Applilcaio How Low Can It Go? Dwayne sat at his desk wondering what he should do

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Applilcaio How Low Can It Go? Dwayne sat at his desk wondering what he should do. Having opted for early retirement, six months ago, he knew that he needed to make some changes in the way his investment portfolio was structured. However, being primarily focused on science during his career, he had a fairly limited knowledge of stock selection and portfolio management. One thing was certain, though, Dwayne had an eagerness to learn and that's exactly what he planned to do during his appointment with his broker, Jonathan Price. Dwayne Stevenson, aged 58, had joined the Pharmacopia Company approximately thirty years ago, as a post-doctoral researcher in the field of immunology. His strong work ethic and knowledge of science enabled him to progress steadily along the research track of the company He won a number of awards and earned many promotions along the way Five years ago, Dwayne earned the coveted title of "Research 5 Scientist enjoyed b y only 4 other individuals in the corporation. One of the main

Explanation / Answer

2..Growth rates , in sales or earnings per share or dividends per share are calculated by subtracting the previous period's figute from the current period's figure & dividing the result by the previous period's figure -to know the growth over the previous figure. It is normally expressed as a % age of that previous figure. This is done for trh entire period under study & average of all such growth rates gives the average growth rate . From Table 1, the firm's growth Rate with respect to sales, net income, EPS & DPS can be found out as follows: Year Sl.no. Sales (Current Yr.-Prev. Yr.)Prev. Yr. Net Income (Current Yr.-Prev. Yr.)Prev. Yr. EPS (Current Yr.-Prev. Yr.)Prev. Yr. DPS (Current Yr.-Prev. Yr.)Prev. Yr. 1995 1 3000 150 1.5 0.6 1996 2 3200 6.67% 160 6.67% 1.6 6.67% 0.64 6.67% 1997 3 4000 25.00% 200 25.00% 2 25.00% 0.8 25.00% 1998 4 4400 10.00% 220 10.00% 2.2 10.00% 0.88 10.00% 1999 5 4800 9.09% 240 9.09% 2.4 9.09% 0.96 9.09% 2000 6 5000 4.17% 250 4.17% 2.5 4.17% 1 4.17% 2001 7 5200 4.00% 260 4.00% 2.6 4.00% 1.04 4.00% 2002 8 5100 -1.92% 255 -1.92% 2.55 -1.92% 1.02 -1.92% 2003 9 4900 -3.92% 245 -3.92% 2.45 -3.92% 0.98 -3.92% 2004 10 4700 -4.08% 235 -4.08% 2.35 -4.08% 0.94 -4.08% Av. Growth rate 5.44% 5.44% 5.44% 5.44% 3. Required rate of return The required rate of return for equity is the minimum return the investor expects for holding a company's stock. It is also called the cost of the company's equity.It is normally calculated by dividend discount model or the capital asset pricing model, depending on the data available. This rate is used to discount all the cash flows ,with respect to the stock. Under the Dividend discount model, Required return on equity is calculated as ((Next yr.’s dividends per share/current stock price) + Dividend growth rate).--- where next yr.'s dividend=Current dividend*(1+Dividend growth rate) Under the Capital asset pricing model, Required return on equity takes into account the risk-free rate & provides a premium over that ,based on the stock's individual beta. The formula used is: Cost of Equity/Reqd. return on Equity=Risk-Free rate+(market Risk premium*Market Beta) Where market risk premium is the excess of market return for the stock over the risk free rate,ie. Market rtae of return-Risk-free Rate) For this firm, the rate is calculated as 5.1%+(1.1*9%)= 15% 4.. As said above, dividend-growth rate also can be used in estimating the cost of equity ,or the required rate of return to the investors. ((Next yr.’s dividends per share/current stock price) + Dividend growth rate).--- where next yr.'s dividend=Current dividend*(1+Dividend growth rate) Here, the average growth rate --5.44% will be used. 5..Dividends are used because they are the periodic cash flows which the shareholders receive by holding the stock ,whereas, EPS are not fully distributed to them. Part of the latter is retained in the business itself, for use in the business' growth potentials. Now with the inputs we have, we can estimate PCU's stock price as follows: Cost of equity/Required return (as per CAPM)=15% As per the DDM, Ke=(D1/P0)+g ie. 15%=(0.94*(1+0.0544)/P0)+0.0544 Solving for P0, we get the stock price as $10.37 Or ,if industry av. Growth rate is taken, ie. 15%=(0.94*(1+0.1)/P0)+0.1 $20.68 As Jonathan said, the current intrinsic value of the stock is between $10 & $ 20

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