DOTNET.com is a highly priced internet stock whose earnings in the coming year (

Question

DOTNET.com is a highly priced internet stock whose earnings in the coming year (E1) is expected to be $1.00 per share. Investors expect these earnings to grow at 100% (g) per year for 3 years. This growth rate is estimated by assuming that DOTNET reinvests all of its earnings at a return (R) of 100% per year. After 3 years of this high growth competition is expected to sharply reduce the profitability of DOTNET. Consequently, the forecast is that company will then retain only 30% of its earnings and invest them at a return rate of %25% per year. Investors in DOTNET require a return (k) of 20% per year:

1. what is the price per share of DOTNET

2. what is the premium for growth of the stock? PE Ratio?

3. Suppose DOTNET chooses to pay a small dividend of $0.50 per share in each of the next 4 years, what will be the new price of the stock?

4. What is the new premium for growth and PE ratio?

Explanation / Answer

1. Price of share of dotnet.com using walters method

P = {D/KE + (EPS-DPS)*R/KE} / KE

since co. is retaining 30% therefore dividend paid is 70% i.e $0.70

P = [0.7/20 + (1-0.7)*25/20 ] / 20

= $ 5.375

2. PE Ratio = 1/Ke

=1/20

= 5 times

3. If $0.50 Dividend is paid for next 4 years

Price = PV of earnings

= d1*0.833 + d2*0.694 + d3* 0.578 + d4* .0482

= 0.50*0.833 + 0.50*2*0.694 + 0.50*4*0.578 + 0.50*6*0.482

= $ 3.7125

4. PE Ratio = MPS/EPS

   = 3.7125/1

= 3.7125 times

Premium = $5.375-$3.7125

=$ 1.6625

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