Jack George is evaluating Dunger Inc., a waste management firm. The company has been experiencing a strong 15% growth rate, which is forecasted to continue over the next three years before growth settles down to a sustainable level. Dunger's annual return on equity is expected to be 10%. The company recently paid a dividend of $0.50 per share from reported earnings of $2.50 per share. George has calculated a 10% weighted average cost of capital for Dunger Inc. The firm has no debt. The company's last reported trade on the New York Stock Exchange was $35 per share. Based on the multi-stage dividend discount model, George should:
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A. B. C.A
To determine the intrinsic value of Dunger Inc.'s stock using the multi-stage dividend discount model, we need to calculate the present value of future dividends. The multi-stage model is appropriate in this case because the company is expected to have a high growth rate for the next three years before settling down to a sustainable level.
Step 1: Calculate the dividends during the high-growth period The annual dividend during the high-growth period can be estimated by multiplying the earnings per share (EPS) by the payout ratio. The payout ratio is the portion of earnings that the company pays out as dividends. In this case, the dividend payout ratio is calculated as:
Dividend Payout Ratio = Dividend / Earnings = $0.50 / $2.50 = 0.2 or 20%
Since the growth rate is expected to be 15%, we can calculate the dividends for the next three years as follows:
Year 1 Dividend = $2.50 * (1 + 0.15) * 0.2 = $0.50 * 1.15 * 0.2 = $0.115 Year 2 Dividend = $2.50 * (1 + 0.15)^2 * 0.2 = $0.50 * 1.3225 * 0.2 = $0.13225 Year 3 Dividend = $2.50 * (1 + 0.15)^3 * 0.2 = $0.50 * 1.520875 * 0.2 = $0.1520875
Step 2: Calculate the sustainable dividend After the high-growth period, the company is expected to settle down to a sustainable growth rate. In this case, the return on equity (ROE) is expected to be 10%. We can estimate the sustainable dividend as follows:
Sustainable Dividend = EPS * ROE * Payout Ratio
Sustainable Dividend = $2.50 * 0.10 * 0.2 = $0.05
Step 3: Calculate the present value of dividends To calculate the present value of dividends, we need to discount each dividend by the weighted average cost of capital (WACC), which is given as 10% in this case. The present value formula is:
Present Value = Dividend / (1 + WACC)^n
Where n represents the number of years into the future.
Using this formula, we can calculate the present value of each dividend:
Year 1 Present Value = $0.115 / (1 + 0.10)^1 = $0.10455 Year 2 Present Value = $0.13225 / (1 + 0.10)^2 = $0.1077 Year 3 Present Value = $0.1520875 / (1 + 0.10)^3 = $0.11894
Step 4: Calculate the terminal value To estimate the value of the stock beyond the three-year period, we use the Gordon Growth Model, which assumes a constant growth rate for perpetuity. The terminal value is calculated as:
Terminal Value = Sustainable Dividend / (WACC - Sustainable Growth Rate)
In this case, the sustainable growth rate is the same as the ROE, which is 10%.
Terminal Value = $0.05 / (0.10 - 0.10) = $0.05 / 0 = undefined
Since the sustainable growth rate is the same as the WACC, the terminal value cannot be calculated.
Step 5: Calculate the intrinsic value To calculate the intrinsic value, we sum the present value of dividends and the terminal value, if applicable.
Intrinsic Value = Year