Question

A stock is expected to pay a dividend in 1 year of $3.00. Dividends are expected to grow at a rate of 15% in year 2 and year 3, and then slow down to 4% per year in perpetuity thereafter. The required return is 18%. An analyst mistakenly uses the constant growth dividend discount model and assumes the perpetual growth rate will be 15% forever. By how much does he overestimate or underestimate the stock's actual value?

A. Overestimates by $3.24.

B. Overestimates by $74.63.

C. Underestimates by $74.63.

Answer 1

By how much does he overestimate or underestimate the stock's actual value?
B. Overestimates by $74.63

=3/(18%-15%)-(3/1.18+3/1.18*1.15/1.18+3/1.18*1.15/1.18*1.15/1.18+3/1.18*1.15/1.18*1.15/1.18*1.04/(18%-4%))
=74.6271