Question

Jane’s sister-in-law, a stockbroker at Invest, Inc., is trying to get Jane to buy stock of HealthWest, a regional HMO. The stock has a current market price of $25, its last dividend was $2.00, and the company’s earnings and dividends are expected to increase at a constant growth rate of 10 percent. The required return on this stock is 20 percent. From a strict valuation standpoint, should Jane by the stock?

Answer 1

From a strict valuation standpoint, Jane should not buy the stock as it is overvalued.

Step-by-step explanation:

To determine if Jane should buy the stock, we can calculate the intrinsic value of the stock using the constant growth rate formula. The formula is:

Intrinsic Value = Dividend / (Required Return - Growth Rate)

In this case, the dividend is $2.00 and the growth rate is 10%. The required return is 20%. Substituting these values into the formula, we get:

Intrinsic Value = $2.00 / (0.20 - 0.10) = $2.00 / 0.10 = $20.00

The intrinsic value of the stock is $20.00, which is below the current market price of $25. From a strict valuation standpoint, Jane should not buy the stock as it is overvalued.