Question

Zylon Corporation’s stock is selling for $48 a share according to The Wall Street Journal. We’ve heard a rumor that the firm will make an exciting new product announcement next week. By studying the industry, we’ve concluded that this new product will support an overall company growth rate of 20% for about two years. After that, we feel growth will slow rapidly and level off at about 6%. The firm currently pays an annual dividend of $2.00, which can be expected to grow with the company. The rate of return on stocks like Zylon is approximately 10%. Is Zylon a good buy at $48? A: We’ll estimate what we think Zylon should be worth given our expectations about growth.

Answer 1

To determine whether Zylon is a good buy, we’ll estimate what it should be worth on the basis of the present value of future cash flows, and compare that result with the listed price. If our valuation is higher, we might conclude that the stock is a bargain and buy it.

The dividend paid recently, D₀, is given as $2.00. The first future dividend is forecast by growing $2.00 at the first year’s growth rate. That’s accomplished by multiplying by 1 plus the growth rate in that year.

D₁ = D₀(1+ g₁) = $2.00(1.20) = $2.40

To get the second year’s dividend we multiply by (1 g₁) again.

D₂ = D₁(1 + g₁) = $2.40(1.20) = $2.88

We do nearly the same thing for D₃. The firm is now growing at rate g₂, which is 6% in this example.

D₃ = D₂(1 + g₂) = $2.88(1.06) = $3.05

Next we use the Gordon model at the point in time where the growth rate changes and constant growth begins. That’s year 2 in this case, so

P₂ = D₃ / k - g₂

= $ 3.05 / 0.10-0.06 = $76.25

All that remains in calculating a price is to take the present value of each of the elements to which a buyer at time zero is entitled and add them up; these are D₁, D₂, and P₂

Now we compare $67.57 with the listed price of $48.00. Clearly our valuation is larger. If our assumptions are correct, the stock should be worth almost $20 more than its current market price. If we’re right, the price will rise substantially in a relatively short time, so we would be wise to buy.