The dividend discount model assumes the value of a share of common stock is the present
value of all future dividends.
One year holding period
Assume an investor wants to buy a stock, hold it for one year, and then sell it. The company
earned $2.50 a share last year and paid a dividend of $1 a share. The company maintains a 40%
payout ratio over time. Financial analysts suggest the firm will earn about $2.75 per share
during the coming year and will raise its dividend to $1.10 per share. The risk free rate is 10%
and the market risk premium is currently 4%. You project the sale price of this stock a year
from now to be $22.
? Estimate the value of this stock.
? Would you buy this stock?
Multiple holding period
Assume the expected holding period is three years and you estimate the following dividend
payments at the end of each year.
Year 1 – $1.10 per share
The Business School
BUACC3701: Financial Management
Year 2 – $1.20 per share
Year 3 – $1/35 per share
The risk free rate is 10% and the market risk premium is currently 4%. You project the sale
price of this stock at the end of the period to be $34.
? Estimate the value of this stock.
? Would you buy this stock?
1
Infinite period model with supernormal growth
The Brown Company has a current dividend of $2 per share. The following are the expected
annual growth rates for dividends. The required rate of return for the stock is 14%.
Year 1-3: 25%
Year 4-6: 20%
Year 7-9: 15%
Year 10 on: 9%
? Estimate the value of this stock.