Question

A company is expected to have earnings of $3.46 per share next year, $4.19 in two years, and $5.58 in three years. The dividend payout ratio is expected to remain at 40% over the next three years. You estimate the risk-free rate to be 5% per year and the expected market risk premium to be 6% per year. In two years, you expect the lagging PE ratio to be 14. The beta of the stock is 0.7. What would be an appropriate estimate of the stock price today? (Answer to the nearest penny, i.e. 55.55 but do not use a $ sign).

Answer 1

The stock price today is the Present Value of Future Cash flows (ie, Present value of future dividends plus Present value of Stock price in year 2)

Step-1, Calculation of Cost of Equity (Ke)

As per CAPM Model, Cost of Equity (Ke) = Rf + [Beta x Market Risk Premium]

= 5.00% + [0.7 x 6.00%]

= 5.00% + 4.20%

= 9.20%

Step-2, Calculation of Future Dividends

Dividend per share = EPS x Dividend Payout Ratio

Dividend in Year 1[D1] = $1.3840 per share [$3.46 x 40%]

Dividend in Year 2[D2] = $1.6760 per share [$4.19 x 40%]

Step-3, Calculation of Stock Price in Year 2

Stock Price in Year 2 = EPS for year 2 x P/E Ratio

= $4.19 x 14 Times

= $58.66 per share

Step-4, Computation of the stock price today

Stock Price Today = D1(1 + Ke)¹ + D2(1 + Ke)² + P2(1 + Ke)²

= $1.3840/(1 + 0.092)¹ + $1.6760/(1 + 0.092)² + $58.66/(1 + 0.092)²

= [$1.3840 / 1.092] + [$1.6760 / 1.19246] + [$58.66 / 1.19246]

= $1.27 + $1.41 + $49.19

= $51.87 per share

“Therefore, the stock price today = $51.87 per share”