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 $6.80, all of which was reinvested in the company. The firm’s expected ROE for the next four years is 25% 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 20% per year. GG’s market capitalization rate is 24% per year. A.) What is your estimate of GG’s intrinsic value per share? 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

Growth Rate, g = ROE x Retention Ratio = 25% x 100% = 25%

EPS in year 4, EPS4 = EPS0 x (1 + g)^4 = 6.80 x (1 + 25%)^4 = $16.60

In year 5, EPS5 = EPS4 x (1 + g) = 16.60 x (1 + 20%) = 19.92188

Price in year 4, P4 = EPS5 / k = 19.92188 / 24% =$83.00

Intrinsic Value today, P0 = P4 / (1 + k)^4 = 83 / (1 + 24%)^4 = $35.11

The price will increase by 24% over the next year.

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