Based on the below formula for finding the ROR, how is RM found, where did the 7

Question

Based on the below formula for finding the ROR, how is RM found, where did the 7% come from? Also, in the bottom section, where the explanation say's "growth is greater than Ke, the price of $41.32 is not the true representation." What does Ke, stand for, and is this saying that the stock is over valued? Should the $11.00 value be negative? Can you offer any suggestions as to reasons the price could be so over valued? I'd appreciate as much explanation as you can offer. Thanks.  

Ketuim Zhuoluga CPM. 42 1 4-). (us so ypas truasy Rate) em - Rp = 4.24:). RR = R+ (Rm - R)x P - 2.6 + (4. 245x0.43 - 4.533°) Discount Meelel muaur groupn Model - PO u Po - DI O. 4 2 0-0US33 - 0.084 2 - 10. OD $ the price od 1-3 2s i nauwe tuue kerkuainsate.

Explanation / Answer

Rm is return on market. It might be given in the question.

Ke is cost of equity

As in Dividend Discount model the formula to calculate price of stock is D1/(Ke-g) where D1 is expected dividends, g is growth rate and Ke is cost of equity
As seen in the above formula, if g>Ke then denominator will become negative and hence Price will become negative.

Using the formula, the price would become negative 11 But we know price cannot be negative so price is not the true representation

We cannot say that it is overvalued just by seeing the price calculated from Dividend Discount Model. Discount Model is incorrect in case of high growth companies and hence we can say that in this case Dividend Discount Model is inapproportate to be applied in this case as we dont use Dividend Discount Model in cases where g is greater than Ke. We should use other valuation models in this case and after that only we will be able to comment on overvaluation.

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