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NISM Certifications · NISM-Series-X-A: Investment Adviser (Level 1) · Investing in Stocks

Caselet: Meera, a 40-year-old client, expects a stock to pay a dividend of Rs 12 next year. Dividends are expected to grow at a constant 6% per year forever, and Meera's required rate of return is 14%. Using the constant growth dividend discount model, what is the intrinsic value, and what should she do if the stock trades at Rs 170?

The intrinsic value is Rs 150 using D1 divided by required return minus growth, which is 12 divided by 0.08. Since the market price of Rs 170 is above this value, the stock is overvalued and Meera should avoid buying it.

  1. AIntrinsic value Rs 150; stock is overvalued, so avoid buyingCorrect
  2. BIntrinsic value Rs 85.71; stock is overvalued, so avoid buying
  3. CIntrinsic value Rs 150; stock is undervalued, so buy
  4. DIntrinsic value Rs 200; stock is undervalued, so buy

Explanation

Value = D1/(k-g) = 12/(0.14-0.06) = 12/0.08 = Rs 150. Market price Rs 170 exceeds this, so the stock is overvalued. Rs 85.71 comes from dividing by 0.14 alone, and Rs 200 uses k minus g of 6%.

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