Question

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Q1: Sam Inc.

Sam Inc., is a rapidly growing manufacturing company involved in selling personal computers (PCs), servers, data storage devices, network switches, and software. The most recent annual (2018) dividend payment of Sam was $2.50 per share. The firm’s financial manager expects that these dividends will increase at 8% annual rate over the next three initial growth periods (IGP). At the end of three years (IGP), the firm’s is expected to result in a slowing of the dividend growth rate to 4% per year for the foreseeable future. Assume that the appropriate discount rate is 10%

Required:

1. Discuss three set of actions when the securities are undervalued, overvalued and correctly priced.
2. Estimate the value of Sam’s shares using variable (two-stage) growth model.
3. State clearly any limitations and assumptions that you made in your calculations.

Answer 1

1.Stocks are said to be under-valued when their market price is less than the intrinsic value or book value.Investors who look for value investing, buy stocks at these cheap prices, with a hope to profit huge, by selling it at good prices later. They know that the stock only appears to be under-valued and will pick up.

Stocks are said to be over-valued when it is trading at a higher price , in the market place, than the intrinsic value or book value.Invetsors who look for growth opportunities , sometimes, buy stocks selling at these prices , unmindful of intrinsic value calculations, confident about its growth opportunities. Most often ,the investors sell the over-valued stocks , fearing it may fall down after a period of boom.

Correctly priced stocks almost match the intrinsic value or book value & investors tend to hold them

2.Estimate of the value of Sam’s shares using variable (two-stage) growth model.
Year	0	1	2	3
1.Dividend cash flows(2.5*1.08^1 from yr.1 & so on)	2.5	2.7	2.916	3.14928
2.Terminal Value(P3)
(3.14928*1.04)/(10%-4%)				54.58752
3.Total CFs(1+2)		2.7	2.916	57.7368
4.PV F at 10%(1/1.10^Yr.n)		0.90909	0.82645	0.75131
5.PV at 10%(3*4)		2.45455	2.40992	43.37851
6.NPV/Value per share(sum of row 5)	48.24298
Value per share=	48.24	(ANSWER)

3.Limitations and assumptions that you made in your calculations

a. Main limitation is that this company pays dividends(increasing annually ) & only then, this model can be used.

b. Even though the year 0 dividend is known as $ 2.50 , the next dividend cash flows are all assumed to grow linearly at 8% for the initial growth.

c. We have assumed that the initial growth period is going to last for 3 years--whether it will be more or less, is only a reasonable guess.

d. Similarly, the long-term growth rate as well as the required return, used to discount the dividendcash flows.

e. We have ignored the effects of share buybacks , on per share dividends .