Question

Bell Beauty Company plc has just paid its annual dividend of $6.00 per share. It has been consistently paying out 30 percent of its earnings in dividends. The beta of the stock of the company is 1.20, the market return is 9.0% and the risk free rate is 4.0%.

(i) Estimate the return to stock and estimate its dividend growth rate.

(ii) Estimate the intrinsic value P of the stock assuming that the dividend growth

you estimated in (i) can be maintained indefinitely and you require the rate of return on stock calculated in (i) above.

(iii) If the market price is $150, state whether the stock is under-valued or over-

valued.

(iv) What P/E ratio would you apply to the company’s earnings? How would you

interpret this ratio?

(v) Explain what the effect of an increase in the payout ratio would be on the

intrinsic value of the company’s shares.

Answer 1

i).

Return on stock can be calculated using CAPM as rf+Beta*(rm-rf)= 4%+1.2(9%-4%)= 10%

Dividend growth rate is calculated as return*(1-Dividend payout ratio)= 10%*(1-30%)= 7%

ii).

Intrinsic value P can be calculated as P= D1/(r-g), shere D1 is dividend paid next year= 6*(1.07)= 6.42

So, P= 6.42/(10%-7%)= $214

iii).

If market price is 150, it is lower than the intrinsic value of 214, so it is undervalued.

iv).

P/E ratio is price per share / earnings per share which will be 150/214= 0.7

As P/E ratio is less than 1, we can interpret that the stoxk is undervalued.

v).

If the payout ratio is increased, under dividend discount model, growth rate of dividends will decrease which results in decrease the intrinsic value of company's shares.