth is in Year 6, we can find the price of the stock in Year 5, one year before the constant dividend growth begins as:

P₅ = D₆ / (R – g)

P₅ = D₀(1 + g₁)⁵(1 + g₂) / (R – g)

P₅ = $2.65(1.200)⁵(1.0525) / (0.14 – 0.0525)

P₅ = $79.32

The price of the stock today is the present value of the first five dividends, plus the present value of the Year 5 stock price. The price of the stock today will be:

P₀ = $2.65(1.200) / 1.14 + $2.65(1.200)² / 1.14² + $2.65(1.200)³ / 1.14³ + $2.65(1.200)⁴ / 1.14⁴ + $2.65(1.200)⁵ / 1.14⁵ + $79.32 / 1.14⁵

P₀ = $56.69

2. According to the constant growth model, the stock seems to be overvalued.