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.?

Question

Quizplus · Accepted Answer

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.

You Are Considering Investing in ABC, Inc