A company currently pays a dividend of $2 per share, D0 = $2. It is estimated that the company’s dividend will grow at a rate of 20% per year for the next 2 years then the dividend will grow at a constant rate of 7% thereafter. The company’s stock has a beta equal to 1.2, the risk-free rate is 7.5%, and the market risk premium is 4%. What is your estimate of the stock’s current price?

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Asked Aug 24, 2019
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A company currently pays a dividend of $2 per share, D0 = $2. It is estimated that the company’s dividend will grow at a rate of 20% per year for the next 2 years then the dividend will grow at a constant rate of 7% thereafter. The company’s stock has a beta equal to 1.2, the risk-free rate is 7.5%, and the market risk premium is 4%. What is your estimate of the stock’s current price?
 

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Expert Answer

Step 1

Price of a stock today = PV of all the future dividends

Cost of equity = Risk free rate + Beta x Market risk premium

Step 2

Hence, cost of equity, Ke = Risk free rate + Beta x Market risk premium = 7.5% + 1.2 x 4% = 12.30%

D0 = $ 2

Dividend growth rate forthe next two years = g' = 20%

Hence, D1 = D0 x (1 + g') = 2 x (1 + 20%) = $ 2.40

D2 = D1 x (1 + g') = 2.40 x (1 + 20%) = 2.40 x (1 + 20%) = $ 2.88

Step 3

Terminal growth rate = growth rate beyond the horizon period = g = 7%

Hence, terminal value at the ...

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