Lee Corp. is expected to experience a transitory turnaround period during which

Question

Lee Corp. is expected to experience a transitory turnaround period during which its dividends are expected to cut the current amount of $1.50 by 40% next year, and to grow at 35% and 25%, respectively, in the following year two years. Afterwards, its dividends will experience sustainable growth indefinitely at an annual rate that reflects a 45% dividend payout ratio and a ROE of 18%. The discount rate is 14%. (a) Compute the intrinsic value of Lee Corp's stock today. If the stock price for Lee Corp. is $32.50 today, what is your recommendation on this stock according to the intrinsic value analysis? Why? Be concise! (b) Compute the value of income component and the value of growth component (NPVGO) of Lee Corp's stock at the END of its abnormal growth horizon.

Explanation / Answer

The table below shows the PV calculation of the dividends till the 3rd year:

From 4th year, dividend will grow indefinitely. Dividend payout ratio = dividend/net income = 45%

ROE = net income/equity = 18%

Last dividend payment = 1.51875. Thus 1.51875/net income = 45%

or, net income (per share) = 1.51875/.45 = 3.375

ROE = net income/equity = 18%

3.375/equity = 18% or equity = 3.375/.18 = 18.75

The intrinsic value will be thus = sum of PV of all dividends+sum of perpetuity dividend+equity price as calculated (18.75)

sum of PV of all dividends = 4.25 (from the table presented above)

PV pf perpetual dividend = dividend/discount rate = 1.51875/.14 = 10.84

Thus untrinsic value = 4.25+10.84+18.75 = 33.85

Recommendation: as the current price of $32.5 is less than the intrinsic value of $33.85, the stock is undervalued and there is room for growth. So it should be kept on "hold" mode.

Dividend Discount factor PV Current (Time 0) 1.5 1.14 1.5 Next (decrease of 40%) (Time 1) 0.9 1.14 0.789473684 Growth of 35% (Time 2) 1.215 1.14 0.934903047 Growth of 25% (Time 3) 1.51875 1.14 1.02511299

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