Question

An analyst uses the constant growth model to evaluate a company with the following data:

• Leverage ratio (asset/equity): 1.5
• Total asset turnover: 1.6
• Current ratio: 1.8
• Net profit margin: 6%
• Dividend payout ratio: 35%
• Earnings per share in the past year: $0.9
• The required rate on equity: 14%

Based on an analysis, the growth rate of the company will drop by 25 percent per year in the next two years and then remain unchanged afterward. Assume that the company will keep its dividend policy unchanged.

1. Determine the growth rate of the company for each of next three years.

Growth rate of the company = Retention ratio x return on equity

Retention ratio = 1 - dividend payout ratio = 1 - 0.35 = 0.65

Return on equity = 14%

Growth rate = 0.65 x 14% = 9.1%

Growth rate in the first year = 9.1% x (1-0.25) = 6.83%

Growth rate in tqhe second year = 6.83% x (1-0.25) = 5.12%

2. Use the multi-period DDM to estimate the intrinsic value of the company’s stock.
3. Suppose after one year, everything else will be unchanged but the required rate on equity will decrease to 13%. What would be your holding period return for the year?

Answer 1

Intrinsic value = present value of dividends + present value of terminal value

dividend in any year = EPS * payout ratio. In year 1, the dividend is current dividend + 6.83%. In year 2, the dividend is year 1 dividend + 5.12%

dividend in year 1 = $0.9 * 35% * 1.0683 = $0.3365

dividend in year 2 = $0.3365 * 1.0512 = $0.3537

terminal value at end of year 1 = year 2 dividend / (required return - constant growth rate)

terminal value at end of year 1 = $0.3537 / (0.14 - 0.0512) = $3.98

Intrinsic value = present of value of year 1 dividend + present value of terminal value

Intrinsic value = ($0.3365 / 1.14) + ($3.98 / 1.14) = $3.80

Intrinsic value after 1 year = terminal value at end of year 1 = $0.3537 / (0.13 - 0.0512) = $4.49

Holding period return = (ending value / beginning value) - 1

Holding period return = ($4.49 / $3.80) - 1 =  0.1816, or 18.16%