Question

Adams and Collin Enterprises expect earnings and dividends to grow at a rate of 25% for the next 4 years, after the growth rate in earnings and dividends will fall to 3%. The company's last dividend was $1.25, its beta is 1.20, the market risk premium is 5.50%, and the risk-free rate is 3.00%. What is the current price of the common stock?

1. What is the terminal (or horizon value)?
2. What is the required rate of return by investors?
3. What is the intrinsic price of this company’s stock?
4. If the stock is currently priced at $40.00, given your answer to Question 3, would you purchase this security?

Answer 1

P0 = D0(1+G)/(1+Ke)^1 + D0(1+G)^2/(1+Ke)^2 + …….+ D0(1+G)^n/(1+Ke)^n + Dn(1+Gn)/Ke-Gn

Required Rate of Return (Ke)

Ke = E(r) = Rf + Beta * (Rm-Rf)

= 3 + 1.20*(5.5-3) = 6.00% -- Required Rate of Return

D0 = 1.25, G = 25%, Gn = 3%

Terminal Value = D₄ *(1+Gn) / (Ke-Gn)

= [1.25(1+0.25)^4 * (1+0.03)] / (0.06-0.03) = $104.777

Intrinsic price = 1.25(1+0.25)^1 / (1+0.06)^1 + 1.25(1+0.25)^2 / (1+0.06)^2 + 1.25(1+0.25)^3 / (1+0.06)^3 + 1.25(1+0.25)^4 / (1+0.06)^4 + [1.25(1+0.25)^4 * (1+0.03)] / (0.06-0.03)

= 1.4740 + 1.7383 + 2.0499 + 2.4173 + 104.777 = $112.4565

If the stock price is $40 then we will have to buy the stock since its value is $112.4565. The stock is hugely undervalued