The Digital Electronic Quotation System (DEQS) Corporation pays no cash dividend

Question

The Digital Electronic Quotation System (DEQS) Corporation pays no cash dividends currently and is not expected to for the next 5 years. Its latest EPS was $16, all of which was reinvested in the company. The firm’s expected ROE for the next 5 years is 19% per year, and during this time it is expected to continue to reinvest all of its earnings. Starting in year 6, the firm’s ROE on new investments is expected to fall to 14%, and the company is expected to start paying out 20% of its earnings in cash dividends, which it will continue to do forever after. DEQS’s market capitalization rate is 24% per year.

1. What is your estimate of DEQS’s intrinsic value per share?

Explanation / Answer

To answer this question, we first need to calculate the growth rate of DEQS. As the company is expected to retain all the earnings & reinvest it, the plowback ratio is to be 100%.

Growth Rate in first five year = Plow Back Ratio X ROE
=> 100% x 19% = 19%

EPS at the end of the 5th year = $16 x (1+Growth Rate)5 = $16 x (1.19)5 = $38.18

Now, as in year 6 the ROE is expected to fall to 14% and company will start paying out dividends resulting in changed Plowback ratio.

So, new Plow back ratio = 1 – Payout Ratio = 1 – 20% = 80%

Growth Rate from 6th Year = 80% x 14% = 11.20%

Expected dividend in 6th year = 20% of EPS = 20% x $38.18 = $7.64

So, the intrinsic value of the stock in year 6 = Dividend /(Market Capitalization Rate – Growth Rate)

=> $7.64/(0.24 – 0.112) = $59.66

The PV of the value = $59.66/(1.24)5 = $20.35

So, the intrinsic value of DEQS’s stock is $20.35.

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