The earnings of Best Forecasting Company are expected to grow at an annual rate of 14%...

The earnings of Best Forecasting Company are expected to grow at an annual rate of 14% over the next five years and then slow to a constant rate of 10% per year. Best currently pays a dividend of $0.55 per share. What is the value of Best stock to an investor who requires a 16% rate of return? If stock has a market price of $15 do you buy?

Expert Solution

Value of Stock = Present value of dividend till year 5 when growth is extraordinary + Present value of price at the end of year 5 when growth becomes stable

D0 (Dividend currently paid) = $0.55

D1 (Year 1) = $0.55 x (1 + g) = $0.55 x (1 + 0.14) = $0.627

D2 (Year 2) = $0.627 x 1.14 = $0.715

D3 = $0.715 x 1.14 = $0.815

D4 = $0.815 x 1.14 = $0.929

D5 = $0.929 x 1.14 = $1.059

P5 (price at the end of year 5) = [D5 x (1 + g)] / (Ke - g) = [$1.059 x (1 + 0.10)] / (0.16 - 0.10) = $19.415

where, D5 = dividend of year 5, g = stable growth, ke = required return

Value of Stock
Particulars	Year	PVF@16%	Amount	Present Value
D1	1	0.862	$0.627	$0.540
D2	2	0.743	$0.715	$0.531
D3	3	0.641	$0.815	$0.522
D4	4	0.552	$0.929	$0.513
D5	5	0.476	$1.059	$0.504
P5	5	0.476	$19.415	$9.242
*Total*				$11.852

If the market price if $15, you would not want to buy as the stock has a value of only $11.852 and is overpriced.

jeff jeffy answered 2 years ago

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