Why can't I use DDM here?

[mnieman]

An analyst gathered the following information about a company:

Current dividend per share = $4.2
Expected growth rate for the year = 6%
Risk-free rate of return = 5%
Expected return on the market portfolio = 12%
Beta of the company�s common stock = 1.3

The analyst expects the price of the stock after one year to be $38.5. The value of the company�s stock today is closest to:
Answer choices:
� $37
� $38
� $55

Your choice: $55

Correct Answer: $38

Explanation:
D1 = 4.2 (1 + 0.06) = $4.45

Required return on equity = RF + [β * (RM � RF)]

Required return on equity = 0.05 + [1.3 * (0.12 � 0.05)] = 14.1%

Value of the stock today = (4.45 / 1.141) + (38.5 / 1.141) = $37.64

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I feel like I'm missing something obvious, but why is the DDM model here wrong?? When should I know to discount the cash flows rather than use the DDM? Is there some key word or something that I'm overlooking that should immediately tell me to just discount cash flows rather than use the DDM?

P0 = (D1) / (k - g) ---> [(4.2)(1.06)] / [(.141) - (.06)]



Edited 1 time(s). Last edit at Thursday, December 2, 2010 at 12:04PM by mnieman.

 

[cokecan]

maybe becuase the analyst expects the price to be 38.5

so discount the divident plus the expected price to find the price today

 

[mnieman]

cokecan Wrote:
-------------------------------------------------------
> maybe becuase the analyst expects the price to be
> 38.5
>
> so discount the divident plus the expected price
> to find the price today



That is what I thought, but when do I know which model is the correct one? The answers for both models were there, so it is quite tricky. If they give me the expected price should I always just discount cash flows then??

 

[ohai]

I guess the point is that it's the expected growth rate "for the year", rather than forever. DDM assumes constant growth. Though, I do think they should have been more specific by saying that the answer is based on the analyst's opinion on the future price of the stock.

 

[mriz21]

You should use the one-year DDM here instead of the infinite period DDM (Gordon Growth Model) because you are given the growth rate for the year.
In general remember that there are 3 DDMs:
1) One (or multiple) year DDM: Value=(D1/(1+k) + (P1/(1+k))
2) Infinite period DDM (GGM). P0=D1/k-g
3) Supernormal growth DDM in which you forecast the DVD for each year of non-constant growth and for the first year of constant growth, then you find the value of the stock one period before the DVD that will grow at a constant rate, and you finally find the PV of the exp. DVDs and of the expected future stock price.



Edited 1 time(s). Last edit at Thursday, December 2, 2010 at 12:18PM by mriz21.

 

[wbrocks]

I think because the question states "The analyst expects the price of the stock after one year" you can assume that this is for a one-year holding period DDM valuation.

Patrick
neemonyx.com (or nee.ms)

 

[FinNinja]

mriz is correct, you cannot assume that the dividend will grow at the rate they give you forever. it specifically says "Expected growth rate for the year = 6%" not expected growth forever.

Besides, who would pay $55 for a stock that they expect to be worth $38.50 in one year? If that's the case I say sell that sucker now and buy it back at $38.50 next year!