ABC Company is currently a rapidly growing company that pays no dividends as of

Question

ABC Company is currently a rapidly growing company that pays no dividends as of yet. EPS for the current year was $3 per share. The ROE is currently 20% and the dividend payout ratio is currently 0%. The ROE and dividend payout ratio are both forecasted to be the constant over the next 3 years. Analysts forecast that the ABC Company’s earnings growth rate will converge to the longterm industry average growth rate of 5.5% per year for year 4 and into perpetuity. The ABC Company is expected to start paying dividends in year 4; the dividend payout ratio is expected to be 25% in year 4 and all following years into perpetuity, thus earnings and dividends will grow at the same growth rate from year 4 and into perpetuity. c. What is the forecasted EPS for year 4? Please show work d. What is the forecasted value for Dividends per Share for year 4? Please show work e. The beta value for the ABC Company stock is estimated to be 1.30 while the risk-free rate is 1% and the expected market risk premium is 10%. e. What is the Required Return for the Vesper Company stock? Please show work f. What is the forecasted stock value per share at year 3? Please show work g. Given all of the information above, what is the current value per share (intrinsic value) of the ABC Company stock? Plese who work

Explanation / Answer

c) The EPS will be constant for the next 3 years, therefore EPS for year 3 will be same as now, i.e., $3 per share. Now, EPS for year 4 will be the EPS of year 3 multiplied by the growth rate in year 4 -

EPS in year 4 = $3 x (1 + g) = $3 x (1 + 0.055) = $3.165

d) Dividend per share for year 4 (D4) = EPS for year 4 x Dividend payout ratio = $3.165 x 25% = $0.79125

e) Required Return = Risk free rate + Beta x market risk premium

Required return = 1% + 1.30 x 10% = 14%

f) As per the dividend growth model, Price would be computed as follows -

Price at the end of year 3 (P3) = Expected dividends (D4) / (Ke - g)

where, Ke = required return, g = growth rate

P3 = $0.79125 / (0.14 - 0.055) = $9.30882352941 or $9.309

g) The current stock price would be the present value of dividends till growth stabilises, i.e., till year 3 plus the present value of price at year 3. Since, their are no dividends till year 3, current stock price would be the present value of the price at year 3. Using the required return as the discount rate, we have -

Current stock price (P0) = Price at year 3 x PVIF (14%, 3)

P0 = $9.30882352941 x 0.67497151619 = $6.28319073159 or $6.28

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