Question

A stock offers an expected dividend of $3.50, has a required return of 14%, and has

historically exhibited a growth rate of 6%. Its current price is $35.00 and shows no

tendency to change.

1. How can you explain this price based on the constant growth dividend discount

model?

2. Compare valuing common stock and preferred stock.

Answer 1

1) According to Dividend discount model

The Value of share = Dividend / (Required Return - Growth)

= 3.50 / 14% - 6%)

= 3.50 / 8%

= $43.75

The Stock price according to dividend discount model is $43.75 while the current price is $35, which shows that the stock required return has remain unchanged over the period and the company and the investors are expecting growth rate to be lower than 6%. When the growth rate will be 4%, the Share price would be exactly $35.00.

2) The value of the common stock varies according to the different factors which includes the company net earning, dividend yield and the future growth of the company, if all these fundamentals are good then the price of share will likely to outperform otherwise it can go down than intrinsic value, while the preferred stock price depends on the dividend the company pays, the price is not likely affect much by other factors than dividends. The company has to make regular payments of dividends to the preferred stockholders while the dividends of the common shareholders depends on the earnings of the company.

Preferred stock = Dividend / Discount rate (Cost of capital)