Question

The expected annual cash flow on a restaurant is $300,000 (assume growth = 0%), and my cost of equity capital for restaurants if 33.3% (restaurants are very risky!). What is the maximum price I am willing to pay for that business? A stock has a current dividend of $2.00, a forecasted growth rate of 10%, a beta = 2, market return = 12.4% and the risk-free rate (30 year US T-Bond YTM) = 4%. The current stock price on the NYSE is $15. What is the value of the stock and is the stock over- or under-valued?

Answer 1

Maximum price that we should be willing to pay for the business is as follows:

= Expected Annual cash flows / Cost of equity capital

Expected annual cash flows = $ 300,000

Cost of equity capital = 33.3%

By feeding these values in the above mentioned equation we shall get:

= $ 300,000 / 33.3%

= $ 900,900.90 Approximately

Value of the stock is computed by using the below formula:

= [ Current Dividend ( 1 + growth rate ) ] / ( Cost of equity - growth rate )

Current dividend = $ 2.00

Growth rate = 10%

Cost of equity is computed by using the below mentioned formula:

Risk free rate + Beta ( Return on market - Risk free rate)

= 0.04 + 2 ( 0.124 - 0.04 )

= 0. 208 or 20.8%

By feeding these computed values in the above mentioned formula we shall get stocks price as below:

= [ 2 ( 1 + 0.10 ) ] / (0.208 - 0.10 )

= $ 20.37

The $ 20.37 is the fair value that the stock should trade in the market but the stock is trading at $ 15, hence the stock is undervalued.

Feel free to ask in case of any query relating to this question