Question

Question 5. It is January 1st, 2019 and you are thinking about buying some Warm Inc. stocks. Last year’s earnings per share (EPS) was $3 and the company did not pay any dividend. Earnings are expected to grow at 14% for the next six years (2019 to 2024). The company will pay its first dividend in December 2024, and the dividend will be 50% of its earnings that year. The dividend afterward is expected to grow at a constant rate of 6% per year in perpetuity. If the cost of equity is 10%, how much should you be willing to pay for a share today using the dividend discount model?

Answer 1

Given Information: Cost of equity = 10% , Dividend payout ratio = 50%,

Terminal growth rate / Dividend Growth rate after 2024 = 6%

Solution:

Expected Earnings for Year end 2024 = 3*(1+14%)^6 = $6.5849

Expected Dividend for Year 2024 = Earnings*payout ratio = 6.5849*50% = $3.2924

Stock Price as per Dividend discount model as on 2024 = Dividend*(1+ Dividend Growth rate) / (cost of equity - Dividend growth rate) = 3.2924*(1+6%) / (10% - 6%) = $87.2486

Stock Price as on Jan 2019 = 87.2486/(1+10%)^6 = $49.2495

Price to be paid for buying Warm Inc. Stock is $49.2495/-