Brian Dobson, an analyst at UK-based globally diversified equity mutual fund, has been assigned the task of estimating a fair value of the common stock of Charmed Energy. Dobson is aware of several approaches that could be used for this purpose. After carefully considering the characteristics of the company and its competitors, he believes Charmed will have extraordinary growth for the next few years and normal growth thereafter. So, he has concluded that a two-stage DDM is the most appropriate for valuing the stock.
Charmed pays semi-annual dividends. The total dividends during 2016, 2017, and 2018 have been C$0.114, C$0.15, and C$0.175, respectively. These imply a growth rate of 32% in 2017 and 17% in 2018. Dobson believes that the growth rate will be 14% in the next year. He has estimated that the first stage will include the next eight years.
Dobson is using the CAPM to estimate the required return on equity for Charmed. He has estimated that the company’s beta, as measured against the S&P/TSX Composite Index (formerly TSE 300 Composite Index), is 0.84. The Canadian risk-free rate, as measured by the annual yield on the 10-year government bond, is 4.1%. The equity risk premium for the Canadian market is estimated at 5.5%. Based on these data, Dobson has estimated that the required return on Charmed Energy’s stock is 0.041 + 0.84(0.055) = 0.0872, or 8.72%. Dobson is doing the analysis in January 2019, and the stock price at that time is C$17.
Dobson realizes that even within the two-stage DDM, there could be some variations in the approach. He would like to explore how these variations affect the stock’s valuation. Specifically, he wants to estimate the value of the stock for each of the following approaches separately.
Q] What is the terminal value of the stock based on the first approach?
- A.C$17.65.
- B.C$31.06.
- C.C$33.09.
Solution- A
Time Value Calculation Dt or Vt Present Values
Dt/(1.0872)t
or Vt/(1.0872)t
1 D 1 C$0.175(1.14) C$0.1995 C$0.1835
2 D 2 0.175(1.14)2 0.2274 0.1924
3 D 3 0.175(1.14)3 0.2593 0.2018
4 D 4 0.175(1.14)4 0.2956 0.2116
5 D 5 0.175(1.14)5 0.3369 0.2218
6 D 6 0.175(1.14)6 0.3841 0.2326
7 D 7 0.175(1.14)7 0.4379 0.2439
8 D 8 0.175(1.14)8 0.4992 0.2557
8 V 8 0.175(1.14)8(1.07)/(0.0872 − 0.07) 31.0550 15.9095
Total C$17.6528
WHY GROWTH IS TAKEN AS 7% WHERE AS IT IS 14%???