We can rearrange this formula and

see two very distinct components that are in fact very insightful.

So the first component is if we isolate r, it is going to be the dividend

divided by the price, and that gives us the dividend yield.

That's the first part.

And then, of course, the second part, which is g, the capital gains portion.

If we plug the number into the example that we had,

we have a dividend, expected dividend of $3.

We have a price today of $30, and we know that our

total return, the expected return, was 15%.

And since this is 10%, we also know that

the capital gains component, or g, is 5%.

All right, now let's look at the third case, and

in this case, we're going to look at growth rates that vary over time.

So we call this the non-constant growth model.

Suppose our firm is projecting growth rates of 5% for

the next two years that are going to be followed by 2% growth thereafter.

How do we price stocks in these cases of variable growth?

To find the answer, we'll start with our established method of plotting information

on a timeline and then we are going to use three particular steps to get the answer.

So what about that timeline?

If we draw a timeline, we can see that generally speaking, we have time zero.

And then in this case, we're going to have the next period's dividend,

the following period's dividend.

And until now, we have a growth rate of 5%, which was for the first two periods.

Following this, we had predicted the growth rate of 2% thereafter.

So all we need to do now is to make sure that we at least account for

the next period's dividend, which is D3.

And we also want to calculate the price at this point, which is going to be P2.

And remember, always the price refers to the next period's dividend,

D3, again divided by r minus g.

Right, so

then let's apply the information in the problem with the three step procedure.

Step one.

In step one we forecast the future dividends until they become constant,

as in this case, or zero growth.

So if we do the forecasting, notice for these three periods,

one, two, and three, we have a dividend that is forecasted

to be $3 in the first period that grows by 5%.

So this is going to be 3 times 1.05,

and that gives us $3.15.

And then from thereon to D3, which is going to grow at 2%.

So we're going to take $3.15, and

that will grow at 2%, which gives us a value of $3.21.

That's step one.

Let's move on to step number two.