225 ELW Co recently paid a dividend of $0.50 a share. This is $0.10 more than three years ago. Shareholders have a required rate of return of 10%. Using the dividend valuation model and assuming recent dividend growth is expected to continue, what is the current value of a share (to two decimal places)?
Question
225 ELW Co recently paid a dividend of 0.10 more than three years ago. Shareholders have a required rate of return of 10%.
Using the dividend valuation model and assuming recent dividend growth is expected to continue, what is the current value of a share (to two decimal places)?
Solution
The dividend valuation model, also known as the Gordon Growth Model, is used to calculate the intrinsic value of a stock based on a future series of dividends that grow at a constant rate. The formula is:
P = D / (r - g)
where: P = price of the stock D = expected dividend in next year r = required rate of return g = growth rate of dividends
First, we need to calculate the growth rate (g). We know that the dividend three years ago was 0.10 = $0.40. The growth rate can be calculated as follows:
g = (D_recent - D_past) / D_past / number_of_years
g = (0.40) / $0.40 / 3 = 0.0833 or 8.33%
Now we can substitute D, r, and g into the formula. The expected dividend in the next year (D) would be the most recent dividend plus the growth, so D = 0.5417.
P = D / (r - g) = 32.50
So, the current value of a share is $32.50.
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