Finance Investment question

Question

Analysts expect dividends to growth 5% for the next 2 years, 10% for the 3 years after that, and then 5% for the indefinite future period after the next 5 years.

 

Analysts just posted EPS of $2.50 per share, and paid out 40% of that to shareholders.

 

beta is 1.15, the expected market return is 10%, and the current Treasury rate is 4%.
 
 
 a) Calculate the firm's required rate of return for use in the intrinsic value estimation:

 

b)Use a multi-growth rate valuation approach to estimate the firm's intrinsic value. 

Use the constant growth version of the DDM at year 5 to calculate the PV of all dividends expected to be paid after year 5.

 

c)If the stock's current market price is above your estimate in c), and you are confident in your analysis, what type of order could you place to make sure you do 

for purchasing the shares?  Specify all aspects of that order.
 
 
 
 
 

Answer 1

Well, first of all, we need to break down the steps:

a) Calculating the Firm's Required Rate of Return

To calculate the firm's required rate of return, we need to use the Capital Asset Pricing Model (CAPM):

Required Rate of Return (r) = Risk-Free Rate + β × (Market Return - Risk-Free Rate)

Given the information:

1. Risk-Free Rate (Treasury Rate) = 4%
2. Beta (β\beta) = 1.15
3. Expected Market Return = 10%

r = 4% + 1.15 × (10% − 4%)

r = 4% + 1.15 × 6%

r = 4% + 6.9%

r=10.9%

So, the firm's required rate of return is 10.9%.

b) Multi-Growth Rate Valuation Approach

First, we will calculate the dividends for the next 5 years, considering the varying growth rates:

1. Dividend at Year 0 (D0) = $2.50 × 0.40 = $1.00

For the next 2 years with a 5% growth rate (remember to keep all the dividend values at least 4 decimal places):

D1 = D0 × (1 + 0.05) = $1.00 × 1.05 = $1.05

D2 = D1 × (1 + 0.05) = $1.05 × 1.05 = $1.1025

For the 3 years after that with a 10% growth rate:

D3 = D2 × (1 + 0.10) = $1.1025 × 1.10 = $1.2128

D4 = D3 × (1 + 0.10) = $1.2128 × 1.10 = $1.3340

D5 = D4 × (1 + 0.10) = $1.3340 × 1.10 = $1.4674

From Year 6 onwards, the dividends grow at a constant rate of 5%. So, at Year 5, we calculate the present value of all future dividends using the Gordon Growth Model (or) Dividend Discount Model (DDM):

P5 = D6 / r−g

D6 = D5 × (1 + 0.05) = $1.4674 × 1.05 = $1.5408

P5 = $1.5408 / (0.109 - 0.05) = $1.5408 / 0.059 = $26.12

Now, we calculate the intrinsic value of the firm which is the present value (PV) of the dividends and the price at Year 5 (P5) by using the required rate of return (r = 10.9%):

PV = D1 / (1+r)1 + D2 / (1+r)² + D3 / (1+r)³ + D4 / (1+r)⁴ + D5 / (1+r)⁵ + P5 / (1+r)⁵

PV = 1.05 / (1.109)¹ + 1.1025 / (1.109)² + 1.2128 / (1.109)³ + 1.3340 / (1.109)⁴ + 1.4674 / (1.109)⁵ + 26.12 / (1.109)⁵

PV = $20.09

c) Placing an Order

If the stock's current market price is above your estimate and you are confident in your analysis, you might consider placing a limit order which nowadays, you can easily do in almost any trading platform.

A limit order allows you to specify the maximum price you're willing to pay for the stock. Here are the aspects you need to specify for your order:

1. Type of Order: Limit Order
2. Number of Shares: Specify the quantity of shares you want to buy.
3. Limit Price: The maximum price per share you are willing to pay.
4. Duration: Specify how long the order should remain active. Options include "Day" (valid for the trading day) or "GTC" (Good 'Til Canceled).

Example: "Place a limit order to buy 100 shares at or below the intrinsic value of the firm which is $20.09 using GTC (Good 'Til Canceled). This ensures that you do not purchase the shares above your estimated intrinsic value. This strategy ensures you don't overpay and provides a buffer for market volatility.