Question

You are currently thinking about investing in a stock priced at $22.00 per share. The stock recently paid a dividend of $2.40, and its dividend is expected to grow at a rate of 4 percent for the foreseeable future. You normally require a return of 14 percent on stocks of similar risk. Is the stock overpriced, underpriced, or correctly priced?

Answer 1

The stock is underpriced.

Step-by-step explanation:

To determine if a stock is overpriced, underpriced, or correctly priced, we can use the Dividend Discount Model (DDM). The DDM calculates the intrinsic value of a stock based on its expected dividends and the required rate of return. In this case, the stock paid a dividend of $2.40 and is expected to grow at a rate of 4 percent. The required rate of return is 14 percent. Using the DDM, we can calculate the intrinsic value of the stock and compare it to the current price. If the intrinsic value is higher than the current price, the stock is underpriced. If the intrinsic value is lower, it is overpriced. If they are equal, it is correctly priced.

The formula for the DDM is:

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

Let's calculate the intrinsic value:

Intrinsic Value = 2.40 / (0.14 - 0.04) = 30

Since the current stock price is $22.00, which is lower than the intrinsic value of $30, the stock is underpriced.