Class Problems – Chapter 7B – Stock Valuation

1. EDM, Inc. just paid a dividend of $2.35 per share on its stock. The dividends are
expected to grow at a constant rate of 4.1% per year, indefinitely. If investors
require a return of 10.4% on this stock, what is the current price?

D1
P0 = D1 = D0 x (1+g)
R-g
$2.35 x (1+.041)
=
(.104-.041)

= $38.83

2. What will the price be in three years?

D4
P3 = D4 = D0 x (1+g)4
R-g
$2.35 x (1 + .041)4
=
(.104 - .041)
Stock price grows at dividend growth rate
= $43.81
P3 = P0 x (1 + g)3
= $38.83 x (1 + .041)3
= $43.81
3. What will the price be in 15 years?

D16
P15 = D16 = D0 x (1 + g)16
R-g
$2.35 x (1 + .041)16
=
(.104 - .041)
Stock price grows at dividend growth rate
= $70.95
P15 = P0 x (1 + g)15
= $38.83 x (1 + .041)15
= $70.95 1
4. Pasha Entertainment, Inc. is expected to pay the following dividends over the next
four years: $6, $12, $17, and $3.25. Afterward, the company pledges to maintain
constant 5% growth rate in dividends, forever. If the required return on the stock
is 11%, what is the current share price?

D5
P4 = D5 = D4 x (1+g)
(R – g)
$3.25 x (1.05)
=
= (.11 - .05)

P4 = $56.88

$6 $12 $17 $3.25 $56.88

P0 = + + + +
(1.11) (1.11)2 (1.11)3 (1.11)4 (1.11)4

= $67.18

5. Suppose you know that a company’s stock currently sells for $67 per share and the
required return on the stock is 11.5%. You also know that the total return on the
stock is evenly divided between capital gains yield and dividend yield. If it is the
company’s policy to always maintain a constant growth rate in its dividends, what
is the current dividend per share?
D1
R = Dividend yield + Capital gains yield = +g
P0

Dividend yield = Capital gains yield  given from the problem

.115 = Dividend yield + Capital gains yield

x x
.115 = 2x D1
D0 =
½ (.115) = x (1 + g)
.0575 = x D1 D0 = $3.85
Dividend yield = .0575 = 5.75% = P0 1.0575
D1 = .0575 x P0
D0 = $3.64  Answer
D1 = .0575 x $67

D1 = $3.85 2
6. Take Time Corporation will pay a dividend of $3.65 per share next year. The
company pledges to increase its dividend by 5.1% per year, indefinitely. If you
require a return of 11% on your investment, how much will you pay for the
company’s stock today?

D1
P0 =
R-g
$3.65
=
(.11 - .051)

= $61.86

7. The next dividend payment by Dizzle, Inc. will be $2.48 per share. The dividends
are anticipated to maintain a growth rate of 4.5% forever. If the stock currently
sells for $39.85, what is the required return?

D1
R= +g
P0
$2.48
= + .045
$39.85

= .1072 or 10.72%

8. Mitchell, Inc. is expected to maintain a constant 4.6% growth rate in its dividend,
indefinitely. If the company has a dividend yield of 5.8%, what is the required
return on the company’s stock?

R = Dividend yield + Capital gains yield

= .058 + .046
= .1040 or 10.40%

3
9. Gontier Corporation stock currently sells for $53.95 per share. The market requires
a return of 10.3% on the firm’s stock. If the company maintains a constant 4.9%
growth rate in dividends, what was the most recent dividend per share paid on
the stock?

D0 x (1 + g)
P0 =
(R – g)

P0 x (R - g)
D0 =
(1 + g)

$53.95 x (.103 - .049)

D0 =
(1 + .049)

D0 = $2.78

10. Metallica Bearings, Inc. is a young start-up company. No dividends will be paid on
the stock over the next nine years because the firm needs to plow back its
earnings to fuel growth. The company will then pay a dividend of $19 per share 10
years from today and will increase the dividend by 5% per year thereafter. If the
required return on this stock is 13%, what is the current share price?

Find the stock price in Year 9:

D10
P9 =
(R – g)
$19.00
=
(.13 - .05)

= $237.50

$237.50
P0 =
(1.13)9

P0 = $79.06

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 Class Problems – Chapter 7C – Stock Valuation

1. Ushuaia, Inc. currently has an EPS of $4.13, and the benchmark PE ratio for the
company is 15. Earnings are expected to grow at 5% per year. What is your
estimate of the current stock price?

P0 = Benchmark PE ratio x EPS

= 15 x $4.13
= $61.95

2. What is the target stock price in one year?

EPS1 = EPS0 x (1 + g) P1 = Benchmark PE ratio x EPS1

= $4.13 x (1 + .05) = 15 x $4.34

= $4.34 = $65.05
- or -
P1 = P0 x (1 + g)
= $61.95 x (1 + .05)
= $65.05

3. Assuming the company pays no dividends, what is the implied return on the
company’s stock over the next year?

Similar to:
(P1 - P0)
R= D1
P0 P0 =
R-g
($65.05 - $61.95) D1
= R= +g
$61.95 P0

= .05 = 5% This is 0 if no dividends

R=g (when no dividends)

So, if EPS is growing at 5% per year, there are no

dividends and the PE ratio is constant, then the
implied return is 5%.
5
4. The Sleeping Flower Co. has earnings of $2.65 per share. The benchmark PE for
the company is 18. What stock price would you consider appropriate? What if the
benchmark PE were 21?

P0 = Benchmark PE ratio x EPS

Benchmark PE ratio = 18
EPS = $2.65
P0 = 18 x $2.65
= $47.70

If Benchmark PE ratio = 21
P0 = 21 x $2.65
= $55.65

5. Davis, Inc. currently has an EPS of $2.75 and an earnings growth rate of 8%. If the
benchmark PE ratio is 21, what is the target share price five years from now?

EPS5 = EPS0 x (1 + g)5

= $2.75 x (1 + .08)5
= $4.04
P5 = Benchmark PE ratio x EPS5
= 21 x $4.04
= $84.84

6. TwitterMe, Inc. is a new company and currently has negative earnings. Its sales are
$1.35 million and there are 130,000 shares outstanding. If the benchmark price-
sales ratio is 4.8, what is you estimate of the appropriate stock price?

Sales
Sales per share = P = Benchmark PS ratio x Sales per share
Shares outstanding
Benchmark PS ratio = 4.8
$1,350,000
= Sales per share = $10.38
130,000
P = 4.8 x $10.38
= $10.38 = $49.85
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Problem Set 1
ABC stock just paid a $2 dividend and will grow it at 4% thereafter.
The company also has a bond maturing in 4 years which pays a 5% annual coupon
and has a face value of $1000.

You own 1 share of stock and 1 bond.

The appropriate interest rate to use in both of the following calculations is 6%
1. What is the price of one share of stock (R=6%) ?
$2 (1.04) = $104
(.06-.04)
2. What is the price of one bond (YTM=6%) ?

1
1- $1,000
Bond Value = $50 * (1.06)4 +
(1.06)4
.06

$1,000
= $50 * 3.4651 +
1.2625

= $965.35

The Federal Reserve Bank DECREASED interest rates to 5%

3. What is the new price of your share of stock (R=5%) ?
$2 (1.04) = $208
(.05-.04)

4. What is the new price of your bond (YTM=5%) ?

No math needed

Bond price must be $1000 because YTM is the same as the coupon rate

5. How much money did you gain or lose as a result of the change in interest rates?
($208+1000) - ($104+965.35) = $138.65 gain