Question

Consider a growth stock. Laramie Connection (LC) has the following data:
• Expected EPS next year is $6.50;
• Payout ratio is 40%;
• Return on equity (ROE) is 25%
• Costs of capital or discount rate, r = 20%.
A) What is the value of LC's stock? What is the value of LC's growth
opportunity?
B) What happens to the value of LC's stock if the company increases the
payout ratio from 40% to 60%?
C) What is the change in the value of LC's growth opportunity relative to part
(A) answer? Please explain.
D) What happens to the value of LC's stock if the company increases the
payout ratio from 40% to 60%, and its ROE is 10% instead of 25%? What is
the change in the value of LC's growth opportunity relative to part (A) and
part (B) answers? Please explain.

Answer 1

First let's write down the equation to calculate the value of the stock and then let's answer all the three parts:

D₁ = expected dividend

r= discount rate

g= growth rate

Part A)

B) If the company increases the payout ratio from 40% to 60%?

C) Relative to part (A), the value of the stock falls from 52 to 39, this is because, as the payout ratio increases, the growth rate falls leading to a higher value in the denominator which overpowers the higher value in the numerator giving out a lower value to the entire fraction. Intuition behind this is that a company will only increase the payout ratio when it doesn't have enough avenues to invest in and thus not enough incentive to retain profits. When such is the scenario, then  growth opportunities for the company are smaller as implied by the growth rate and thus the value of the stock is lower because risk in the stock is also lower. The company has matured. Going by the principle of high risk and high return, those with a higher growth rate have greater value as there is more scope of greater return in the future and thus such stock are pricier.

D) If the company increases the payout ratio from 40% to 60%, and its ROE is 10% instead of 25%?

Relative to part (A) and part (B), the value of the stock has fallen to 24.375, this is because, as the payout ratio increases, the growth rate falls leading to a higher value in the denominator which overpowers the higher value in the numerator giving out a lower value to the entire fraction and along with that the ROE has fallen to leading to an even bigger value in the denominator as compare to part B. Intuition behind this is that a company will only increase the payout ratio when it doesn't have enough avenues to invest in and thus not enough incentive to retain profits. When such is the scenario, then  growth opportunities for the company are smaller as implied by the growth rate and thus the value of the stock is lower because risk in the stock is also lower. The company has gone even further into maturity. Going by the principle of high risk and high return, those with a higher growth rate have greater value as there is more scope of greater return in the future and thus such stock are pricier.