Question

Question text

Michelle wants to value the stock of Gamma Corporation and gathers the following information:

• Current market price per share = $70
• Current book value per share = $28
• Perpetual ROE = 20%
• Perpetual growth rate = 5%
• Required rate of return on equity = 11%

The stock is most likely:

Select one:

a. Undervalued.

b. Fairly valued.

c. Overvalued.

Answer 1

Perpetual ROE = 20 % and Book Value per Share = BVPS = $ 28

Therefore, Earnings Per Share = E0 = ROE x BVPS = 0.2 x 28 = $ 5.6

Perpetual Growth Rate = g = 5 % = Retention Ratio x ROE

5 = Retention Ratio x 20

Retention Ratio (RR) = 0.25

Dividend Payout Ratio (DPR) = 1-RR = 1-0.25 = 0.75

Dividend Paid = E0 x DPR = 5.6 x 0.75 = $ 4.2

Expected Dividend Next Year = D1 = D0 x (1+g) = 4.2 x (1.05) = $ 4.41

Required Rate of Return = r = 11 %

Intrinsic Price per Share = D1 / (r - g) = 4.41 / (0.11 - 0.05) = $ 73.5

Market Value per Share = $ 70

As the intrinsic price is higher than the prevalent market price, the stock is undervalued.