eddy is considering a stock purchase. the stock pays constant annual dividend of $2.00 per share, and is currently trading at $20 . Eddy's required rate of return for this stock is 12%. should he buy this stock?
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To determine if Eddy should buy this stock, we can use the dividend discount model (DDM) to calculate the intrinsic value of the stock and compare it to the current trading price.
The DDM formula is:
Intrinsic Value = Dividend / (Required Rate of Return - Dividend Growth Rate)
In this case, we know that the annual dividend is $2.00 per share, and Eddy's required rate of return is 12%. However, we don't have information about the dividend growth rate. Without that information, we cannot accurately calculate the intrinsic value of the stock.
If we assume that the dividend growth rate is zero, we can simplify the formula:
Intrinsic Value = Dividend / Required Rate of Return
Plugging in the values:
Intrinsic Value = $2.00 / 0.12 = $16.67
Based on this calculation, the intrinsic value of the stock is $16.67 per share. Since the current trading price is $20, the stock is trading above its intrinsic value.
Therefore, based on the information provided, Eddy should not buy this stock because it is overvalued compared to its intrinsic value.