2 Consolidated Software doesn’t currently pay any dividends but is expected to
start doing so in 4 years. That is, Consolidated will go 3 more years without paying
any dividends, and then is expected to pay its first dividend (of $3 per share) in the
fourth year. Once the company starts paying dividends, it’s expected to continue to
do so. The company is expected to have a dividend payout ratio of 40% and to maintain
a return on equity of 20%. Based on the DVM, and given a required rate of
return of 15%, what is the maximum price you should be willing to pay for this
stock today?
To calculate the maximum price you should be willing to pay for the stock today, we can use the Dividend Valuation Model (DVM). The DVM formula is:
P = D / (r - g)
Where:
P = Price you should be willing to pay for the stock today
D = Dividend expected to be paid in the fourth year ($3 per share)
r = Required rate of return (15%)
g = Growth rate of dividends (which is the product of the dividend payout ratio and the return on equity, 40% * 20% = 8%)
Using these values, we can calculate the maximum price:
P = 3 / (0.15 - 0.08)
P = 3 / 0.07
P ≈ 42.86
Therefore, the maximum price you should be willing to pay for this stock today is approximately $42.86 per share.