Company JUK has a ROE of 25% and the company will not pay any dividend for the n

Question

Company JUK has a ROE of 25% and the company will not pay any dividend for the next 3 years. It is estimated that the company will pay $2 dividend per share after three years and then to level off to 5% per year forever.  

The company has a beta of 2. Assume the risk-free interest rate is 4%, and the market risk premium is 8%.

What is your estimate of the fair price of a share of the stock?

If the market price of a share is equal to this intrinsic value, what is the P/E ratio?

What do you expect its price to be 1 year from now? Is the implied capital gain consistent with your estimate of the dividend yield and the market capitalization rate?

Explanation / Answer

Rate of return = risk free rate + beta x (market risk premium) = 4% + 2 x 8% = 20%

At end of 3 years:

share price = PV of future dividend payments = [Dividend / (rate of return - growth rate)]

= $2 / (20% - 5%) = $13.33

discounted back to today's value,

Share price = $13.33 / (1.2)3 = $7.71

To calculate P/E ratio and expected price after 1 year, Earnings of the firm is a required information which is missing.

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