Question

1. Charles Freeman, portfolio manager for Windsor Fund, was considering the purchase of CISCO’s common stock. Freeman believed that CISCO’s earnings can grow at 20 percent per year over the next five years after which the CISCO’s earnings multiple will fall to a market multiple. Freeman thinks that the risk involved in CISCO’s shares is greater than that for the general market during its high-growth phase and, therefore, the appropriate discount rate to be applied to CISCO’s shares should be 3 percentage points greater than the long-run return from the market over the next five years.

Using the growth-stock valuation model, answer the following two questions

1. What is the proper value of CISCO?

Hint: It is possible to obtain the dividend yield of the S&P by dividing payout of the S&P by its P/E.

2. What growth rate is implied by CISCO’s current price?

Additional information at the time of decision:

• CISCO’s earnings per share (current year)                      $.70
• CISCO’s dividend payout ratio                                            0
• CISCO’s market price                                                   21.00
• P/E for S&P 500 (next year’s earnings)                              20
•                                                                   (you can use this for M_S&P)

• Assume the dividend payout for S&P 500                     30%
• Anticipated long-run growth rate for earnings and dividends S&P 500                                    6½%

                                               g                         (1+g)⁵

                                              .10                          1.61

                                              .11                          1.69

                                              .12                          1.76

                                              .13                          1.84

                                              .14                          1.93

                                              .15                          2.01

                                              .20                          2.49

                                              .25                          3.05

                                              .30                          3.71

                                              .36                          4.65

                                              .40                          6.19

                                              .50                          9.13

Answer 1

A) what is the proper value of Cisco?

Sol:- by the hint given in the question, we can easily calculate the growth rate of S&P as 1.5%, and add 3% premium for calculating the growth rate of Cisco as 1.5%+3% as 4.5%.

Based on earning per share, we can calculate the discounted value (discounted by 4.5%) of future cash flow as:-

year	1	2	3	4	5	sum
Cash Flow	$0.70	$0.84	$1.01	$1.21	$1.45
present value of Earning per shares	$0.67	$0.77	$0.88	$1.01	$1.16	$4.50

so, the current value of cisco's share will be the current value plus the discounted cash flow of future earning as $21+$4.5 = $25.5

B) what growth rate is implied by CIsco's current price?

Sol:-

cisco earning growth	20%	YOY
growth rate of cisco	3%	above market rate
EPS	$0.70
DPR	0%
market price of cisco	$21
P/E for S&P 500	$20.00
Dividend payout for S&P	30%
long term growth rate for earning and dividends S&P 500	6.50%
Growth rate of S&P	1.50%	by dividing dividend payout ratio with P/E of S&P
Growth rate for cisco	4.50%