Concept explainers
PE and Terminal Stock Price. In practice, a common way to value a share of stock when a company pays dividends is to value the dividends over the next five years or so, then find the “terminal” stock price using a benchmark PE ratio. Suppose a company just paid a dividend of $1.15. The dividends are expected to grow at 10 percent over the next five years. The company has a payout ratio of 40 percent and a benchmark PE of 21. What is the target stock price in five years? What is the stock price today assuming a required return of 11 percent on this stock?
To determine: The target stock price in five years.
Introduction:
Target stock price is a price in which the investor wants to exit from the current position to attain maximum earnings.
Answer to Problem 30QP
The target stock prices in five years are $97.23.
Explanation of Solution
Given information:
The company currently paid dividends of $1.15. The constant growth rate is 10% over the next five years. The benchmark price to earnings ratio is 21 and the estimated payout ratio is 40%.
The formula to calculate the dividend for each year:
Where,
D1refers to the next periods dividends per share
Dorefers to the currently dividend paid
g refers to the expected constant growth rate
n refers to the number of years
The formula to calculate the earnings per share:
The formula to calculate the target stock price of the year:
Where,
EPS1 refers to the earnings per share of next year,
P1 refers to the price of stock per share.
Note:
The current stock price is often called as target stock prices over the next year.
Compute the dividend of Year 1:
Hence, the dividend of Year 1 is $1.27.
Compute the dividend of Year 2:
Hence, the dividend of Year 2 is $1.39.
Compute the dividend of Year 3:
Hence, the dividend of Year 3 is $1.53.
Compute the dividend of Year 4:
Hence, the dividend of Year 4 is $1.68.
Compute the dividend of Year 5:
Hence, the dividend of Year 5 is $1.85.
Compute the earnings per share in Year 5:
Hence, the earnings per share in Year 5 are $4.63.
Compute the target stock price in Year 5:
Hence, the target stock price in Year 5 is $97.23.
To determine: The current stock price when the required rate of return is 11%.
Answer to Problem 30QP
The current stock price is $63.30.
Explanation of Solution
Given information:
The required return on its stock is 11%.
The formula to calculate the current stock price:
Where,
P1 refers to the next period’s price of the stock
nrefers to the number of years
Compute the price of the stock:
Hence, the price of a stock is $63.30.
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