Question

Reeves Inc. has recently launched a ramen fusion dish that has received an overwhelmingly positive reaction from the market. In response to this success, the company is reinvesting all of its earnings to fuel further expansion. This past year, the earnings per share stood at $10, and these are anticipated to increase by 20% annually over the next 5 years. However, by the end of the fifth year, it’s expected that competitors will introduce similar products. Consequently, analysts forecast that Reeves will then reduce its reinvestment rate and start distributing 60% of its earnings as dividends. Additionally, from that point onwards, the company’s growth rate is projected to decelerate to a stable 3% per annum. If Reeves’s equity cost of capital is 8%, what is the value of a share today?

Answer 1

The value of a share today for Reeves Inc. is calculated using the present value of future earnings and dividends, considering an initial 20% growth in EPS for five years before a transition to a stable 3% growth with a 60% dividend payout ratio, discounted by an 8% equity cost of capital.

Step-by-step explanation:

To determine the value of a share today for Reeves Inc., we need to calculate the present value of future earnings and dividends. Initially, earnings per share (EPS) are $10, which are expected to grow at 20% per year for the next 5 years. In the terminal phase, starting at the end of the fifth year, Reeves Inc. is anticipated to payout 60% of its earnings as dividends and the growth rate will decelerate to a stable 3%. The equity cost of capital is 8%.

For the first five years, we use the expected growth rate of 20% to forecast EPS, and subsequently use the constant growth model (dividend discount model) with a 3% growth rate and the 60% dividend payout ratio. The value of a share today is the sum of the present value of forecasted dividends during the high-growth phase plus the present value of the terminal value, which represents the dividends growing at a stable rate into perpetuity.

Performing this calculation involves multiple steps, including forecasting EPS for each of the first five years, calculating the expected dividends from the sixth year onwards and discounting these cash flows back to their present value using the 8% equity cost of capital. This valuation approach considers both the reinvestment phase and the payout phase in the company's lifecycle.