A company is expected to have earnings of $3.46 per share next year, $4.89 in tw

Question

A company is expected to have earnings of $3.46 per share next year, $4.89 in two years, and $5.82 in three years. The dividend payout ratio is expected to remain at 30% over the next three years. You estimate the risk-free rate to be 3% per year and the expected market risk premium to be 5% per year. In two years, you expect the lagging PE ratio to be 22. The beta of the stock is 1.4. What would be an appropriate estimate of the stock price today? (Answer to the nearest penny, i.e. 55.55 but do not use a $ sign).

Explanation / Answer

Risk free rate =3% Stock beta=1.4 Market Risk Premium =Rpm=5% As per CAPM ; Stock return =Rs =Rf+Rpm*beta =3%+5%*1.4 =10% So Cost of Equity =10% Details Year 1 Year 2 Year 3 Expected Earning                    3.46               4.89                     5.82 Expected Dividend @30%=                    1.04               1.47                     1.75 Share Value at year 3=22*EPS=22*4.89=                   107.6 Lagging P/E Ration in 2 years =22 Sum of Dividends and Ex dividend price                    1.04               1.47                109.33 pv FACTOR @10%=                  0.909             0.826                   0.751 PV of expected cash flows=                    0.94               1.21                   82.14 Sum of PV of Cash flows=                  84.29 So current expected stcok price =84.29

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