Concept explainers
Stock Valuation. According to the 2015 Value Line Investment Survey, the growth
To determine: Whether the stock price is correct and the factors that could affect it.
Introduction:
Stock is a type of security in a company which denotes ownership. On issuing stocks, the company can raise the capital.
Stock price is the cost incurred to purchase a security on an exchange. Every investor will be careful on purchasing a stock of the company because the stock price will fluctuate based on the economic market conditions.
Explanation of Solution
Given information:
IB Company has an expected dividend growth rate for next five years, which is 7.5%. In case, the company meets the specified growth rate on dividends for next five years; then dividend growth rate will decline to 5%. The required rate of return is 10% on the company’s stock.
The formula to calculate price of stock in Year 5:
Where,
P5refers to the price of stock of Year 5,
D6 refers to the next period dividend per share that is Year 6,
R refers to the required return on the stock,
g1 refers to the expected growth rate of dividend,
g2 refers to the constant rate of growth,
t refers to the number of years.
The formula to calculate the current stock price:
Where,
P5refers to the price of stock of Year 5,
D6 refers to the next period dividend per share that is Year 6,
R refers to the required return on the stock,
g1 refers to the expected growth rate of dividend,
g2 refers to the constant rate of growth.
Compute the price of stock in Year 5:
Hence, the stock price in Year 5 is $128.13.
Compute the current stock price:
Hence, the current stock price is $99.40. The stock is overvalued as per the constant growth model. Therefore, the stock price does not seem to be correct.
The factors which affect the stock price are as follows:
- Non-constant growth rate
- Long-term growth rate
- Length of non-constant growth
- Required rate of return
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Chapter 7 Solutions
Essentials of Corporate Finance (Mcgraw-hill/Irwin Series in Finance, Insurance, and Real Estate)
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