Question

(a) You are a stock analyst in charge of valuing high-technology firms, and you are expected to come out with buy-sell recommendations for your clients. You are currently analyzing a firm called e talk.com that specializes in internet-based communication. You are expecting explosive growth in this area. However, the company is not currently profitable even though you believe it will be in the future. Your projections are that the firm will pay no dividends for the next 3 years. F our years from now, you expect the stock to pay its first dividend of $1 per share. You expect dividends to increase at a rate of 20 percent per year for three years after that. At that point, the industry will start to mature and slow down;dividends will continue to grow but only at a rate of 10 percent per year for the foreseeable future.The stock is priced in the market at $20 per share. Given a required rate of return of 14 percent, what is your estimate of the value of the stock? Should you issue a recommendation to buy or to sell?

(b) The day after you make your estimate in part (a), new information indicates that things are not going as smoothly as predicted for this business. Your estimates of the initial dividend and the growth rates remain the same, but the timing has changed. You now estimate that the firm will pay its first dividend ($1) in 6 years. The high-growth period (20 percent per year) will last for only two years before slowing to growth of 10 percent per year for the foreseeable future. Given a required rate of return of 14 percent, what is your new estimate of the value of the stock? Should you change your recommendation (assuming the stock is still priced in the market at $20)?

Answer 1

Part A:

The value of the share as per Gordon Model (Dividend discount Model) is the present value of all the dividends.

The calculation is shown as under:

Year	Dividend	PV of the Dividend
4	$                          1.0000	$                          0.5921
5	$                          1.2000	$                          0.6232
6	$                          1.4400	$                          0.6560
7	$                          1.7280	$                          0.6906
8	$                          1.9008#1	$                          0.6663
T8#2	$                       52.2720	$                       18.3244
		$                       21.5527

#1: This is the growth at the new stable rate of 10%

#2: This is the terminal value as per Gordon model Po = D1 / (Ke - g),

where, Ke = Cost of Discount

g = Growth Rate

D1 = Dividend of the next year

Since the value of the share in the market is $ 20, the actual price is undervalued and, hence we should buy the share today.

Part B: Similarily like the above-mentioned calculation, the share price is calculated as per the new information available:

Year	Dividend	PV of the Dividend
6	$                          1.0000	$                          0.4556
7	$                          1.2000	$                          0.4796
8	$                          1.4400	$                          0.5048
9	$                          1.5840#4	$                          0.4871
T9#3	$                       43.5600	$                       13.3950
		$                       15.3221

#3: This is also the terminal value as per Gordon model Po = D1 / (Ke - g),

where, Ke = Cost of Discount

g = Growth Rate

D1 = Dividend of the next year

#4 This is the growth at the new rate of 10%

Since the value of the share in the market is $ 20, the actual price is overvalued and, hence we should sell the share today as per the new information acquired from the market.