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

Caselet: Meera Iyer, 45, is considering a stock whose next year's dividend is expected to be Rs 18 per share. Dividends are expected to grow at a constant 6% forever. Meera's required rate of return on this stock is 12%. The stock currently trades at Rs 270. Using the constant growth dividend discount model, what is the intrinsic value and what should Meera conclude?

Intrinsic value is Rs 300, found by dividing the expected next dividend of Rs 18 by the difference between the required return 12% and growth 6%. As the market price of Rs 270 is lower, the stock is undervalued and attractive to buy.

  1. ARs 150; stock is overvalued, avoid
  2. BRs 300; stock is undervalued, so it is attractive to buyCorrect
  3. CRs 318; stock is undervalued but risky
  4. DRs 270; stock is fairly valued

Explanation

Value = D1/(k - g) = 18/(0.12 - 0.06) = 18/0.06 = Rs 300. Check: 300 x 0.06 = 18. Market price Rs 270 is below Rs 300, so the stock is undervalued. Rs 150 results from using k alone (18/0.12). Rs 318 wrongly multiplies D1 by (1+g) first, which double counts growth since 18 is already next year's dividend.

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