The Generic Genetic (GG) Corporation pays no cash dividends currently and is not

Question

The Generic Genetic (GG) Corporation pays no cash dividends currently and is not expected to for the next four years. Its latest EPS was $5.60, all of which was reinvested in the company. The firm’s expected ROE for the next four years is 22% per year, during which time it is expected to continue to reinvest all of its earnings. Starting in year 5, the firm’s ROE on new investments is expected to fall to 17% per year. GG’s market capitalization rate is 21% per year.

a. What is your estimate of GG’s intrinsic value per share? (Round your answer to 2 decimal places.)

b. Assuming its current market price is equal to its intrinsic value, what do you expect to happen to its price over the next year?

Explanation / Answer

Using Gordon's growth Model, we know that,

Growth, g = ROE x Plowback Ratio = 0.22 x 1.00 =0.22 or 22%

Earnings in Year-1 =(1+0.22)x5.60 =$6.832

Earnings in Year-2 =(1+0.22)x6.832 =$8.335

Earnings in Year-3 =(1+0.22)x8.335 =$10.1687

Earnings in Year-4 =(1+0.22)x10.1687 =$12.4058

Earnings in Year-5 =(1+0.17)x12.4058 =$14.5148

a.) Price in Year-4 = EPS5/r = 14.5148/0.17 =$85.38

Price in Year-0 =$85.38/(1+0.22)4 =$38.54

b.) Current Market Price = Intrinsic Value

Its price should increase by 22% next year and it will become =1.22x38.54 =$47.02

Year Number --> 0 1 2 3 4 5 Earnings 5.60 6.832 8.335 10.1687 12.4058 14.5148 Dividend 0 0 0 0 0 14.5148

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