Question

Question text

Juan Diaz is contemplating investing in the stock of Indigo Inc, whose stock is currently trading for $18.99 per share. The company has recently commenced its operations and is not expected to pay any dividends for the next four years. The company's EPS currently stands at $2.75 and is expected to grow at a rate of 16% per annum over the next four years. Beginning in Year 5, the company's growth rate is expected to fall to 5% and remain at that level into perpetuity. From Year 5 onward, Indigo is also expected to retain 60% of its earnings and distribute the rest as dividends. Given a required rate of return of 12%, the company's stock is currently most likely:

a. Undervalued.

b. Overvalued.

c. Fairly valued.

Answer 1

EPS end of year 4 =

Future value = present value*(1+ rate)^time

Future value = 2.75*(1+0.16)^4

Future value = 4.98

Dividend year 5

=EPS year 4*(1+year 5 growth rate)*(1-retention ratio) = 4.98*(1+0.05)*(1-0.6)=  2.0916

Price at end of year 4

As per DDM

Price = Dividend in 1 year* (1 + growth rate )/(cost of equity - growth rate)

Price = 2.0916/ (0.12 - 0.05)

Price = 29.88

Intrinsic today

Future value = present value*(1+ rate)^time

29.88 = Present value*(1+0.12)^4

Present value = 18.989

Which is equal to current market price of 18.99 hence fairly valued