Question

Nina, a lead fundamental analyst was trying to calculate the intrinsic value of ABC Co. stock. She had learnt about dividend discount models as an application of time value of money to price equity instruments. She projected the expected dividends which ABC Co. will be paying. ABC Co. is expected to pay a dividend of $5 at the end of second year with an expected dividend payment of zero for first year. The dividend is expected to grow at 5% p.a. for next 3 years, then (from 5^th year onwards) it will grow at 1% p.a in perpetuity. The discount rate is 10% p.a. compounded annually.

What is the intrinsic value of ABC Co. stock?

If the market price of the security is $100, should Nina give the recommendation to buy it or sell it based on the intrinsic value calculated?   (If intrinsic value> Market price, buy else sell)

Answer 1

Solution:

The share price according to the dividend discount method is $54.09

The market price of the security is $100 and the intrinsic price is $54.09. Intrinsic price is less than the market price hence Nina should give sell recommendation.