Question

You are a financial analyst at Bank of America and you have collected following information for Lotus Tech Company. The company has beta of 1.25 and a ROE of 20%. The dividend payout ratio is 50%. Last twelve month earnings were $4 per share. The annual dividend was just paid. The consensus estimate of the coming year’s market return is 13%, and T-bills currently offer a 5% return.

1a. What is the intrinsic value of the stock? (input format: $15.32)
1b. What is PVGO? (input format: $15.32)
1c. Suppose your research convinces you that company will announce momentarily that it will immediately change its dividend payout ratio to 40%. Find the intrinsic value of the stock. (input format: $15.32)

Answer 1

1a. The intrinsic value of the stock can be calculated using the Dividend Discount Model (DDM) formula:
Intrinsic Value = (Dividend / (Required Rate of Return - Dividend Growth Rate))
Given the information provided, we can calculate the required rate of return using the Capital Asset Pricing Model (CAPM) formula:
Required Rate of Return = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate)
Required Rate of Return = 5% + 1.25 * (13% - 5%) = 15%
We can also calculate the dividend growth rate using the formula:
Dividend Growth Rate = ROE * (1 - Dividend Payout Ratio)
Dividend Growth Rate = 20% * (1 - 50%) = 10%
Now we can plug in the values into the DDM formula:
Intrinsic Value = ($4 * 50% / (15% - 10%)) = $40
Therefore, the intrinsic value of the stock is $40.

1b. PVGO (Present Value of Growth Opportunities) is the difference between the intrinsic value of the stock and the no-growth value of the stock. The no-growth value of the stock can be calculated using the formula:
No-Growth Value = (Earnings / Required Rate of Return)
No-Growth Value = ($4 / 15%) = $26.67
PVGO = Intrinsic Value - No-Growth Value = $40 - $26.67 = $13.33
Therefore, the PVGO is $13.33.

1c. If the company changes its dividend payout ratio to 40%, we need to recalculate the dividend growth rate and intrinsic value.
New Dividend Growth Rate = 20% * (1 - 40%) = 12%
New Intrinsic Value = ($4 * 40% / (15% - 12%)) = $53.33
Therefore, the new intrinsic value of the stock is $53.33.