Question

You are a stock analyst in charge of valuing high-technology firms, and you are expected to come out with buy-sell recommendations for your clients.  You are currently analyzing a firm called etalk.com that specializes in internet-based communication.  You are expecting explosive growth in this area.  However, the company is not currently profitable even though you believe it will be in the future.  Your projections are that the firm will pay no dividends for the next 3 years.  Four years from now, you expect the stock to pay its first dividend of

               $1 per share.  You expect dividends to increase at a rate of 20 percent per year for three years after that. At that point, the industry will start to mature and growth will slow down; dividends will continue to grow at a rate of 10 percent per year for the foreseeable future.

                        The stock is trading on the Stock Exchange for $20 per share. If you believe that the required rate of return is 14 percent, what is your estimate of the value of the stock?  Should you issue a recommendation to buy or to sell?  

Answer 1

Dividends are as follows

Year 4= 1

Year 5= 1*120%=1.2

Year 6= 1.2*120%= 1.44

Year 7= 1.44*120%= 1.728

Year 8= 1.728*110%= 1.9008

Terminal value= P7= D8/(k-g)

=1.9008/ (14%-10%)

= $ 47.52

Intrinsic price= D1/(1+k)+ D2/(1+k)^2 +... (Dn+Pn) /(1+k)^n

= 1/1.14^4+ 1.2/1.14^5+ 1.44/1.14^6+ (1.728+47.52)/1.14^7

= 21.55270616

=$21.55

Issue recommendation to buy since the stock is underpriced in the market.