ou are thinking about investing in stock in a company who paid a dividend of $10 this year and whose dividends you expect to grow at 4 percent a year. The risk-free rate is 3 percent and you require a risk premium of 5 percent. If the price of the stock in the market is $200 a share, should you buy it

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Business

Christopher Roth

11 October, 06:34

ou are thinking about investing in stock in a company who paid a dividend of $10 this year and whose dividends you expect to grow at 4 percent a year. The risk-free rate is 3 percent and you require a risk premium of 5 percent. If the price of the stock in the market is $200 a share, should you buy it

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Alexandra Weaver · Answer 1

Yes

Explanation:

To make the decision to buy the share, we first need to calculate the fair value per share today, We can use the Dividend Discount model to estimate today's value of stock based on future cash flow (dividend).

The formula for Price is,

P = D (1 + g) / r - g Where D is dividend today g is the growth rate of dividend r is the required return

We calculate r by adding the risk free rate and stock's risk premium.

r = 3 + 5 = 8%

Now we calculate the stock's fair price today,

P = 10 (1 + 4%) / 8% - 4% ⇒ $260 / share

We compare the Fair price per share with the market price and if the fair price (260) is more then the market price (200), the share is understood to be undervalued and the decision will be to buy the share as in this case.