Question

Your task is to find the value of a company stock. You have the following information:

a) Investors expect 10 EUR dividend next week. Buying stock today entitles you to receive that dividend

b) Dividends are expected to stay constant for the next three years.

c) However, dividends are expected to start growing 3% a year starting from year 4.

d) Expected return from investments with comparable risk is 13%.

Question:

1. Based on information above, what is the fundamentally justified price of a stock?

2. You observe that the current market price is 95 EUR. What should be your investment strategy given your calculations above. Even if you were not able to estimate the price, you can still describe your course of action

Answer 1

1. Given present divident = 10 Eur so D0 is 10 EUR

For next 3 years it will be constant so D1 D2 D3 =10 EUR Each

Do D4 the dividend will be D3 (1+g) g is the growth rate

so D4= 10*(1+3%)=10.30

Given Expected return from investments with comparable risk Ke = 13%

as per divident discount model

price of the stock at the end of year3=D4/(Ke-g)

=10.30/(13%-3%)=103

Current price of the stock is the present value of all its future dividends untill the dividend growths at constant rate + Present value of the stock price of the year from which dividend grows at constant rate.

present vlaue can be found by using Ke as a dicount rate

using future cashflow= Present cashflow*(1+r)^n so  Present cashflow=future cashflow/(1+r)^n

= Current price of the stock= D0/(1+Ke)^0+ D1/(1+Ke)^1+D2/(1+Ke)^2+D3/(1+Ke)^3+Price/(1+Ke)^3

=10+10/(1+13%)+10/(1+13%)^2+10/(1+13%)^3+103/(1+13%)^3

=104.9957$ or 105Eur

the fundamentally justified price of a stock =105Eur

2. Given the current market price is 95 EUR , but the fundamental justified price of the stock is 105 Euro as calcualted in 1. So the stock is of good quality and currently it is undervalued. The best strategy is to buy the undervalued stock because we can get at cheaper rate. So buy the stock now at 95 Eur.