Question

A company currently pays a dividend of $4 per share (D₀= $4). It is estimated that the company’s dividend will grow at a rate of 10% per year for the next 2 years, and then at a constant rate of 5% thereafter. The company’s stock has a beta of 1.6, the risk-free rate is 4% and the market risk premium is 2%. What is your estimate of the stock’s current price?

Please show solution in Excel. Thank you!

Answer 1

First we need to calculate the rate of return on equity

Using the CAPM model,

r = R_f + β(ER_m - R_f)

where,

r = return on equity
R_f = Risk-free rate = 4%
β = Beta of the stock = 1.6
ER_m - R_f = market risk premium = 2%

=> r = 4 + 1.6*2 = 7.2%

Calculate in Excel as below -

Let current price of stock be P₀

Let current period be Period 0, and Dividend in Period 0 = D₀

Given D₀ = 4

D₁ = 4*1.10 = 4.40

D₂ = 4.40*1.10 = 4.84

Using Gordon Growth model,

Hence, P₁ = D₂/(r-g) = 4.84/(0.072-0.05) = 220

P₀ = P₁/(1+r) = 220/1.072 = $205.22

Calculate in excel -