In practice, a common way to value a share of stock when a company pays dividend
ID: 2728268 • Letter: I
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 $1.85. The dividends are expected to grow at 10 percent over the next five years. In five years, the estimated payout ratio is 45 percent and the benchmark PE ratio is 35.
What is the target stock price in five years?
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 $1.85. The dividends are expected to grow at 10 percent over the next five years. In five years, the estimated payout ratio is 45 percent and the benchmark PE ratio is 35.
Explanation / Answer
= $ 231.70
Answer Dividend in Fifth Year D5 =1.85*(1.10)5 D5 = 2.98 EPS will be in 5th Year EPS = D5/Payout ratio = 2.98/45% EPS = 6.62 So the terminal Stock price in 5th year will be P5 = Benchmarke PE ratio*EPS = 35*6.62= $ 231.70
If required return is 12.5%, Present value of the target stock P = 2.04/1.125+2.24/1.1252+2.46/1.1253+2.71/1.1254+(2.98+231.70)/1.1255 P = $ 137.23