In practice, a common way to value a share of stock when a company pays dividend
ID: 2775100 • 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 $1.40. The dividends are expected to grow at 14 percent over the next five years. In five years, the estimated payout ratio is 40 percent and the benchmark PE ratio is 26.
What is the target stock price in five years? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)
What is the stock price today assuming a required return of 12 percent on this stock?
What is the target stock price in five years? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.)
Explanation / Answer
Calculate what is the dividend paid at the end of year 5 as below
D5 = 1.4 * (1+14%)5 = 2.70
Since the payout ratio is 40%, net earnings per share in year 5 would be = 2.7 / 0.4 = 6.75
Benchmark PE is given as 26, we have calculated EPS as 6.75 so Price at the end of year 5 would be
P5 = 26 * 6.75 = 175.50
Discount P5 with 12% discount rate to get present stock price P0
P0 = 175 / (1+12%)5 = 99.58