Asked by Roberta McGuire on May 17, 2024
Verified
You are considering investing in ABC, Inc.'s stock which is selling at $45.95. Similar stocks return 16%. ABC's last dividend ABC was $4.50 and a 6% constant growth rate is anticipated. Should you purchase ABC, Inc.?
A) No, because the stock is overpriced by $1.75.
B) No, because the stock is overpriced by $3.85.
C) Yes, because the stock is underpriced by $1.75.
D) Yes, because the stock is underpriced by $3.85.
Constant Growth Rate
In finance, it refers to the steady rate at which a company’s dividends or earnings are expected to grow indefinitely.
Similar Stocks
Stocks of companies operating in the same industry or sector, often exhibiting similar price movements and trends.
- Implement dividend growth model strategies to compute stock values.
- Evaluate stock investment decisions based on calculated valuations and market conditions.
Verified Answer
JL
Jeddah Lyn GulaneMay 18, 2024
Final Answer :
C
Explanation :
To determine if the stock is overpriced or underpriced, we need to calculate the intrinsic value (or fair value) of the stock based on the dividend discount model.
Using the formula for constant growth model:
Fair Value = (Dividend/(Rate of Return - Growth Rate)) + Next Year's Estimated Dividend / (Rate of Return - Growth Rate))
= (4.50/(0.16-0.06)) + (4.50 * 1.06)/(1.16 * (0.16-0.06))
= 40.50 + 41.85
= $82.35
Since the intrinsic value of the stock is higher than the market price, ABC, Inc. is underpriced by $1.75 ($82.35 - $45.95). Therefore, it would be a good investment to purchase ABC, Inc.'s stock.
Using the formula for constant growth model:
Fair Value = (Dividend/(Rate of Return - Growth Rate)) + Next Year's Estimated Dividend / (Rate of Return - Growth Rate))
= (4.50/(0.16-0.06)) + (4.50 * 1.06)/(1.16 * (0.16-0.06))
= 40.50 + 41.85
= $82.35
Since the intrinsic value of the stock is higher than the market price, ABC, Inc. is underpriced by $1.75 ($82.35 - $45.95). Therefore, it would be a good investment to purchase ABC, Inc.'s stock.
Learning Objectives
- Implement dividend growth model strategies to compute stock values.
- Evaluate stock investment decisions based on calculated valuations and market conditions.