You dive deeply into the depths of the detailed data for DEEP and discover: DEEP

Question

You dive deeply into the depths of the detailed data for DEEP and discover: DEEP's expected rate of retum is 20% (this may be different than you calculated above) DEEP's current Book Value/Share is $15.00 DEEP's common stock is currently selling for $29.00/share. DEEP's Earnings Per Share from its most recent annual report is $4.00 DEEP's does not currently and is not expected to pay dividends. If you expect the growth rate of the company will be 15%/year, would purchase DEEP stock for $29/share? Why or why not? Support you answer with a computation using the Residual Income Method of stock valuation.

Explanation / Answer

By residual income method, intrinsic value of a stock= B(1+ (ROE-r)/(r-g) )

where B= Book value of stock= $15

ROE= Return on equity= EPS/Book Value = $4/$15= 26.67%

r= Required rate of return= 20%

g= Growth rate= 15%

So, intrinsic value of stock = $15( 1+ (26.67-20)/(20-15) )

=$ 35.01

It is given that the current market price of the stock is $29. So it would be wise to purchase the stock as it is available at a cheaper price than its intrinsic value.

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