Question

A stock is expected to pay a dividend of $2.50 at the end of the year (i.e., D1 = $2.50), and it should continue to grow at a constant rate of 8% a year. If its required return is 14%, what is the stock's expected price 2 years from today?

Answer 1

The stock's expected price 2 years from today, denoted as P2, can be calculated using the Gordon Growth Model (Dividend Discount Model):

`\[ P_2 = (D_1 * (1 + g))/(r - g) \]`

Substituting the given values:

`\[ P_2 = (2.50 * (1 + 0.08))/(0.14 - 0.08) \]`

`\[ P_2 = (2.70)/(0.06) \]`

`\[ P_2 = $45 \]`

Step-by-step explanation:

The Gordon Growth Model is employed to determine the expected stock price in the future based on its dividends and growth rate. In this case, the model is applied to find the stock's expected price 2 years from today. The formula incorporates the expected dividend at the end of the first year (D1 = $2.50), the growth rate (g = 8%), and the required return (r = 14%).

The calculation involves substituting these values into the formula to arrive at the expected stock price 2 years from today. In this instance, the expected price is $45.

It's crucial to note that the Gordon Growth Model assumes a constant growth rate, making it suitable for companies with stable dividend policies. Additionally, the model provides an estimate and is subject to changes in the company's dividend growth rate or required return.