Bert's Car Sales is a new firm that is still in a period of rapid growth. The company plans on retaining all of its earnings for the next four years. Five years from now, the company projects paying an annual dividend of $.20 a share and then increasing that amount by 3.5 percent annually thereafter. To value this stock as of today, you would most likely determine the value of the stock years from today before determining today's value. a. 3
b. 4
c. 5
d. 6
e. 7

The correct choice is C)

The most logical thing to do would be to calculate the value of the stock in 5 years time.

Explanation:

This speaks to ones understanding of dividend growth stock valuation models. These tools are used to establish a fair value for a stock by discounting the present value of its future dividends. A commonly used model is the constant growth dividend discount model.

The formula for the DDM, which assumes constant growth in dividends, is provided below.

P0 = D1/(r-g)

Where,

P0 = intrinsic value of stock

D1 = dividend payment one year from today

r = discount rate

g = growth rate

Identifying the correct answer entails establishing a timeline of the expected cash flows. We are given the following information:

t0 = $0

t1 = $0

t2 = $0

t3 = $0

t4 = $0

t5 = $0.20

t6 = $0.20 * 1.035

Given a rate of return, we could use the constant growth dividend discount model to establish the fair value of the firm at t5 (five years from today). Incidentally, to determine today's value, we'd discount it back another five years.

Based on the information above,  we are able to prove that the answer is '5'.

Cheers!

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