IBM has generated annual dividend growth of 15.1% over the past 3 years. IBM\'s
ID: 2759074 • Letter: I
Question
IBM has generated annual dividend growth of 15.1% over the past 3 years. IBM's most recent annual dividend is $2.90. Assume IBM will continue to increase dividends at 15.1% for the next 5 years before reducing its dividend growth to 6% for the long term. Also assume that the required return for IBM stock is 9.5%. It is currently trading for $179.90.
1) Use the two-stage dividend discount model to determine the current intrinsic value for IBM given these assumptions.
2) Is the stock overvalued or undervalued? Briefly explain the possible reasons for your response.
3) What long term dividend growth rate will provide an intrinsic value similar to the current market price? (Leave all other assumptions in place.)
4) Reset the long term dividend growth rate to 6%.
5) What required rate of return would provide an intrinsic value similar to the current market price? (Leave all other assumptions in place.)
Explanation / Answer
Dividend for first five years = Dividend in previous year + (Dividend in previous year x 15.1%)
Using above formula, the dividends are:
Year
Dividend
1
$3.34
2
$3.84
3
$4.42
4
$5.09
5
$5.86
Now we need to calculate the PVs of all dividends. Formula is: Dividend / (1+Ke)period
Present value of dividends = [($3.34)/(1.095)1] + [($3.84)/(1.095)2] + [($4.42)/(1.095)3] + [($5.09)/(1.095)4] + [($5.86)/(1.095)5] = $16.88
Now we need to terminal value of stock. Formula is:
[Dividend in Year 5 x (1+Long term growth)] / (Ke – G)
[$5.86*(1.06)] / (0.095 – 0.06) = $177.42
Present Value of the terminal value = $177.42/ (1.095)5 = $112.70
So, the current intrinsic value = PV of all dividends + PV of terminal value = $16.88 + $112.70 = $129.58
As the intrinsic value of the stock is lower than the current market price, the stock is over-valued.
For intrinsic value to be similar to current market price, PV of the terminal value must be:
$179.90 - $16.88 = $163.02
So, the terminal value must be: $163.02 x (1.095)5 = $256.63
So, we solve for the growth rate:
$256.63 = [$5.86*(1+G)] / (0.095 – G)
=> 24.37985 – 256.63G = 5.86 + 5.86G
=> G = 0.07 or 7%
So, the growth rate must be 7%.
The answer is similar to part 1 as the dividend growth is 6% in both the cases.
Year
Dividend
1
$3.34
2
$3.84
3
$4.42
4
$5.09
5
$5.86