Question

In practice, a common way to value a share of stock when a company pays dividends is to value the dividends over the next five years or so, then find the "terminal" stock price using a benchmark PE ratio. Suppose a company just paid a dividend of $1.15. The dividends are expected to grow at 10 percent over the next five years. The company has a payout ratio of 40 percent and a benchmark PE of 19. The required return is 11 percent. a. What is the target stock price in five years? b. What is the stock price today?

Answer 1

Answer and Explanation:

The computation is shown below:

a. The Target stock price in five years is

As we know that

Target stock price in five years = Earnings per share in Year 5 × Benchmark P/E Ratio

where,

Earnings per share in Year 5 is

= D5 ÷ Pay-out Ratio

Now

D0 = $1.15 per share

D1 = $1.15 × 1.10 = $1.265per share

D2 = $1.265 × 1.10 = $ 1.3915

D3 = $1.3915 × 1.10 = $1.53065

D4 = $1.53065 × 1.10 = $1.683715

D5 = $1.683715 x 1.10 = $1.85209

Now

Earnings per share in Year 5 is

= D5 ÷ Pay-out Ratio

= $1.85209 ÷ 0.40

= $4.630225

Now

The Target stock price in five years is

= Earnings per share  in Year 5 × Benchmark P/E Ratio

= $4.630225 × 19 Times

= $87.97;

b. Now the stock price today is to be shown in the spreadsheet below