Question

Frieda Farfrumter would like to purchase the stock of Farflung Furniture Corp. The company plans to pay a dividend of $3.58 next year and projects that the dividend will grow to $3.89 per share the following year. Frieda plans to be able to sell the stock at the end of that year for $112 per share. She uses the Capital Asset Pricing Model (CAPM) to calculate her required rate of return. The present annual Rate of Return on 10-year U.S. Treasury Notes is 3.6%, the Beta of the company is 1.32, and the expected annual Rate of Return on the stock market for the near future is 16.23%. What is the intrinsic value of the stock ?

Answer 1

required return = risk free rate + (beta * (expected market return - risk free rate))

required return = 3.6% + (1.32 * (16.23% - 3.6%))

required return = 20.2716%

Intrinsic value of stock = present value of next 2 years dividends + present value of selling price after 2 years

present value = future value / (1 + required return)^{number of years}

Intrinsic value of stock = ($3.58 / (1 + 20.2716%)¹) + ($3.89 / (1 + 20.2716%)²) + ($112 / (1 + 20.2716%)²)

Intrinsic value of stock = $83.09