In: Finance
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.
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 | ||||||||
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