Question

The current price of a company is $40/share. The dividends per share for years 1, 2, 3 and 4 are forecasted to be $1.0, 1.5, 2.0 and 2.5 respectively. Furthermore, analysts are forecasting EPS to go to $5.00 in four years. Similarly, the PE-multiple is estimated to be 18 in four years.

a) Find the expected return or IRR, the expected price return, the expected dividend return, Using a required rate of 12 %, find the intrinsic value, and finally, is the company undervalued?

Answer 1

	A	Earning Per Share (EPS)in year4	$5
	B	PE-multiple in year 4	18
	C=A*B	Expected Price of share in year 4	$90
		InternalRate of Return:
		Year	Cash Flow
		0	($40)
		1	$1.00
		2	$1.50
		3	$2.00
		4	$92.50	(2.5+90)
		Internal Rate of Return (IRR)	25.54%	(Using IRR function of excel over the cash flow)
		Expected Price Return:
	A	Price in Year 0	$40
	B	Expected Price in Year 4	$90
	C=(B/A)-1	Expected Price Return:	1.25
		Expected Price Return (%)	125%
		Expected annual price return=r
		(1+r)^4=(1+1.25)
		1+r=(2.25^(1/4)=	1.22474487
		Expected annual price return=r	0.22474487
		Expected annual price return=r	22.47%
		Expected Dividend Return
		Year	Cash Flow
		0	($40)
		1	$1.00
		2	$1.50
		3	$2.00
		4	$42.50	(2.5+40)
		Expected Annual Dividend Return	4.31%	(Using IRR function of excel over the cash flow)
		INTRINSIC VALUE
		Present Value (PV) of Cash Flow:
		(Cash Flow)/((1+i)^N)
		i=Discount Rate=12%=0.12
		N=Year of Cash Flow
		Horizontal value in year 4	$90.00
		N	A	B=A/(1.12^N)
		Year	Cash Flow	PV of Cash flow
		1	$1.00	0.892857143
		2	$1.50	1.195790816
		3	$2.00	1.423560496
		4	$2.50	1.588795196
		4	$90.00	57.19662706
			SUM	62.29763071
		Intrinsic Value	$62.30
		Yes, the company is undervalued
		The current price is less than the intrinsic value