Question

XYZ Pharmaceutical, Inc. just got FDA approval for their new drug, Viagrina. The company has never paid a dividend, but they expect to pay one for the first time by the end of the year. The expected dividend is $3.00 per share and the company expects that dividend to increase at a rate of 20% for five years. After that, XYZ expects to see its dividend growth limited by the growth rate the US economy, which on average is 4.5% per year. If the required rate of return for other startup pharmaceutical companies like XYZ is 11%, what should be the fair price of XYZ’s stock today?

Answer 1

XYZ's stock price would be composed of two parts. The first part will be the summed present value of the supernormally growing dividends at 20 % per annum for five years. The second part will be the present value of the terminal value of the perpetually growing dividends beginning from the end of year 6.

Year 1 Dividend = D1 = $ 3

D2 = D1 x 1.2 = $ 3.6, D3 = D2 x 1.2 = $ 4.32, D4 = D3 x 1.2 = $ 5.184, D5 = D4 x 1.2 = $ 6.2208 and D6 = 6.2208 x 1.045 = $ 6.500736

Discount Rate = 11 %

Terminal Value of Perpetual Dividends at end of Year 5 = 6.500736 / (0.11 - 0.045) = $ 100.011

PV of TV of Perpetual Dividends at present = P1 = 100.011 / (1.11)^(5) = $ 59.35

Present Value of supernormally growing dividends = P2 = 3 /1.1 + 3.6 / (1.1)^(2) + 4.32 / (1.1)^(3) + 5.184 / (1.1)^(4) + 6.2208 / (1.1)^(5) = $ 16.35

Fair Price of Stock = P1 + P2 = 59.35 +16.35 = $ 75.7