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In practice, a common way to value a share of stock when a company pays dividends...

In practice, a common way to value a share of stock when a company pays dividends is to value the dividends over the next seven years or so, then find the “terminal” stock price using a benchmark PE ratio. Suppose a company just paid a dividend of $3.50. The dividends are expected to grow at 8 percent over the next seven years. The company has a payout ratio of 35 percent and a benchmark PE of 45. What is the target stock price in seven years? What is the stock price today assuming a required return of 12 percent on this stock?

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Expert Solution

Price of Stock = PV of CFs from it.

Div Calc:

Year CF Formula Calculation
1 $      3.78 D0(1+g) 3.5*1.08
2 $      4.08 D1(1+g) 3.78*1.08
3 $      4.41 D2(1+g) 4.08*1.08
4 $      4.76 D3(1+g) 4.41*1.08
5 $      5.14 D4(1+g) 4.76*1.08
6 $      5.55 D5(1+g) 5.14*1.08
7 $      6.00 D6(1+g) 5.55*1.08

EPS7 = DPS7 / Payout Ratio

= $ 6 / 35%

= $ 17.14

P7 = EPS 7 * PE ratio

= $ 17.14 * 45

= $ 771.22

P0:

Year CF PVF @12% Disc CF
1 $      3.78     0.8929 $      3.38
2 $      4.08     0.7972 $      3.25
3 $      4.41     0.7118 $      3.14
4 $      4.76     0.6355 $      3.03
5 $      5.14     0.5674 $      2.92
6 $      5.55     0.5066 $      2.81
7 $      6.00     0.4523 $      2.71
7 $ 771.22     0.4523 $ 348.86
Price of Stock $ 370.10

jeff jeffy answered 3 months ago
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