Question

Your task is to find the value of a company stock. You have the following information:

a) Investors expect 8 EUR dividend next year.

b) Dividends are expected to stay constant for the next four years.

c) However, dividends are expected to start growing 3% a year starting from year 5.

d) Expected return from investments with comparable risk is 13%.

Question:

1. Based on information above, what is the fundamentally justified price of a stock?

2. You observe that the current market price is 70 EUR. What should be your investment strategy given your calculations above. Even if you were not able to estimate the price, you can still describe your course of action

Answer 1

Based on details in the question, we can prepare the below table:

(in EUR)	Year 1	Year 2	Year 3	Year 4
Dividend	8.00	8.00	8.00	8.00
PV of dividend	7.08	6.27	5.54	4.91
Terminal value				82.40
PV of terminal value				50.54

PV of dividend is calculated as:

Year 1: 8 / (1.13) = 7.08; Year 2: 8 / (1.13 ^ 2) = 6.27; Year 3: 8 / (1.13 ^ 3) = 5.54; Year 4: 8 / (1.13 ^ 4) = 4.91

Terminal value in year 4 is calculated using dividend discount model = dividend in year 5 / (discount rate - dividend growth rate) = (8 * 1.03) / (13% - 3%) = 82.40

PV of terminal value = 82.40 / (1.13 ^ 4) = 50.54

1) Intrinsic value of stock = PV of dividends + PV of terminal value = 7.08 + 6.27 + 5.54 + 4.91 + 50.54 = 74.33 EUR

2) As intrinsic value is greater than market price (70 EUR), we would buy the stock