Question

The dividend discount model is suitable for pricing the price of one stock on the basis of the pricing of other stocks in the same industry (answer yes or no and give explanation for your answer)

Answer 1

No, the statement is not true with regards to the dividend iscount model. In order to understand the reason, the details of explaination is given ahead.

The dividend discount model is a method that is used for predicting the price of a company's stock based on the concept that its present-day price is worth the sum of all of its future dividends when they are discounted to their present value, given the cost of capital we can calculate the present value of the stock, taking into consideration the market risk and return and expected dividend payout.

The Dividend Discount model can help us in determining whether investing in particular stock will be beneficial or not. As if the price obtained by using this model is higher than the current price, it means that the price of the stock is undervalued, which means more returns from the stock will be realised in the future. So it will be beneficial to purchase this stock.

In the contrast to the above, if the price of the stock using the Dividend discount model comes out to be less than the current price, the stock will be considered over-valued, means that the future return from the stock will be less. So decesion not to make investment in this stock should be taken.

In order to explain the above situation, an example is given below:

Assume a company ABC, the stock price of which is $40 paid a dividend of $1.40 per share this year. The company expects dividends to grow at 7 percent per year, and the company's cost of equity capital is 10%.

Here we need to calculate the estimated dividend for the future year which is

= Current year dividend * growth rate of dividend

= 1.40 * 7% = $ 1.50

Now we can calculate the price of stock using Dividend Discount model as follows:

= Estimated Dividend in future year / (Cost of capital - growth rate of dividend)

= 1.50 / (10 - 7)

= 1.50 / 3%

= $ 50

So, as per the Dividend Discount model the current price of stock comes out to be $ 50, which is higher than the present day value. So it will be beneficial to purchase this stock as per the model.

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