Question

An investor with a required return of 10 percent for very risky investments in common stock has analyzed three firms and must decide which, if any, to purchase. The information is as follows:

                                                 McD             KFC              W

Current Earnings                                 $2.00            $3.00            $6.50

Current Dividend                                $1.20            $2.80            $7.00

Expected annual growth rate in dividends        5%        3%        -2%

and earnings

Current share prices                                   $25        $48        $75

A. What is the maximum price that the investor should pay for each stock based on the dividend-growth model?

B. If the investor does buy stock McD, what is the implied percentage return?

C. If the appropriate P/E ratio is 12, what is the maximum price the investor should pay for each stock? Would your answers be different if the appropriate P/E were 7?

D. What does stock W’s negative growth rate imply?

Answer 1

A.

According to Dividend Growth Mode, Price = Dividend at year1/(Required Rate - Growth Rate)
Dividend at year1 = Current Dividend*Growth Rate

Price of McD = (1.20*1.05)/(.10 - .05) = $25.20
Price of KFC = (2.80*1.03)/(.10-.03) = 41.20
Price of W = 7*(.98)/(.10-(-.02)) =57.17

B.

Implied Return = Dividend at Year 0/Price at which stock is purchased + Growth Rate
= 1.20/25 + 5% = 9.80%

C.

Price to Earning Ratio = Price per share/Earning per share
Therefore, Price = P/E Ratio*Earning Per Share

When P/E = 12

Price of McD = 12*2 = $24
Price of KFC = 12*3 = $36
Price of W = 12*6.50 = $78

Only stock W is underpriced and hence, it can be purchased

When P/E is 7

Price of McD = 7*2 = $14
Price of KFC = 7*3 = $21
Price of W =7*6.50 = $45.50

No stock is underpriced and hence no stock should be purchased.

D.

Negative growth rate in W implies that stock will pay less divdend at the end of each year and growth of the company will be negative. Hence investor should not buy it. He should only buy it when the price is less than the intrinsic value of the stock.