2. The dividends per share of Lee Corp., which has a stock beta of 1.15, is expe

Question

2. The dividends per share of Lee Corp., which has a stock beta of 1.15, is expected to be $0.90 next year, and will grow by 15% in the following year. Afterwards, its dividends will remain unchanged for one year before regaining momentum with a 40% growth in Year 4. Afterwards, its dividends will grow indefinitely at an annual rate that reflects Lee Corp.’s 55% earnings retention ratio and a constant ROE of 20%. The risk-free rate and the market risk premium are 2% and 10%, respectively. Compute the intrinsic value of Lee Corp's stock today. If the stock price for Lee Corp. is $45.0 today, what is your investment recommendation on the stock according to the intrinsic value analysis? Why?

Explanation / Answer

This is a question based on Gordan dividend model .

Since the dividends are growing at different rates , we will use the multistage dividend discount model.

Dividend for next year D1=0.90

Dividend for second year D2=0.90*1.15=1.035

Dividend for third year D3=1.035

Dividend for forth year D4=1.035*1.40=1.449

Dividend growth rate from 5th year=Constant =Dividend payout ratio * ROE=45% * 20*=9%

Now since dividends will remain constant from 4th year onwards , we will use the forth dividend to calculate the value of stock on the basis of constant dividend discount model.

P5=D4/(k-g)

D4=1.449

K=required rate of return

G=dividend growth rate

We will use CAPM model to calculate the required rate of return on equity.

Required rate of return is also known as cost of equity.

Required rate of return=Risk free rate + Beta (Market rate of return-Risk free rate)

K=.02 +1.15(.10-.02)

K=.112 =11.2%

Now we will calculate the value of stock as :

P=1.449/ (.112-.09)=65.86

Stock price =45

Since the instrinsic value of stock is greater than price ,the stock is undervalued and hence should be bought. Since stock price is not fairly valued today ,it will increase in future so that investor can buy today and sell tomorrow to profit from the difference.

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