The growth rate in dividends for IBM for the next five years is expected to be 19 percent. Suppose IBM meets this growth rate in dividends for the next five years and then the dividend growth rate falls to 5 percent indefinately. Assume investors require an 11 percent return on IBM stock. Is the stock priced correctly? What factors could affect your answer?

Question

The growth rate in dividends for IBM for the next five years is expected to be 19 percent. Suppose IBM meets this growth rate in dividends for the next five years and then the dividend growth rate falls to 5 percent indefinately. Assume investors require an 11 percent return on IBM stock. Is the stock priced correctly? What factors could affect your answer?

Answer 1

I believe something is missing. What is the current price of IBM?

Answer 2

To determine if the IBM stock is priced correctly, we need to calculate its intrinsic value using the Dividend Discount Model (DDM). The DDM calculates the present value of future dividends to estimate the stock's worth.

The formula for the DDM is as follows:

V = D1 / (r - g)

Where:
V = Intrinsic value of the stock
D1 = Expected dividend in the next period (D0 * (1 + g))
r = Required rate of return
g = Dividend growth rate

Let's calculate the intrinsic value of IBM stock using the provided information.

First, we need to calculate the expected dividend for year 1 (D1):

D1 = D0 * (1 + g)
D1 = Current dividend * (1 + growth rate)
D1 = Current dividend * (1 + 0.19)

Next, we'll calculate the intrinsic value (V) of the stock:

V = D1 / (r - g)
V = D1 / (0.11 - 0.19)
V = D1 / (-0.08)

Since the dividend growth rate (g) falls to 5% indefinitely after the initial five-year period, we need to evaluate the intrinsic value for two different scenarios: the first five years and the period after that.

For the first five years:

D0: The current dividend
g: Dividend growth rate for the first five years (19%)
r: Required rate of return (11%)

After the first five years:

D0: Dividend at the end of year 5
g: Dividend growth rate indefinitely (5%)
r: Required rate of return (11%)

To determine if the stock is priced correctly, we compare the calculated intrinsic value to the current market price. If the intrinsic value is higher than the market price, the stock is undervalued, and vice versa.

Please note that the accuracy of the calculation depends on the accuracy of the projected growth rates and the required rate of return assumptions. Additionally, other factors, such as changes in market conditions or company performance, could affect the stock's price. It is crucial to regularly reassess the valuation as these factors evolve.