The Starr Co Just Paid A Dividend Of 215 Per Share On Its Stock T
The Starr Co. just paid a dividend of $2.15 per share on its stock. The dividends are expected to grow at a constant rate of 5% per year, indefinitely. If investors require a return of 11% on the stock, what is the current price? What will the price be in three years? In 15 years? complete, detailed and clear written calculations (including all formulas used) for all three questions. Given: P_t = Div_t / (R - g)
The valuation of a stock with dividends that grow at a constant rate is typically approached using the Gordon Growth Model, also known as the Dividend Discount Model (DDM). This model allows investors to estimate the present and future prices of a stock based on expected dividends, the growth rate of dividends, and the required rate of return. In this analysis, we will systematically compute the current stock price, the projected price in three years, and the price in fifteen years based on the given information.
The problem provides the most recent dividend payment, which is $2.15 per share, and states that the dividends will grow at a constant rate of 5%, or 0.05 annually. Investors require an 11% return, or 0.11, for investing in this stock. The key formula used is:
P_t = Div_t / (R - g) where:
P_t = Price of the stock at time t
Div_t = Dividend at time t
R = required rate of return (11%)
g = dividend growth rate (5%)
The current dividend per share, Div_0, is $2.15. Since dividends grow at a rate g, the expected dividend in one year (Div_1) can be calculated as:
Div_1 = Div_0 * (1 + g) = 2.15 * (1 + 0.05) = 2.15 * 1.05 = 2.2575
Applying the Gordon Growth Model to find the current stock price (P_0), which is based on Div_1:
P_0 = Div_1 / (R - g) = 2.2575 / (0.11 - 0.05) = 2.2575 / 0.06 ≈ 37.625
Hence, the current stock price is approximately $37.63.
Calculating the Price in Three Years (P_3)
To find the stock price three years from now, note that dividends will have grown further. Specifically, Div_3 (the dividend at year 3) is:
Div_3 = Div_0 * (1 + g)^3 = 2.15 * (1.05)^3 ≈ 2.15 * 1.157625 ≈ 2.491
Similarly, the expected dividend in year 4 (Div_4), which is used to compute P_3, is:
Div_4 = Div_0 * (1 + g)^4 ≈ 2.15 * 1.215506 ≈ 2.614
The stock price at year 3, P_3, is based on Div_4:
P_3 = Div_4 / (R - g) ≈ 2.614 / 0.06 ≈ 43.567
Therefore, the projected stock price in three years is approximately $43.57.
Calculating the Price in Fifteen Years (P_15)
The same approach applies for the 15-year horizon. The dividend at year 15 (Div_15) is:
Div_15 = Div_0 * (1 + g)^15 ≈ 2.15 * (1.05)^{15}
Calculating (1.05)^{15}: (1.05)^{15} ≈ e^{15 * ln(1.05)} ≈ e^{15 * 0.04879} ≈ e^{0.7319} ≈ 2.079
Thus:
Div_15 ≈ 2.15 * 2.079 ≈ 4.473
The dividend at year 16 (Div_16) is:
Div_16 = Div_0 * (1 + g)^{16} ≈ 2.15 * (1.05)^{16} ≈ 2.15 * 2.183 ≈ 4.690
Using Div_16 to find P_15:
P_{15} = Div_{16} / (R - g) ≈ 4.690 / 0.06 ≈ 78.167
Therefore, the estimated stock price in fifteen years is approximately $78.17.
The calculated current price reflects the present value of all future dividends growing indefinitely at a 5% rate, discounted at an 11% required rate of return. The significant increase from the current price to the projected prices in three and fifteen years demonstrates the continued growth expectation embedded in the stock's valuation.
Investors use this model for assessing stocks with stable growth patterns, especially firms with predictable dividend policies. However, it’s important to acknowledge that real-world factors like changing growth rates, macroeconomic shifts, and company performance can influence actual stock prices, underscoring the importance of incorporating broader analysis alongside dividend valuation models.
Conclusion
Applying the Gordon Growth Model, we determined that the current stock price of Starr Co. is approximately $37.63, with an expected price of about $43.57 in three years and approximately $78.17 in fifteen years. These calculations underline the importance of understanding dividend growth, discount rates, and how they shape stock valuation and investment decision-making in practice.
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