Joy Medical Company is a little-known producer of heart pacemakers. The earnings and dividend growth prospects of the company are disputed by analysts.
Jimmy is forecasting 5% growth in dividends indefinitely. However, Susan is predicting a 20% growth in dividends, but only for the next three years, after which the growth rate is expected to decline to 4% for the indefinite future.
Joy's dividends per share are currently $3, i.e. D0 = $3. Stocks with similar risk are currently priced to provide a 14% expected return.
(a) What is the intrinsic value of Chief stock according to Jimmy?
(b) What is the intrinsic value of Chief stock according to Susan?
(c) Assume that Joy's stock now sells for $39.75 per share. If the stock is fairly priced at the present time, what is the implied perpetual dividend growth rate g ? What is the implied P/E (Price-Earnings ratio) on next year's earnings, based on this perpetual dividend growth assumption and assuming a 25% dividend payout ratio?
Stock valuation formula: Next Dividend * [(1 + Dividend Growth Rate) / (Discount Rate - Dividend Growth Rate)]
(a) Based on the above formula, the stock's value to Jimmy is
[$3 * (1 + 5%)] * (1 + 5%)/(14% - 5%) = $36.75
(b) For Susan, dividends are
D1 = ...
This solution provides step by step calculations for intrinsic value, growth rate, and dividend payout ratio.