Question

In: Finance

Suppose that a firm's recent earnings per share and dividends per share are $5.00 and $1.00,...

Suppose that a firm's recent earnings per share and dividends per share are $5.00 and $1.00, respectively. Both are expected to grow at 5 percent. However, the firm's current P/E ratio of 18 seems high for this growth rate. The P/E ratio is expected to fall to 10 within five years. Compute a value for this stock by first estimating the dividends over the next five years and the stock price in five years. Then discount these cash flows using a 12 percent required rate.

Solutions

Expert Solution

Price of share today = Present value of share price after 5 years + present value of dividend over the years
Dividend = (1+growth rate)*dividend for previous year
Calculation of dividend over next 5 years
Year 1 2 3 4 5 6
Dividend 1*1.05=1.05 1.05*1.05=1.1025 1.1025*1.05=1.1576 1.1576*1.05=1.2155 1.2155*1.05=1.2763 1.2763*1.05=1.3401
Price of stock at the end of year 5 = Dividend for year 6/(Required rate-growth rate)
= $1.3401/(0.12-0.05)
= $1.3401/0.07
= $          19.14
Calculation of present value of dividend and stock price
Year 1 2 3 4 5 Total
a) Dividend 1.05 1.1025 1.1576 1.2155 1.2763
b) Stock Price $19.14
c)=a+b Total cashflow 1.05 1.1025 1.1576 1.2155 20.4163
d) PVF@12% 0.8929 0.7972 0.7118 0.6355 0.5674
e)=c*d PV of cashflow 0.9375 0.8789 0.8240 0.7725 11.5848 $          15.00
Price of stock today is 15.00
There may be little difference due to decimal places
If you have any doubt,pleaseask

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