Question

Alan is getting nervous about his stock holding in CraneCo. He bought the stock 11 years ago at $20 per share and the price is now $83.50 per share. CraneCo. has a policy of paying out 25 percent of its earnings in dividends and Alan expects the company to continue earning a 12 percent return on equity. Over the past 12 months, CraneCo. paid $2.75 per share in dividends. Assume the discount rate for CraneCo. is 14%. a. Based on Alan’s projections, is the stock overpriced at $83.50 per share? b. Assume Alan’s projections are correct. Should the firm increase or decrease their payout ratio? Explain your answer.

Answer 1

Current Annual Dividend = $ 2.75, Discount Rate = 14%. Return on Equity (ROE) = 12 % and Dividend PAyout Ratio = 25 %

Retention Ratio = (1-Dividend Payout) = (1-0.25) = 0.75

Therefore, Growth Rate = ROE x Retention Ratio = 12 x 0.75 = 9 %

Expected Dividend = 1.09 x 2.75 = $ 2.9975

Therefore, Intrinsic Price = 2.9975 / (0.14 - 0.09) = $ 59.95

(a) As the intrinsic price is lower than the market price, the stock is overpriced at $ 83.5

(b) As the intrinsic price is below the market price, the firm needs to improve the same to bring the two figures at par. Now two possible solutions are either increasing the retention ratio to improve growth rate or increasing the payout ratio to increase dividends. Since, discount rate is above the ROE, thereby eroding firm value, it is obvious that retained earnings are not generating enough profits. Hence, it makes more sense to reduce retention, increase payouts and boost stock price through discounted values of larger dividends.