In practice, a common way to value a share of stock when a company pays dividends is to value the dividend over the

Question

In practice, a common way to value a share of stock when a company pays dividends is to value the dividend over the next five to seven years and then find the terminal stock price using a benchmark PE ratio. Suppose a company just paid a dividend of $1.30. The dividends are expected to grow at 8 percent over the next five years. In five years, the estimated payout ratio is expected to be 40 percent and the benchmark PE ratio is expected to be 20. The required return for the company's stock is 15 percent. What is the target stock price in five years? Enter your answer as dollars with 2 digits to the right of the decimal point in the box shown below.

Help In Homework · Accepted Answer

Dividend paid today = $1.3 Growth in pividend is given @8% Hence dividend for 5th year would be $1.91 ($1.3 + 8% + 8% + 8% + 8% + 8%) Since Dividend payout ratio is 40% Earning per stock (EPS) would be $1.91 / 40 * 100 = $4.775 We know the PE = Stock price / EPS Thus stock price can be calculated below: 20 = Stock price / 4.775 There fore stock price (ie terminal value of stock) = $95 Value of a Stock = Value of dividend + Terminal value of the stock = $1.91 + $95.5 = $97.41 Hence target stock price in 5 years would be $97.41 EXTRA: Also since question gives us the 'required rate of return' @15%, we can calculate the target price as of today by discounting the target price by 5 years. Discounting factor for 5th year @15% would be (1 / 1.15 / 1.15 / 1.15 / 1.15 / 1.15) = 0.497 Therefore stock's value as of today will be $97.41*0.497 = $48.43

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In practice, a common way to value a share of stock when a company pays dividends is to value the dividend over the next five to seven years and then find the terminal stock price using a benchmark PE ratio

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