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D1D0 (1 + g)
( rs – gL ) ( rs – gL )
=
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Stock Price 1 year from now:
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A B C D E F G H I
Constant Growth Model:
INPUTS:
D0 = $2.00
gL = 6%
D1 = D0 (1 + gL) = $2.12
D1$2.12
( rs – gL ) 0.07
( rs – gL )
D2 = D1 (1+gL) = $2.2472
$2.2472
0.07
Dividend Yield = $2.12 CG Yield = $1.82
$30.29 $30.29
o. Assume that Temp Force has a beta coefficient of 1.2, that the risk-free rate (the yield on T-bonds) is 7.0%, and that the
market risk premium is 5%. What is the required rate of return on the firm’s stock?
P1 =
P1 =
CAPM = rRF + b (rRF – rM)
7% + 1.2(5%) = 13%
n. (3.) What happens if a company has a constant gL which exceeds rs? Will many stocks have expected growth greater than
the required rate of return in the short run (i.e., for the next few years)? In the long run (i.e., forever)? Answer: See Chapter 7
Mini Case Show.
P0 =
=
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g0,1 = 30% Growth rate for Year 1 only.
g1,2 = 25% Growth rate for Year 2 only.
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A B C D E F G H I
Dividend Yield = 7.00% CG Yield = 6.00%
Total Yield =
Dividend
Yield
+
CG
Yield
Total Yield = 13.00%
Rearrange to rate of return formula
$2.12
$30.29
13%
Process for Finding the Value of a Nonconstant Growth Stock
INPUTS:
g2,3 = 15% Growth rate for Year 3 only.
gL = 6%
Growth rate 30% 25% 15% 6% 6%
+
0.06
value, which gives the current estimated stock price.
q. Now assume that the stock is currently selling at $30.29. What is its expected rate of return?
For many companies, it is unreasonable to assume that it grows at a constant growth rate. Hence, valuation for these
companies proves a little more complicated. The valuation process, in this case, requires us to estimate the short-run non-
constant growth rate and predict future dividends. Then, we must estimate a constant long-term growth rate at which the firm
is expected to grow. Generally, we assume that after a certain point of time, all firms begin to grow at a rather constant rate.
Of course, the difficulty in this framework is estimating the short-term growth rate, how long the short-term growth will hold,
=
=
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Total Return = 13.0%
Expected Dividend and CG Yields at t = 3
Dividend Yield = 0.0%
CG Yield = 13.0%
Total Return = 13.0%
The dividend stream would be a perpetuity.
A B C D E F G H I
Year 0 1 2 3 4
Dividends $2.6000 $3.2500 $3.7375
↓ ↓ ↓
D1D2D3 D4
────── ────── ──────
──── =
(1+rs)1(1+rs)2(1+rs)3(rs− gL)
↓
D3 (1+gL)
Expected Dividend and CG Yields at t = 0
Dividend Yield = 5.6%
CG Yield = 7.4%
�
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