You are a financial analyst and you have the following information for Dominion Tech Company. Dominion Tech Company has beta of 1.5 and a ROE of 20%. The dividend payout ratio is 60%. Last twelve month earnings were $4 per share. The annual dividend was just paid. The consensus estimate of the coming year’s market return is 14%, and T-bills currently offer a 5% return.
a. Find the intrinsic value of Dominion stock
g = 0.08
D0 = 2.4
D1 = 2.592
K = 0.185
P0 = D1/(k-g) = 24.69
b. Compute the Leading P0/E1 and Trailing P0/E0 ratios.
Leading P0/E1 and Trailing P0/E0 ratios
E1 = 4.32
E0 = $4.0
Leading P0/E1 = 5.714285714
Trailing P0/E0 = 6.17
c. Calculate the PVGO?
P0 = E1/K + pvgo
PVGO = P0-E1/K = 1.33
d. Suppose your research convinces you that Dominion will announce momentarily that it will immediately reduce its dividend payout ratio to 40%. Find the intrinsic value of the stock. The market is still unaware of this decision. Explain why the value changes.
Plow-Back Ratio b = 1 - .4 = 0.6
g = b*ROE = .6 * 20% = 0.12
D0 = E0 * 40% = $4 * .4 = 1.6
D1 = D0 * (1+g) = 1.6 * 1.12 = 1.792
K = 0.185
P0 = D0 / (k-g) = 27.57
The cost of capital is lower than the return on equity,
V0 increases because the firm reinvests more given the higher ROE than the cost of the capital. This information is not yet known to the rest of the market.