Question

Tester Ltd is a fast-growing, dividend-paying corporation. It has just paid a dividend of $1.00 per share. An investment analyst expects its dividend to grow rapidly at 30% for the next five years, and the n at a 5% growth rate for the future years.

a. If the required rate of return is 10%, using a Two-Stage Dividend Growth Model, what is the value of this stock?

b. If the stock’s reported earnings per share (EPS) is $2.00, and the analyst uses a 30x price earnings ratio (P/E) to value the stoc k, what is the value of this stock? What is the target stock price in one year if its dividend payout ratio remains the same?

c. Give two possible reasons for the difference in value of the stock deriving from (a) and (b) above.

Answer 1

.a Value of stock=Present value of future cash flows.

Future Value of cash flow=(Cash flow)/((1+R)^N)

N= Year of cash flow, R=discount rate =Required return=10%=0.1

D0=Dividend just paid=$1.00

D1=D0*(1+0.3)	Dividend Year 1	$1.30
D2=D1*(1+0.3)	Dividend Year 2	$1.69
D3=D2*(1+0.3)	Dividend Year 3	$2.20
D4=D3*(1+0.3)	Dividend Year 4	$2.86
D5=D4*(1+0.3)	Dividend Year 5	$3.71

Growth rate in year 6=5%=0.05

Dividend in year 6=D6=D5*(1+0.05)=3.71*1.05=$3.90

P5=Price in year 5 =D6/(R-0.05)=3.9/(0.1-0.05)=$78

CASH FLOWS AND PRESENT VALUES:

	N	CF	PV=CF/(1,1^N)
	Year	Cash Flow	Present Value
D1	1	$1.30	1.18
D2	2	$1.69	1.40
D3	3	$2.20	1.65
D4	4	$2.86	1.95
D5	5	$3.71	2.31
P5	5	$78	48.43
		SUM	56.92

Value of the stock

$56.92

.b. Earning per share(EPS)=$2.00

P/E ratio=30

Price =30*EPS=30*2=$60

c. Method shown in (a) is the intrinsic “value” of the stock based on fundamental analysis

Method shown in (b) is the “Price” based not historical ratio. There may be divergence between value and price