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Company ABC's shares traded at $83 each in November 2006. Financial analysts were expecting the firm to announce earnings of $3.33 per share for the just-ended October 31 fiscal year and a book value per share of $19.36. The annual dividend per share for fiscal 2006 was 0.64. In addition,analysts were forecasting earnings for fiscal 2007 at $3.75 per share, $4.32 for 2008, and a growth rate in EPS of 12% per year thereafter.

(a) According to the forecasts and with a cost of equity equal to 12%, should we recommend a buy or sell on Company ABC's stock at the time? Why? [Hint: in order to answer this question, you have to make certain assumptions and calculate the value per share.]

(b) What was the market's implied long-term growth rate for residual earnings?

(c) List the difficulties you have in answering questions (a) and (b). What other information would you like to have in order to minimize the uncertainty?

Solution Preview

a) This is a case of two stage dividend discount model. Initially the dividend will grow at different rates but later on it will grow at constant rate.
The value of a stock P=D1/(1+r) + D2/(1+r)^2+D2*(1+g)/((1+r)^2*(r-g))
Where D1= Expected dividends in year 2007
D2= Expected dividends in year 2008
r= cost of equity = 12%
g= growth rate in dividends

The assumptions required to solve the problem:
Assumptions: 1. The dividend payout ratio will remain same as last year
Dividend payout ratio in year 2006 = 0.64/3.33=0.1922
Thus, every year 19.22% of the earnings will be distributed as dividends to calculate D1 and D2
Expected dividends in year 2007 = EPS in year 2007 * Dividend payout ratio = 3.75*0.1922=0.72
Expected dividends in year 2008 = EPS in ...

Solution Summary

The following posting addresses a problem that involves minimizing uncertainty.

$2.19