Thursday 27th CHAPTER 8 STOCK VALUATION February 2010 1. Suppose you are thinking of purchasing the stock of X Inc. You expect it to pay a $3 dividend in one year, $3.20 in two years, and $ 3.80 in three years. You believe that you can sell the stock for $25 at the end of year 3. If the required return is 6%, how much would you be willing to pay for this stock? Constant dividend (1.e., zero growth) The firm will pay a constant dividend forever. The price is computed using the perpetuity formula. If dividends are expected at regular intervals forever, then this is a perpetuity, and the present value of expected future dividends can be found using the perpetuity formula. Po D/R 2. Suppose a stock is expected to pay a S0.75 dividend every quarter and the required return is 8% with quarterly compounding. What is the price of the stock? Constant dividend growth The firm will increase the dividend by a constant percent every period. The price is computed using the growing perpetuity model, dividend growth model: Po = Dol+ /(R-) =D / (R- 3.Suppose a firm is expected to pay a $2 dividend in one year. If the dividend is expected to grow at 5% per year and the required return is 7%, a) find the dividend in two years? b) what is the current price? c) what is the price expected to be in year 2? 4. Suppose a firm just paid a dividend of $2.5 per share. It is expected to increase its dividend by 2% per year. If the market requires a return of 6% on assets of this risk, how much should the stock be selling for? Supernormal growth(Nonconstant Growth) Dividend growth is not consistent initially, but settles down to constant growth eventually. The price is computed using a multistage model. 5. Suppose a firm is expected to increase dividends by 5% in one year and by 6% in two years. After that, dividends will increase at a rate of 4% per year indefinitely. If the last dividend was $2 and the required return is 8%, what is the price of the stock? Finding the Required Return 6.Suppose a firm's stock is selling for $100. It just paid a $4.5 dividend, and dividends are expected to grow at 5% per year. al What is the dividend vield, stock's expected cash dividend divided by its current price ID / Pol? b) What is the capital gains yield? c) What is the required return? Stock Valuation Using Multiples What if a company doesn't pay any dividend? Another common stock valuation approach is to multiply a benchmark PE ratio by carnings per share (EPS) to find stock price. P = Benchmark PE ratio x EPS. The benchmark PE ratio is often an industry average or based on a company's own historical values. 7.Suppose a company had earnings per share of $3 over the past year. The Industry average PE ratio is 12. Use this information to value this company's stock price