Illustration of a Constant Growth Stock

by Maestri

Assume that MicroDrive just paid a dividend of $1.15 (that is, D0 $1.15). Its stock has a required rate of return, rs, of 13.4 percent, and investors expect the dividend to grow at a constant 8 percent rate in the future. The estimated dividend one year hence would be D1 $1.15(1.08) $1.24; D2 would be $1.34; and the estimated dividend five years hence would be $1.69:

We could use this procedure to estimate each future dividend, and then use Equation 5-1 to determine the current stock value, ˆP0. In other words, we could find each expected future dividend, calculate its present value, and then sum all the present values to find the intrinsic value of the stock.

Such a process would be time consuming, but we can take a short cut—just insert the illustrative data into Equation 5-2 to find the stock’s intrinsic value, $23: The concept underlying the valuation process for a constant growth stock is graphed in Figure 5-1. Dividends are growing at the rate g 8%, but because rs
g, the present value of each future dividend is declining. For example, the dividend Year 1 is D1 D0(1 g)1 $1.15(1.08) $1.242. However, the present value of this dividend, discounted at 13.4 percent, is PV(D1) $1.242/(1.134)1 $1.095.

Taken From : Five-Minute MBA – Corporate Finance

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