In practice, a common way to value a share of stock when a company pays dividend
ID: 2729019 • 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 $1.35. The dividends are expected to grow at 13 percent over the next five years. In five years, the estimated payout ratio is 35 percent and the benchmark PE ratio is 25.
What is the target stock price in five years? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))
What is the stock price today assuming a required return of 11.5 percent on this stock? (Do not round intermediate calculations and round your final answer to 2 decimal places. (e.g., 32.16))
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 $1.35. The dividends are expected to grow at 13 percent over the next five years. In five years, the estimated payout ratio is 35 percent and the benchmark PE ratio is 25.
Explanation / Answer
(a) Computation of the target stock price in five years.We have,
EPS at 5 years = Dividend paid x (1+ growth rate)n / Dividend payout ratio
EPS at 5 years = 1.35 x ( 1.13)5 / 0.35 = $ 7.11
Stock price = EPS X PE ratio
Stock price = 7.11 x 25 = $ 177.75
Hence, the target stock price at end of 5 years is $ 177.75
(b) Computation of the current stock price.We have,
Current stock price = 177.5 / (1.115)5 = $ 103.06