Assume the average earnings growth rate on common stock 5.0%. The average divide

Question

Assume the average earnings growth rate on common stock 5.0%. The average dividend payout ratio is 40%, the average earnings on common stock is $7.125, and the average long-run return on common stock is 10.0%. Compute the fair market value of a share of common stock using a Gordon growth DDM for the average markets stock. If the market index equals 5 times the average stock price, and is currently at 300, can you determine whether the market is over-valued, under-valued, or correctly priced? Explain your answer using the numbers you derived.

Explanation / Answer

Average Stock Price=7.125*40%*(1+5%)/(10%-5%)=59.85

Market Index=5*Average Stock Price=5*59.85=299.25

As we see market index is at 300 but its fair value is 299.25 so it is overvalued

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