Question

Q.2. 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 5th 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

Given, D1=0

D2=$5

For next three years, dividends grow at 5%

D3=$5*(1+5%)=$5.25

D4=$5.25*(1+5%)=$5.51 (rounded off two decimals)

D5=$5.51*(1+5%)=$5.79

from then onwards it gows at 1% at perpetuity

D6=$5.79*(1+1%)=$5.85

Terminal value ay year5=D6/(discount rate-growth rate)=$5.85/(10%-1%)=$64.96

Value of the stock=(D1/(1+10%))+(D2/(1+10%)^2)+(D3/(1+10%)^3)+(D4/(1+10%)^4)+((D5+Terminal value at year5)/(1+10%)^5)

=0+(5/1.1^2)+(5.25/1.1^3)+(5.51/1.1^4)+(70.74/1.1^5)

=0+4.13+3.94+3.77+43.93

=$55.77

The intrinsic value<Market value of $100. hence, Nina has to sell the share