Question

You are the investment manager of a Stock Fund.

You have the following three stocks in portfolio (Eli SuperMarkets (ESM), Kean Luxury Clothing (KLC) and Eds Financial Services (ESF)) and now you need to re-evaluate your positions and make decisions to either buy, hold, sell or maybe even short these stocks.

Please answer the following questions. Use the information mentioned at the bottom of this page.

1. What is the fair value of stock ESM? Explain/Show Calculations.

Stock 1 – Eli SuperMarkets (ESM)

This stock is active in the Food Industry (supermarkets), just paid out a dividend of $1.70 per share, the dividend had a growth rate of 3% over the last 10 years and a required return of 7%. The stock currently trades for $35 on the New York Stock Exchange (NYSE).

Management expects the dividend to grow by a steady 3% for the next 3 years, after which a one-time special dividend will be paid out of $5 per share in year 4. Once the special dividend is paid out in year 4, management expects to pay out a dividend of $2 per share in year 5 and a constant growth rate of 3% into perpetuity.

Answer 1

Dividend is represent as D; D1 is dividend in year 1 & so on; Growth rate (g1), (g2),(g3) & (g6) = 0.03; required return (Ke) = 0.07

D1 = D0*(1+g1) = 1.7*(1+0.03) = 1.7*1.03 = $1.751

D2 = D1*(1+g2) = 1.751*(1+0.03) = 1.751*1.03 = $1.80353

D3 = D2*(1+g3) = 1.80353*(1+0.03) = 1.80353*1.03 = $1.857636; D4 = $5; D5 = $2;

D6 = D5*(1+g6) = 2*(1+0.03) = 2*1.03 = 2.06

Price of the share at the end of year 5 (P5) = D6/(Ke-g6) = 2.06/(0.07-0.03) = 2.06/0.04 = $51.20

Expected price of the stock = {D1/(1+Ke)} + {D2/[(1+Ke)^2]} + {D3/[(1+Ke)^3]} + {D4/[(1+Ke)^4]} + {D5/[(1+Ke)^5]} + {P5/[(1+Ke)^5]} = {1.751/(1+0.07)}+{1.80353/[(1+0.07)^2]}+{1.857636/[(1+0.07)^3]}+{5/[(1+0.07)^4]}+{2/[(1+0.07)^5]}+{51.2/[(1+0.07)^5]} = (1.751/1.07)+{1.80353/[1.07^2]}+{1.857636/[1.07^3]}+{5/[1.07^4]}+{2/[1.07^5]}+{51.2/[1.07^5]} = 1.64+{1.80353/1.1449}+{1.857636/1.225043}+{5/1.31079601}+ {2/1.402551731}+{51.2/1.402551731} = 1.64+1.58+1.52+3.81+1.43+36.50 = $46.48

Currently the stock is trading at $35 on NYSE, which is underpriced hence recommeded to buy the share now.