Solutions for In-Class Stock Valuation Examples:

(from “Lecture 22/24/25” notes)

C) Non-Constant Dividend Growth

• some “unusual” dividends, then dividends that follow some pattern

ex. 1: The next 3 dividends are expected to be $.50, $1.00, and $1.50…and
then grow at 5% thereafter. Required return is 10%.

What would you pay for this stock?

The shortest solution:

P0 = .50/(1.10)1 + 1.00/(1.10)2 + P2/(1.10)2

and P2 = D3/(r-g) = 1.50/(.10-.05) = 30.00

So, P0 = $26.07

You should be able to see that the following is equivalent to what is above:
P0 = .50/(1.10)1 + 1.00/(1.10)2 + 1.50/(1.10)3 + P3/(1.10)3

and P3 = D4/(r-g) = 1.50*(1.05)1/(.10-.05) = 31.50

So, P0 = $26.07

We could keep going, but that would mean extra work and the same final answer!
For example, we could find P0 as:
P0 = .50/(1.10)1 + 1.00/(1.10)2 + 1.50/(1.10)3 + D4/(1.10)4 + D5/(1.10)5 + P5/(1.10)5

D4 = 1.50(1.05) = 1.575
D5 = 1.575(1.05) = 1.65375
P5 = D6/(.10-.05) = 1.7364375/(.05) = 34.72875
So, P0 = $26.07 (still!)
 ex. 2 – non-constant growth stock

A new pharmaceutical firm will not pay dividends in years 1 or 2. Three years from
today it will pay a $.25 dividend. The dividend is projected to grow at a rate of 10%
per year for 5 years after that, and then at 5% per year forever afterward. The
required return is 15%.
a) Estimate the current value of the stock.
b) Estimate the stock’s price at the end of the 8th year (P8).

D3 = .25
D4 = .25(1.10)1 = .275
D5 = .25(1.10)2= .3025
D6 = .25(1.10)3= .33275
D7 = .25(1.10)4= .366025
D8 = .25(1.10)5= .40263

Part a)
P0 = D3/(1.15)3 + D4/(1.15)4 + D5/(1.15)5 + D6/(1.15)6 + D7/(1.15)7 + P7/(1.15)7

and P7 = D8/(r-g) = .40263/(.15-.05) = 4.0263

So, P0 ≈ $2.27
• This is the shortest solution… use the Gordon Growth formula as early as
possible… in this case from D8 onward we are assuming constant growth in the
dividend, so we can put D8 in the formula and account for the earlier dividends
separately as lump sums.
• Note that if you separately value dividends beyond D7 that will also work (you
would need to adjust what you enter in the Gordon Growth formula) – you
should still get a P0 estimate of $2.27 (see the previous example here for a
similar expansion).

Part b)
• The estimated price at year 8 should be the Present Value at that point of all
future dividends (D9 and beyond). We are assuming constant dividend growth
forever starting with D8, so any price P7 or beyond can be estimated using the
Gordon Growth formula immediately:

P8 = D9/(r-g) = .40263(1.05)1/(.15-.05) = .42276/.10 = $4.23