1) A company's stock sells at a P/E ratio of 21 times earnings. It is expected to pay dividends of $2 per share in each of the next five years and to generate an EPS of $5 in year 5. Using the "dividends-and-earnings model" and a 12% discount rate, compute the stock's justified price.
2) A particular company currently has sales of $250 million; sales are expected to grow by 20%, next year (year 1). For the year after next (year 2), the growth rate in sales is expected to equal 10%. Over each of the next two years, the company is expected to to have a net profit margin of 8% and a payout ratio of 50% and to maintain the common stock outstanding at 15 million shares. The stock always trades at a P/E of 15 times earnings, and the investor has a required rate of return of 20%. Given this information:
a) Find the stock's intrinsic value (justified price).
b) Use the IRR approach to determine the stock's expected return, given that it is
currently trading at $15 per share.
c) Find the holding period returns for this stock for year 1 and for year 2
The solution computes stock price using DDM, calculates stock intrinsic value and also uses the IRR approach to determine the stock's expected return.