In practice, a common way to value a share of stock when a company pays dividend
ID: 2813426 • 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 $1.36. The dividends are expected to grow at 13 percent over the next five years. In five years, the estimated payout ratio is 40 percent and the benchmark PE ratio is 19. a. 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.) b. What is the stock price today assuming a required return of 11 percent on this stock? (Do not round intermediate calculations and round your answer to 2 decimal places, e.g., 32.16.) a. Target stock price in 5 years b. Stock price todayExplanation / Answer
Answer to Part a:
Expected Dividend = Current Dividend * (1 + growth rate)
D1 = $1.3600 * (1 + 0.13) = $1.5368
D2 = $1.5368 * (1 + 0.13) = $1.7366
D3 = $1.7366 * (1 + 0.13) = $1.9624
D4 = $1.9624 * (1 + 0.13) = $2.2175
D5 = $2.2175 * (1 + 0.13) = $2.5058
D5 = EPS5 * Payout Ratio
$2.5058 = EPS5 * 40%
EPS5 = $6.2645
PE Ratio = P5 / EPS5
19 = P5 / $6.2645
P5 = $119.0255
Stock Price in 5 years is $119.03
Answer to Part b:
P0 = $1.5368/1.11 + $1.7366/1.11^2 + $1.9624/1.11^3 + $2.2175/1.11^4 + $2.5058/1.11^5 + $119.03/1.11^5
P0 = $77.82
Stock Price today is $77.82