Red, Inc., Yellow Corp., and Blue Company each will pay a dividend of $3.10 next year. The growth rate in dividends for all three companies is 4 percent. The required return for each company’s stock is 7 percent, 10 percent, and 13 percent, respectively. What is the stock price for each company?

Red, Inc., Yellow Corp., and Blue Company each will pay a dividend of $3.10 next year. The growth rate in dividends for all three companies is 4 percent. The required return for each company’s stock is 7 percent, 10 percent, and 13 percent, respectively. What is the stock price for each company?

Explanation

Note: Intermediate answers are shown below as rounded, but the full answer was used to complete the calculation.

We can use the constant dividend growth model, which is:

Pt = Dt × (1 + g)/(R – g)

So the price of each company’s stock today is:

Red stock price = $3.10/(.07 − .04) = $103.33

Yellow stock price = $3.10/(.10 − .04) = $51.67

Blue stock price = $3.10/(.13 − .04) = $34.44

As the required return increases, the stock price decreases. This is a function of the time value of money: A higher discount rate decreases the present value of cash flows. It is also important to note that relatively small changes in the required return can have a dramatic impact on the stock price.