Question

In practice, a common way to value a share of stock when a company pays dividends is to value the dividends over the next five years or so, then find the “terminal” stock price using a benchmark PE ratio. Suppose a company just paid a dividend of $1.36. The dividends are expected to grow at 13 percent over the next five years. In five years, the estimated payout ratio is 40 percent and the benchmark PE ratio is 19.

a.	What is the target stock price in five years? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)
b.	What is the stock price today assuming a required return of 11 percent on this stock? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)

Answer 1

(a). Current dividend (d) = 1.36; growth rate (g) = 13%

Dividend after 5 years = d*(1+g)^5 = 1.36*(1+13%)^5 = 2.5057

Dividend payout ratio = 40%

Therefore, earnings = dividend/dividend payout ratio = 2.5057/40% = 6.2643

Benchmark P/E = 19

Target price per share = 19*E = 19*6.2643 = 119.02 (Answer)

(b).

Formula	Year (n)	0	1	2	3	4	5
growth of 13% p.a.	Dividend	1.3600	1.5368	1.7366	1.9623	2.2174	2.5057
1/(1+d)^n	Discount factor @11%	1.0000	0.9009	0.8116	0.7312	0.6587	0.5935
		-	1.3845	1.4095	1.4348	1.4607	1.4870
	Stock price	7.1765

Current stock price = $7.18 (Answer)