Question

You have been asked to value the shares of L Corp. You estimate that L's Net Income will be $1 billion in the next 12 months (year 1). You further forecast that L's Net Income will increase by $100 million each year in years 2 to 4. Starting from year 5, you forecast that L's Net Income will grow by 4% per year forever. That is, Net Income in year 5 will be 4% higher than Net Income in year 4, Net Income in year 6 will be 4% higher than Net Income in year 5, and so on. L currently pays out 40% of its Net Income as dividends and share repurchases, and you expect the payout rate to stay constant at this level in the future. You have determined that the appropriate cost of capital for L's equity is 10% (EAR). Levron has 500 million shares outstanding.

a. What is valuation of a share of L stock?

b. You have obtained an analyst report on L Corp. in which the analyst determines L's shares to be worth $20 each. The analyst has made the same forecasts of L's earnings for years 1 to 4 as you made, and the analyst uses the same payout rate and cost of capital as you did. Moreover, the analyst agrees with you that L's earnings will grow at a constant rate from year 5 onward. What constant growth rate did the analyst use for L's earnings from year 5 onward?

Answer 1

First we will get the details of the case

Growth rate = 4%

Payout ratio 40%

WACC = 10%

Shares outstanding = 0.5 bn

Now we will do a simple DCF analysis

Cash Flows
	1	2	3	4	5	6
Net Income	1.00	1.10	1.20	1.30	1.35	1.41
Dividend	0.40	0.44	0.48	0.52	0.54	0.56
Income post dividend	0.60	0.66	0.72	0.78	0.81	0.84
						14.06
Discount Factor	1.10	1.21	1.33	1.46	1.61	1.77
Value	0.55	0.55	0.54	0.53	0.50	0.48
						7.94
NPV	11.08
Stock price	22.16

All the figures are in Billion $

Discount factor is = Wacc *( 1+ Year)

Terminal value caculated = Year 5 cash flow * Terminal growth

NPV = sum of values

Stock price NPV/ shares outstanding

The analyst used a growth rate of -4.5% to come up with a valuation of $20/ share