Question

In practice, a common way to value a share of stock when a company pays dividends is to value the dividends over the next five years or so, then find the "terminal" stock price using a benchmark PE ratio. Suppose a company just paid a dividend of $1.75. The dividends are expected to grow at 21 percent over the next five years. In five years, the estimated payout ratio is 35 percent and the benchmark PE ratio is 33.

Answer 1

1. $427.97
2. $223.22

Step-by-step explanation:

1. Target stock price in 5 years

First find the dividend in the 5th year;

= 1.75 * ( 1 + 21%)⁵

= $4.5390493

The calculate Earnings per Share;

= Dividend in 5th year/ Payout ratio

= 4.5390493 / 35%

= $12.968712

Now calculate the Share price;

= PE ratio * EPS

= 33 * 12.968712

= $427.97

2. Stock Price today assuming required return rate of 15%

This is the present values of all the dividends in addition to the stock price in 5 years.

`= (1.75 * 1.21)/(1.15) + (1.75 * 1.21^(2) )/(1.15^(2) ) + (1.75 * 1.21^(3) )/(1.15^(3)) + (1.75 * 1.21^(4) )/(1.15^(4) ) + (1.75 * 1.21^(5) )/(1.15^(5) ) + (427.967 )/(1.15^(5) )\\\\= 1.841304 + 1.9373724 + 2.0384526999 + 2.374451111856 + 2.2567097149 + 212.775235875\\\\= 223.2235258`

= $223.22