You want to value a firm which is growing fairly fast now (abnormal growth) but

Question

You want to value a firm which is growing fairly fast now (abnormal growth) but will begin reaching maturity and a correspondingly lower earnings growth rate shortly. You’ve decided that a three-stage dividend discount model fits your needs perfectly for this firm. Using the information below, calculate the present value of this firm.

Earnings last year (E0) = $2.95 per share               Dividends last year (D0) = $0.60

ROE last year = 25%                                  growth = retention rate x ROE             

You expect earnings growth, dividend payout and ROE to be stable over the next two years. At that time we will see the firm slow its earnings growth, increase its dividend payout, and reduce its cost of equity over the next three years.

The long-term Treasury rate is 4%, the firm’s current beta is 1.4, but you expect the long-term beta to fall to 1.0 by the end of your phase down period and the market risk premium is 6%.

Long-term earnings are expected to grow at three percent to perpetuity and firm should be able to maintain a constant ROE of 10% for perpetuity.

What is the present value of this firm’s equity using the three-stage dividend discount model?

Explanation / Answer

For this past month (October), College Painters earned $25,333 in revenues for several different jobs totaling 24,000 sf. College Painters used 72 gallons and 765 hours of labor during the month. The 765 hours of labor cost $11,475, which includes the 32 hours it took to clean up the mess in a customer’s home because a painter accidentally tripped over a full can of paint.

According to their paint supply store, they spent $2,160 on paint and $480 on supplies during the month. The bill for paint for October was higher than normal because Cody and John decided to try a newer, more expensive paint in the hope that it would lead to improved paint and labor efficiencies. They did not think this would affect the amount of supplies used). Finally, they spent $2,250 on fixed costs during October.

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