Celine is an analyst for a money management firm. She is asked by her supervisor to estimate the intrinsic value of the common stocks of Pacific Basin Corporation (PBC), so she collects the following information on PBC.
Year
Dividend per share
2019 $1.2
2020 $1.5
2021 $1.8
2022 $2.2
2023 $2.4
She forecasts that the price/earnings ratio for the year 2024 will be 20. In addition, the forecast earnings for the year 2024 are $6.4 per share. The expected market return is 10% and the risk-free rate is 3%. The variance of returns on the market index is 0.3 and the covariance of returns on PBC’s stocks and the market index is 0.45. The weighted average cost of capital of PBC is 10%.
After collecting the information, Celine starts to estimate the value of the common stocks of PBC. Here is the summary of her estimation.
WACC = 10%
Price (2024) = 20($6.4) = $128
Intrinsic value (2017) = 1.2/1.1 + 1.5/1.12 + 1.8/1.13 + 2.2/1.14 + 2.4/1.15 + 128/1.16
= $78.93
a. As the current market price is $75 per share, which is less than the intrinsic value of the stocks of PBC, it is recommended to buy PBC’s stocks.
b. Discuss two weaknesses of the above estimation in determining the intrinsic value of PBC’s stocks.