CASE - STOCKS AND BONDS

Stock Valuation

Mr. Hillbrandt is impressed with your ability to explain financial concepts so he asks for help with learning about stock valuation. Mr. Hillbrandt really liked the examples you provided last time (module 1), so it seems as if you need to sit down and create some relevant examples for this topic too. Below is some information that helps you brush up on the topic.

Read this article related to the intrinsic value of stock, paying special attention to the section entitled "Constant Growth Model":

Alvarez, S. (2015). What is the intrinsic value of stock? Investopedia. Retrieved from http://www.investopedia.com/articles/basics/12/intrinsic-value.asp

Now, let's work the following problem:

A company just paid an annual dividend of $2.00 per share. Dividends are anticipated to grow at a rate of 8% per year forever. The stock's beta is 1.5, the risk-free rate is 2.5%, and the expected return on the overall stock market is 7.5%. What's the intrinsic value of the company's common stock?

Using the formula:

Stock Price = D₁ ÷ (k - g)

Where:

D₁ = dividend for the coming year

k = required rate of return (NOTE: k must be greater than g)

g = growth rate of dividends

(Note: Decimals and not percentages must be used for the model to work)

1) To calculate the dividend for the coming year, we need to multiply the last dividend by the expected dividend growth rate. And so:

D₁ = $2.00 x 1.08 = $2.16

2) Find the Market risk premium using the following formula:

Market risk premium = Expected return on stock - Risk free rate

= 7.5% - 2.5%

= 5%

3) Then, to find k, or the required rate of return, use the following formula:

k = risk free rate + [market risk premium x beta]

= 2.5% + (5% * 1.5)

= 10%

4) g = 8% (or 0.08) growth rate of dividends

5) Stock Price = D1 ÷ (k - g)

= $2.16 ÷ (.10 - .08)

= $2.16 ÷ .02

= $108.00 (ANSWER)

5) Check your answer with this online calculator: http://www.zenwealth.com/businessfinanceonline/SV/CGStockCalculator.html

Now, work the following problems:

1. A company just paid an annual dividend of $3.25 per share. Dividends are anticipated to grow at a rate of 5% per year forever. The stock's beta is 1.2, the risk-free rate is 3.5%, and the expected return on the overall stock market is 5.5%. What's the intrinsic value of the company's common stock?

2. A company just paid an annual dividend of $2.35 per share. Dividends are anticipated to grow at a rate of 6.25% per year forever. The stock's beta is 1.6, the risk-free rate is 4.25%, and the expected return on the overall stock market is 8.5%. What's the intrinsic value of the company's common stock?

Required: Part I consists of three questions.

Do the computations for the example below. Show the computations step by step, so Mr. Hillbrandt can easily follow your examples.

1. The company's common stock dividends are anticipated to grow at a constant 5.5% growth rate per year going forward. The company just paid an annual dividend (that is, D-zero) of $3 per share. What's the intrinsic value of the stock based on the following required rates of return?

1. 6%

2. 8%

3. 10%

4. 12%

2. If the stock is currently selling for $40 per share, is the stock a good buy? Interpret the results and justify your decision.

3. The company just paid an annual dividend of $1.50 per share. Dividends are anticipated to grow at a stable rate of 10% per year forever. The stock's beta is 1.2, the risk-free rate is 4%, and the expected return on the overall stock market is 11%. What is the intrinsic value of the company's common stock?

Part II

Select one company that is a member of the Dow Jones Industrial Average. The listing is here:

http://finance.yahoo.com/q/cp?s=^DJI+Components

Apply the Dividend Discount Model and justify why you think that the stock is currently undervalued, overvalued, or fully valued. Please be sure to state your assumptions and justify your results. What is the relationship, if any, between stockholders' wealth and financial decisions?

Computations (use Excel).

Use Excel to make the part I and II computations. Make sure you separate the two parts and organize the information, so Mr. Hillbrandt easily understands.

Memo (use Word).

Explain the concept and computations in part I to the CEO. Start with an introduction and end with a conclusion. Each of the four or five paragraphs should have a heading.

Short Essay - Part II (use Word).

Let's look at this issue from an investor's perspective and respond to the question above. Do research as needed and respond to the questions posed in part II.

Start with an introduction and end with a summary or conclusion. Use headings. Don't forget to reference your sources. Maximum length of two pages.