Assume Highline Company has just paid an annual dividend of $ 1.03. Analysts are predicting an 10.5 % per year growth rate in earnings over the next five years. After then, Highline's earnings are expected to grow at the current industry average of 5.3 % per year. If Highline's equity cost of capital is 8.7 % per year and its dividend payout ratio remains constant, for what price does the dividend-discount model predict Highline stock should sell?

The stock should sell for $40.04 today

Explanation:

The current price per share or the fair price can be calculated using the two stage growth model of DDM or Dividend Discount Model. The DDM values a stock based on the present value of the expected future dividends from the stock. The price today can be calculated as follows,

P0 = D1 / (1+r) + D2 / (1+r)^2 + ... + Dn / (1+r)^n  +  [Dn * (1+g2) / (r - g2)] / (1+r)^n

Where,

P0 = 1.03 * (1+0.105) / (1+0.087)  +  1.03 * (1+0.105)^2 / (1+0.087)^2  +  ....  +  

1.03 * (1+0.105)^5 / (1+0.087)^5  +  

[(1.03 * (1+0.105)^5 * (1+0.053)) / (0.087 - 0.053)] / (1+0.087)^5

P0 = $40.04