Question

• Diamond Enterprise is expanding rapidly and currently needs to retain all of its earnings.
• Therefore, the company cannot pay dividends for the first couple of years.
• Considering this, the firm’s management has decided that Diamond Enterprise will start paying dividends, with the first dividend being $2.35 in Year 2.
• Dividends will grow at 40% per year during Years 3 and 4, after which (i.e. from Year 5 onwards) growth will settle at a constant rate of 7% per year.
• The required rate of return on the Diamond Enterprise shares is 11.5%.

1. Calculate the stock’s horizon value. Which year does it fall into?
2. Calculate the value of the stock today.
3. Is this stock worth buying, if its current market price on the New York Stock Exchange is $80.25? Explain.

Answer 1

Solution:

The required rate of return = 11.5%

Dividend is 2.35 in year 2 and it will increase by 40% in year 3 and year 4. Then from year 5 the growth will be 7%.

Part A ) Horizon value is 117.19 and it will fall in year 5

Part B ) Value of stock today is 78.10

Part C ) The current market price is 80.25 while the intrinsic value is 78.10 hence the stock is not worth buying