Question

52 Week Price

Hi Lo Stock (Div) Div Yld% PE Ratio Close Price Net Chg

64.60 47.80 Abbot 1.12 1.9 235.6 62.91 -.05

145.94 70.28 Ralph Lauren 2.50 1.8 70.9 139.71 -.62

171.13 139.13 IBM 6.30 4.3 23.8 145.39 .19

91.80 71.96 Duke Energy 3.56 4.9 17.6 74.30 .84

113.19. 96.20. Disney 1.68 1.7 15.5 ?? .10

According to the 2018 Value Line Investment Survey, the growth rate in dividends for IBM for the next five years is expected to be 5 percent. Suppose IBM meets this growth rate in dividends for the next five years and then the dividend growth rate falls to 3.5 percent indefinitely. Assume investors require a return of 10 percent on IBM stock. Is the stock priced correctly? What factors could affect your answer?

Answer 1

Given, last dividend of IBM (D0) = 6.3

The present stock price of IBM should be equal to the present values of its expected future dividends. As this is expected to follow a two-stage growth model, we can find the present value using cash flows as shown below.

Note that at the end of 5th year, it will become a constant growth stock (with g2 = 3.5%) so we can use the constant growth model to calculate the expected share price at end of 5th year and then we can discount it to present value

Formula view:

So the expected fair value of stock price should be around 106.95. But the last closing price of the stock is given to be 145.39 which is more than the calculated value. So the stock is overpriced.

Factors that could affect the answer:

1. If the expected growth rate during the first 5 years changes, the fair value of the stock would change accordingly.

2. If the high growth rate lasts more than the expected 5 years then the stock would be valued more than what we calculated above.