Question

Q6 A stock of X Co. just gave a dividend of Rs6 per share. Is is expected that dividend will grow by 8.00% over the next 3 years (0-1, 1-2, 2-3years). Beyond 3 years, X co. will be retaining 50% of the earnings and investments in a project which is expected to return a 10% p.a. (EAR) return on equity(ROE) from the investment. This retention ratio of 50% is going to continue forever there after, and the ROE is also expected to continue at 10% p.a. EAR forever thereafter, Hence , growth rate in dividends beyond three years till perpetuity will be 5% p.a.(EAR). The relevant cost of equity capital is estimated at 10% pa. compounded annually. what is the intrinsic value of the stock of X co.? If the market price per share of the stock is Rs. 100, What should be the investment recommendation be related to stock X(buy or sell) ?

Answer 1

Solution:

Calculation of Intrinsic value:

a)First we need to calculate the terminal value(Value at the end of year 3rd) as the growth rate is constant after year 3.Calculation of Terminal value(T3) is as follow:

Dividend for year 1(D1)=Last dividend(1+growth rate)

=Rs6(1+0.08)=Rs 6.48

Dividend for year 2(D2)=Rs6.48(1+0.08)=Rs 6.9984

D3=Rs 6.9984(1+0.08)=Rs7.558272

D4=Rs7.558272(1+0.08)=Rs8.162934

T3=D4/(Cost of equity-growth rate)

=Rs8.162934/(0.10-0.50)

=Rs163.25868

b)Calculation of intrinsic value

Intrinsic value shall be equal to sum of present value of dividend over the three years and present value terminal value.Thus,Intrinsic value is as follow:

=Rs 6.48/(1+0.08)^1+Rs 6.9984/(1+0.08)^2+(Rs7.558272+Rs163.25868)/(1+0.08)^3

=Rs 147.60

Recommendation:Since the market price of stock(Rs 100) is lower than the intrinsic value(Rs 147.60),thus stock shall be considered as undervalued and consequently adivisable to buy.