Question

a) 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 2 years. Three years from now, you expect the stock to pay its first dividend of $1.50 per share. You expect dividends to increase at a rate of 10 percent per year for two 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 5 percent per year for the foreseeable future.
The stock is trading on the Sauder Stock Exchange for $15 per share. If you believe that the required rate of return is 12 percent, what is your estimate of the value of the stock, and should you issue a recommendation to buy or to sell?

b) The day after you make your estimate in part (a), new information indicates that things are not going as smoothly as predicted for this business. Based on the new information, you have revised your estimates. You now estimate that the firm will pay its first dividend ($1) in 4 years. You estimate dividends will grow at 8% for two years after that. Thereafter, you expect dividends to grow indefinitely at 4%.

Given a required rate of return of 12 percent, what is your new estimate of the value of the stock. Should you change your recommendation (assuming the stock is still trading for $15)?

Answer 1

(a): Based on the provided growth rates the dividends will be:

Year	Dividends
0
1
2
3	1.5
4	1.65
5	1.815
6	1.90575

Value of stock in 6th year = (1.90575*1.05)/(0.12 - 0.05)

= $28.58625

Thus intrinsic price of the stock = 1.5/1.12^3 + 1.65/1.12^4 + 1.815/1.12^5 + 1.90575/1.12^6 + 28.58625/1.12^6

= $18.59435. This can be rounded to 2 decimal places to $18.59

As the current price of $15 < intrinsic value of $18.59 the stock should be bought as it is undervalued in the market.

(b):  

Year	Dividends
0
1
2
3	0
4	1
5	1.080
6	1.16640
7	1.213056

Value of stock in 7th year = 1.213056*1.04/(0.12-0.04) = 15.769728

Thus intrinsic value of stock = 1/1.12^4 + 1.08/1.12^5 + 1.1664/1.12^6 + 1.213056/1.12^7 + 15.769728/1.12^7

= $9.52142. This can be rounded to 2 decimal place of $9.52

As the current market price of $15 > intrinsic value of $9.52 the stock should be sold as it is overvalued in the market.