What are the steps to obtain the expected stock price 5 years from now if stock is currently...

Question:

What are the steps to obtain the expected stock price 5 years from now if stock is currently selling for $62.8 per share. The dividend is projected to increase at a constant rate of 7.5% per year. Required rate of return on the stock is 12%.

Dividend Growth Model

The dividend growth model was given by Sir Gordon and hence also known as the Gordon's Model. According to this model the expected rate of return is equal to the ratio of the expected dividend and the current price of the stock after considering the growth rate. Here, the growth should be constant in nature and the expected dividend is the dividend which is expected that the company will pay in the next period.

Answer and Explanation:


The expected price of the share is $90.16

Explanation

Step 1

Required Rate of Return = (Expected Dividend / Current Price) + Growth Rate

Here,

  • Required Rate of Return = 12%
  • Expected Dividend = ??
  • Current Price = $62.8
  • Growth Rate = 7.5%

So,

12% = (Expected Dividend / $62.8) + 7.5%

Expected Dividend = $2.826


Step 2

Expected dividend after 5 years = Current Expected Dividend * (1 + growth rate)^5

So,

Expected dividend after 5 years = $2.826 * (1 + 0.075)^5 = $4.0571


Step 3

Required Rate of Return = (Expected Dividend after 5 years / Price after 5 years) + Growth Rate

Here,

  • Required Rate of Return = 12%
  • Expected Dividend after 5 years = $4.0571
  • Price after 5 years = ??
  • Growth Rate = 7.5%

So,

12% = ($4.0571 / Price after 5 years) + 7.5%

Price after 5 years = $4.0571 / 4.5% = $90.16



Learn more about this topic:

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The Dividend Growth Model

from Finance 101: Principles of Finance

Chapter 14 / Lesson 3
10K

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