Question

In practice, a common way to value a share of stock when a company pays dividends is to value the dividends over the next five years or so, then find the “terminal” stock price using a benchmark PE ratio. Suppose a company just paid a dividend of $2.10. The dividends are expected to grow at 15 percent over the next five years. In five years, the estimated payout ratio is 34 percent and the benchmark PE ratio is 40. a. What is the target stock price in five years? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) b. What is the stock price today assuming a required return of 15 percent on this stock? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Answer 1

Requirement (a). Target stock price in five years

Target stock price in five years = Earnings per share (EPS) in Year 5 x Benchmark P/E Ratio

Earnings per share (EPS) in Year 5 = D5 / Pay-out Ratio

D0 = $2.10 per share

D1 = $2.4150 [$2.10 x 115%]

D2 = $2.7773 [$2.4150 x 115%]

D3 = $3.1938 [$2.7773 x 115%]

D4 = $3.6729 [$3.1938 x 115%]

D5 = $4.2239 [$3.6729 x 115%]

Earnings per share (EPS) in Year 5 = D5 / Pay-out Ratio

= $4.2239 / 0.34

= $12.4231 per share

Target stock price in five years = Earnings per share (EPS) in Year 5 x Benchmark P/E Ratio

= $12.4231 per share x 40 Times

= $496.92

“Hence, Target stock price in five years = $496.92”

Requirement (b) - Stock price today

The stock price today is the aggregate of present value of future dividends and the price at the end of 5^th year

Year	Cash flow ($)	Present Value factor at 15%	Stock price ($)
1	2.4150	0.86957	2.10
2	2.7773	0.75614	2.10
3	3.1938	0.65752	2.10
4	3.6729	0.57175	2.10
5	4.2239	0.49718	2.10
5	496.92	0.49718	247.06
TOTAL			$257.56

“Hence, the Stock price today = $257.56”

NOTE

The Formula for calculating the Present Value Factor is [1/(1 + r)ⁿ], Where “r” is the Discount/Interest Rate and “n” is the number of years.