In practice, a common way to value a share of stock when a company pays dividend
ID: 2778287 • 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 $1.23. The dividends are expected to grow at 18 percent over the next five years. In five years, the estimated payout ratio is 30 percent and the benchmark PE ratio is 18. After five years, the earnings are expected to grow at 7 percent per year. The required return is 14 percent. Required: What are the projected dividends for each of the next five years? What is the EPS in five years? What is the target stock price in five years? What is the stock price today?Explanation / Answer
Dividend for the next 5 years:
Estimated pay out ratio=0.30
i.e.,Dividends/Total earnings =0.30
Dividends paid =2.81
Total earnings= 2.81/0.30
=$9.3798 rounded to $9.38.
Therefore earning in five years =$9.38.
Benchmark PE ratio =18.
Formula for PE ratio = Market value per share/ Earnings per share
18=Market price per share/Earnings per share
Market price = 18 * Earnings per share
=18*$9.38.
=$168.84.
Therefore, price in five years =$168.84
After five years earnings are expected to grow at 7%
Required return =14%.
current price is arrived by totalling Present values of dividends received for the next four years +the present value of the share at the end of year 5.
Year Dividend 1 1.45 2 1.71 3 2.02 4 2.38 5 2.81