Red, Inc., Yellow Corp., and Blue Company each will pay a dividend of $2.60 next year. The growth rate in dividends for all three companies is 4 percent. The required return for each company’s stock is 6 percent, 9 percent, and 12 percent, respectively.

Problem 8-9 Stock Valuation and Required Return [LO1]
Red, Inc., Yellow Corp., and Blue Company each will pay a dividend of $2.60 next year. The growth rate in dividends for all three companies is 4 percent. The required return for each company’s stock is 6 percent, 9 percent, and 12 percent, respectively. What is the stock price for each company? (Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)

 

Explanation
Note: Intermediate answers are shown below as rounded, but the full answer was used to complete the calculation.

We can use the constant dividend growth model, which is:

Pt = Dt × (1 + g)/(R – g)

So the price of each company’s stock today is:

Red stock price = $2.60/(.06 − .04) = $130.00
Yellow stock price = $2.60/(.09 − .04) = $52.00
Blue stock price = $2.60/(.12 − .04) = $32.50

As the required return increases, the stock price decreases. This is a function of the time value of money: A higher discount rate decreases the present value of cash flows. It is also important to note that relatively small changes in the required return can have a dramatic impact on the stock price.