ABC Corporation is expected to pay a dividend next year D1

ABC Corporation is expected to pay a dividend next year, D(1) = 5.00. The company is expected to increase the payout ratio due to strong earnings and cash reserves and hence the dividend irn years 2-4 is expected to increase by 40% each year. In year 5 and beyond assume 3% long-term growth. Based on this information what is the intrinsic value of the company? Assume a Beta of 1.2, risk-free rate of 3% and a market risk premium of 7%.

Solution

As per CAPM Model,
Cost of Equity, Ke = Risk Free Rate + Beta*Market Risk Premium
Cost of Equity, Ke = 3% + 1.2*7%
Cost of Equity, Ke = 11.40%

Dividend of Year 1 (D1) = 5.00
Dividend of Year 2 (D2) = 5 * 1.40 = 7.00
Dividend of Year 3 (D3) = 7 * 1.40 = 9.80
Dividend of Year 4 (D4) = 9.80 * 1.40 = 13.72
Dividend of Year 5 (D5) = 13.72 * 1.03 = 14.13

Terminal Value at the end of Year 4 = D5 / (Ke-g)
Terminal Value at the end of Year 4 = 14.13 / (11.40% - 3%)
Terminal Value at the end of Year 4 = 14.13 / 8.40%
Terminal Value at the end of Year 4 = 168.23

Value of Stock = Present Value of Future Dividend

Value of Stock = D₁/(1+Ke)¹ + D₂/(1+Ke)² + D₃/(1+Ke)³ + D₄/(1+Ke)⁴ + TV₄/(1+Ke)⁴

Value of Stock = 5/(1+11.40)¹ + 7.00/(1+11.40)² + 9.80/(1+11.40)³ + 13.72/(1+11.40)⁴ + 168.23/(1+11.40)⁴
Value of Stock = 4.49+5.64+7.09+8.91+109.24
Value of Stock = 135.36