Stock Valuation Example

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Finance

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Apr 3, 2024

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Stock Valuation 1. Carlton Corporation just paid a dividend of $3 per share. The company expects to grow their dividend at 20% per year for the next three years. After three years, the company expects to grow their dividends at 6% for the foreseeable future. How much would you pay this company if you had a required return of 15%? D1 = D0(1+g1) = $3 (1.20) = $3.60 D2 = D1(1+g1) = 3.60 (1.20) = $4.32 D3 = D2(1+g1) = 4.32(1.2) = $5.18 P2 = D3/(r-g2) = 5.18/(0.15-.06) = 57.56 P0 = 3.60/(1.15) + (4.32 + 57.56)/1.15^2 = 49.92 2. Assume that you have a company that makes $4 per share in net income. Assume the company has a incremental return on investment of 30% and investors require a 15% rate of return on companies of this type. a) If the company were to payout 100% of their earnings, what would be the price and P/E of the stock? Po = $4/0.15 (i.e. pay out all earnings leads to g = 0) Po = 26.67 P/E = 26.67/4 = 6.67 The price= $26.67 The P/E= 6.7 b) If the company were to payout 80% of their earnings, what would be the price and P/E of the stock? Po = 3.20/(0.15 – 0.06) = 35.56, g = reinvestment% x incremental return on inv = 0.20 x 0.30 = 0.06 P/E = 35.56/4 = 8.89 The price= $35.56 The P/E= 8.9

c) If the company were to payout 60% of their earnings, what would be the price and P/E of the stock? Po = 2.40/(0.15 – 0.12) = 80, g = reinvestment% x incremental return on inv = 0.40 x 0.30 = 0.12 P/E = 80/4 = 20 The price= $80.00 The P/E= 20 d) Repeat the process in a) thru c), except assume the incremental return on investment is now 10%. 100% payout Po = $4/0.15 (i.e. pay out all earnings leads to g = 0) Po = 26.67 P/E = 26.67/4 = 6.67 The Price= $26.67 The P/E= 6.7 80% payout Po = 3.20/(0.15 – 0.02) = 24.61, g = reinvestment% x incremental return on inv = 0.20 x 0.10 = 0.02 P/E = 24.61/4 = 6.15 The Price= $24.62 The P/E= 6.2 60% payout Po = 2.40/(0.15 – 0.04) = 21.82, g = reinvestment% x incremental return on inv = 0.40 x 0.10 = 0.04 P/E = 21.82/4 = 5.45 The Price= $21.82 The P/E= 5.5

Lesson to be learned, if your incremental return on investment is greater than your investor’s required return, you will increase value by reinvesting more in your business. However, if your incremental return on investment is less than investor’s required return, you will destroy value.

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Related Questions

If the last dividend paid by Chemical Brothers Inc. was $1.25 and analysts expect these payments to increase 4% per year, what will the stock price be next year if the required return is 15%? Select one: O a. $12.29 O b. $11.82 O c. $31.25 O d. $12.78 O e. $23.11

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