Question

Your sister-in-law, a stockbroker at Invest Inc., is trying to sell you a stock with a current market price of $25. The stock's last dividend (D0) was $2.00, and earnings and dividends are expected to increase at a constant growth rate of 10%. Your required return on this stock is 20%. From a strict valuation standpoint, you should:

Answer 1

As the current market price is $25 which is more than the fair price $22, the stock is overvalued and should not be purchased.

Step-by-step explanation:

The constant growth rate in the stock's dividends requires to use the constant growth approach/model of the DDM.

The formula for the constant growth model is,

P0 = D0 * ( 1+g) / r - g

Where,

• D0 * (1+g) gives the D1 which is dividend expected for the next period
• r is the required rate of return
• g is the growth rate in dividends

SO, the price of the stock is,

P0 = 2*(1+0.1) / 0.2 - 0.1 = $22

The fair price of the stock based on this model is $22

As the current market price is $25 which is more than the fair price $22, the stock is overvalued and should not be purchased.