Luke Warm is valuing the stock of an ice-processing business. He feels confident

Question

Luke Warm is valuing the stock of an ice-processing business. He feels confident in his projection of earnings and dividends to three years (t = 3). Other information and estimates are as follows:

? Required rate of return = 11%

? Average dividend payout rate for mature companies in this market = 0.80

? Industry average ROE = 8.5%

? Earnings per share in year 3 = $2.50

? Industry average P/E = 10 On the basis of this information, answer the following questions:

A. Compute terminal value V3 based on comparables.

B. Contrast your answer in Part A to an estimate of terminal value based on the Gordon Growth Model.

Explanation / Answer

a)

terminal value at t=3 V = Benchmark P/E * Earnings per share in year 3

= 10 * 2.50

= $25

b)

step1:
per sharevalue

dividend payout ratio = dividend per share/earnings per share

=>

0.8 = dividend per share/2.5

dividend per share = 2.5 * 0.8 = 2

step2:

find terminal value using Gordon Growth Model

terminal value = dividend per share/required rate of return

= 2/0.11

= $18.18

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