Shares of the Katydid Co. common stock are currently selling for $33.60. The last dividend paid was $1.60 per share. The market rate of return is 10%. At what rate is the dividend growing? Assume the market is in equilibrium.
Dividend Discount Model:
This problem entails utilization of the constant growth dividend discount model, which is also known as the Gordon Growth Model. It is a popular stock valuation model which views the fair value of a stock as the sum of all future dividends, discounted to the present, using an appropriate rate.
Answer and Explanation:
The answer is 5.0%.
The formula for the DDM is provided below.
P0 = D1 / (r - g)
- P0 = intrinsic value of stock
- D1 = dividend payment one year from today
- r = discount rate
- g = growth rate
To solve for g, we must be cognizant of the fact that D1 = D0(1 + g), where D0 is the last dividend paid.
Armed with this awareness, we can structure and solve the problem, using known information, as follows:
$33.60 = $1.60(1 + g) / (0.10 - g) $3.36 - $33.60g = $1.60 + $1.60g $1.76 = $35.2g
g = 0.05 or 5.0%
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from Finance 101: Principles of FinanceChapter 14 / Lesson 3