A person is considering buying the stock of two home health companies that are s

Question

A person is considering buying the stock of two home health companies that are similar in all respects except the proportion of earnings paid out as dividends. Both companies are expected to earn $6 per sheare in the coming year, but Company D (for dividends) is expected to pay out the entire amount as dividends, while Compasny G (forgrowth) is expected to apy out only one-third of its earnings, or $2 per share. The companiew are equally risky, and their required rate of return is 15 percent. D's constandt growth rate is zero and G's is 8.33 percent. What are the intrinsic values of stock D and G?

Explanation / Answer

Intrinsic value of stock = Dividend next year / (Required return - growth rate) For stock D, dividend next year = $6 Growth rate = 0% Intrinsic value of stock D = 6 / 0.15 = $40.00 For stock G, dividend next year = $2 Growth rate = 8.33% Intrinsic value of stock G = 2 / (0.15 - 0.0833) = $30.00

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