Question

Financial information on a company has just been published including the following:

Net income	$240 million
Cost of equity	12%
Dividend payout rate (paid at year end)	60%
Common stock shares in issue	20 million

Dividends will increase at a growth rate that steadily drops from 14% to 5% over the next four years, then will increase at 5% thereafter.

The intrinsic value per share using dividend-based valuation techniques is closest to:

$118

$121

$127

$145

Answer 1

The basic finance rule is that value of any asset is equal to "Present Value of All Future Cash Flows".

The Dividend Discount Model is based on Same principle. The value of share today is equal to present value of all future cash flows to be generated from share.

Considering this background in mind, the value of shares will be calculated as under :-

1) Computation of Amt. of Divident Per Share :-

  

Particulars	Year o	Year 1	Year 2	Year 3	Year 4 and after
Growth Rate % (*)	14	11.75	9.5	7.25	5
Net Income (In Millions) (A)	240	268.2	293.68	314.97	6299.41
Common Shares (B) (In Millions)	20	20	20	20	20
Total Earning Per Share (A/B) ( C)	12	13.41	14.68	15.75	314.97
Dividend Per Share (C * 60%) (**)	7.20	8.05	8.81	9.45	188.98

* As per the question instruction the growth rate will decline stealy from 14% to 5% in four years. So every year decline would be 2.25% ((14-5)/4). It is assumed that 14% is growth rate for Year 0 current year.

** Payout ratio of 60% has been given in question hence the same would be applied to total income of per share to calculare Dividend per share.

*** From year 4 and onwards there is growth rate of 5% for infinite period. Hence to calculate present value of all Net Income for infinite period at the end of year 4 we use following formula

Net Income at the end of Year 3/Growth Rate =314.97/5% = 6299.41

2) Computing Value Per Share

Now we have Dividend Income for all the year. The Only task Remaining is to Discount the Divident at Equity cost of 12% as below :-

Year	Dividend	Discount Factor@12%	Present Value
1	8.05	0.893	7.18
2	8.81	0.80	7.02
3	9.45	0.711	6.73
4	188.98	0.64	120.10
Total			141.03

Note :-

The Discounting factor will be calculated by 1/(1+r)^n i.e. For year 1- 1/(1+0.12)^1, for year 2- 1/(1+0.12)^2 and so on.

I have use the excel for all calculations so answer in calculator may differ from above due to rouding off difference but it must be close to above answer.

The Intrinsic Share Value that we have got is $ 141.03 hence most appropriate answer would be Option D ($145). The difference is due to the rouding off errors.

I have used Dividend Discount Model for computing Intrinsic Value per share.