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The high “supernormal” growth in the first three years and the decrease in growth thereafter signals that we should use a combination of the multi-period and finite dividend growth models (DDM) to value the stock.

Step 1: Determine the dividend stream through year 4

D₁ = $2.00 (given)
D₂ = D₁ × (1 + g) = 2.00 × (1.25) = $2.50
D₃ = D₂ × (1 + g) = $2.50 × (1.25) = $3.13
D₄ = D₃ × (1 + g) = $3.13 × (1.08) = $3.38

Step 2: Calculate the value of the stock at the end of year 3 (using D₄)

P₃ = D₄ / (k_e – g) = $3.38 / (0.15 – 0.08) = $48.29

Step 3: Calculate the PV of each cash flow stream at k_e = 15%, and sum the cash flows. Note: We suggest you clear the financial calculator memory registers before calculating the value. The present value of:

D₁ = 1.74 = 2.00 / (1.15)¹, or FV = -2.00, N = 1, I/Y = 15, PV = 1.74
D₂ = 1.89 = 2.50 / (1.15)², or FV = -2.50, N = 2, I/Y = 15, PV = 1.89
D₃ = 2.06 = 3.13 / (1.15)³, or FV = -3.13, N = 3, I/Y = 15, PV = 2.06
P₃ = 31.75 = 48.29 / (1.15)³, or FV = -48.29, N = 3, I/Y = 15, PV = 31.75
Sum of cash flows = 37.44.
Thus, the stock is undervalued by 37.44 – 31.00 = approximately 6.40.

Note: Future values are entered in a financial calculator as negatives to ensure that the PV result is positive. It does not mean that the cash flows are negative. Also, your calculations may differ slightly due to rounding. Remember that the question asks you to select the closest answer.

If an analyst estimates the intrinsic value for a security that is different from its market value, the analyst should most likely take an investment position based on this difference if:

A)	many analysts independently evaluate the security.

B)	the model used is not highly sensitive to its input values.

C)	the security lacks a liquid market and trades infrequently.

In general, an analyst can be more confident about an estimate of intrinsic value if the model used is not highly sensitive to changes in its inputs. If a large number of analysts follow a security, its market value is more likely to be a reliable estimate of its intrinsic value. A security that does not trade frequently or in a liquid market may remain mispriced for an extended time, and thus may not result in a profit within the investment horizon even if the analyst’s estimate of intrinsic value is correct.