Question

The Digital Electronic Quotation System (DEQS) Corporation pays no cash dividends currently and is not expected to for the next five years. Its latest EPS was $10.50, all of which was reinvested in the company. The firm's expected ROE for the next five years is 19% per year, and during this time it is expected to continue to reinvest all of its earnings. Starting in year 6, the firm's ROE on new investments is expected to fall to 14%, and the company is expected to start paying out 25% of its earnings in cash dividends, which it will continue to do forever after. DEQS's market capitalization rate is 19% per year.

a. What is your estimate of DEQS's intrinsic value per share?
b. Assuming its current market price is equal to its intrinsic value, what do you expect to happen to its price over the next year?

Answer 1

The intrinsic value per share of DEQS is calculated using a discounted cash flow method, considering projected future earnings and dividends discounted at the market capitalization rate. The market price over the next year is expected to align with the company's performance and market expectations, assuming it is currently priced at intrinsic value.

Step-by-step explanation:

To estimate the intrinsic value of DEQS's shares, we must calculate the present value of future earnings that the company expects to reinvest at a return on equity (ROE) of 19% for the next five years, and then at a lower ROE of 14% from year 6 onwards while starting to pay out 25% of its earnings as dividends. This requires employing a discounted cash flow (DCF) valuation method where future earnings are projected based on the stated ROEs for the respective periods and then discounted back to their present values using the company's market capitalization rate of 19%. Assuming that DEQS has 200 shares, after performing the necessary present value (PV) calculations for the expected earnings and dividends and summing them up, we can divide the total PV by the number of shares to arrive at the price per share.

The expected change in the market price over the next year can be anticipated by looking at the forecasted growth in earnings, reinvestment policies, and market expectations. If the market price currently reflects the intrinsic value, the price is expected to change in line with the company's performance and investor expectations. However, this is just a theoretical estimate and actual market prices can be influenced by a multitude of factors.