Question

Omicron Company has just paid a dividend of $2 per share. Analysts of the company’s shares estimate a supernormal growth rate of 30% for the company for the next two years. Afterwards, the company is expected grow at a rate of 15% for another three years, before settling down to a stable growth rate of 7.5% forever. What is Omicron’s share price in two years’ time (after the second year of supernormal growth), assuming a required return of 12%?

Answer 1

According to the given information we can calculate the current market price of the stock as follows

As the stock is growing at a supernormal rate of 30%, which is greater than the required rate of return, we will discount the present value of the future dividends to calculate the current price

As the dividend paid now is $ 2 per share, the dividend in next year will be

= Current Dividend * ( 1+ growth rate )

= 2 * ( 1+30% ) = 2 * 1.30

= $ 2.60 per share

for the second period the dividend is

= 2.60 * ( 1+30% ) = 2.60 * 1.30

= $ 3.38 per share

After 2 years the growth rate drops to 15% for next 3 years

and so on for the third period the dividend is

= 3.38 * ( 1+15% ) = 3.38 * 1.15

= $ 3.89 per share

for the fourth period the dividend is

= 3.89 * ( 1+15% ) = 3.89 * 1.15

= $ 4.47 per share

for the fifth period the dividend is

= 4.47 * ( 1+15% ) = 4.47 * 1.15

= $ 5.27 per share

Now the growth rate will drop to 7.50% per year and remains same in the years there after, therefore the dividend in the sixth period comes out to be

= 5.27 * ( 1+7.50% ) = 5.27 * 1.075

= $ 5.67 per share

Period	Dividend Calculation	Dividend Amount (A)	Discount Rate (rate of return)	Discount Factor [1 / (1+r%)^n ]       (B)	Present Value    ( A * B ) given below for 6th year
1	2 * 1.30	2.60	12%	0.8929	$ 2.32
2	2.60 * 1.30	3.38	12%	0.7972	$ 2.69
3	3.38 * 1.15	3.89	12%	0.7118	$ 2.77
4	3.89 * 1.15	4.47	12%	0.6355	$ 2.84
5	4.47 * 1.15	5.27	12%	0.5674	$ 2.99
6	5.27 * 1.075	5.67	12%		$ 126

** As the growth rate is constant from the sixth year onwards, so the price of the stock in the sixth year is

= Dividend declared / ( Rate of return - growth rate)

= 5.67 / ( 12 - 7.50 ) = 5.67 / 4.50%

= $ 126

So, we will discount the value of share at the end of 6th year to that of the two years where supernormal growth rate of 30% prevailed and then add this to the present values of those 2 years to reach the current price

Discounted value of stock from previous years at current growth rate is

= 126 / (1.075)^2

= $ 109.03

So, the current price of the stock after 2 years of supernormal growth comes out to be:

= $ 2.32 + 2.69 + 109.03

= $ 114.04

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