Consolidated Software does not currently pay any dividends but is expected to start doing so in four years. That is, Consolidated will go for three more years without paying any dividends and then is expected to pay its first dividend ($1) at the end of the 4th year. Once the company starts paying dividends, it is expected to continue to do so. The company is expected to have a dividend payout ratio of 60% and to maintain a return on equity of 20%. Based on the Dividend Discount Model, and given a required rate of return of 12%, what is the maximum price you should be willing to pay for this stock today?

We need to calculate the sustainable growth rate first to calculate the price of the stock using the constant growth model of DDM. The growth rate can be calculated as,

g = ROE * (1 - Dividend Payout Ratio)

g = 0.2 * (1-0.6) = 0.08 or 8%

The price of the stock today can be calculated using the constant growth model of DDM. The formula for price under this model is,

P0 = D1 / r-g

We can calculate the price at year 3 using the dividend D4 that is given to us and discount it back for three periods to calculta the price of the stock today.

P3 = 1 / (0.12 - 0.08)

P3 = 25

P0 = 25 / (1+0.12)^3

P0 = $17.79