Question

If Stock A has has an expected rate of return of 10%, and selling for $25 with an expected growth rate of 7%, and Stock B has an expected rate of return of 12%, and market price of $40 with an expected growth rate of 9% ,do you think these stocks should have the same dividend yield or the same expected return?

Answer 1

We have following formula to calculate the stock price under constant dividend growth model

Stock Price P0 = D0 * (1+g) / (k – g)

Where: (for stock A)      

P0 = the current stock price =$25

D0 = dividend paid =?

k = expected rate of return =10%

g = growth rate = 7%

Therefore,

$25 = D0 *(1+7%)/ (10% -7%)

Or D0 = $25 *3 %/( 1.07) =$0.701

Dividend paid per share is $0.701, therefore

Dividend yield = dividend paid per share/ Current Stock price

= $0.701/$25 = 0.028 or 2.8%

(For stock B)

Stock Price P0 = D0 * (1+g) / (k – g)

Where:

P0 = the current stock price =$40

D0 = dividend paid =?

k = Expected rate of return = 12%

g = growth rate = 9%

Therefore,

$40 = D0 *(1+9%)/ (12% -9%)

Or D0 = $40 *3 %/( 1.09) =$1.101

Dividend paid per share is $1.101, therefore

Dividend yield = dividend paid per share/ Current Stock price

= $1.101/$40 = 0.028 or 2.8%

Therefore we can say that these stocks have the similar dividend yield (2.8% per share) but not the same expected return as the expected return for stock A is 10% and for stock B is 12%.