Sample Stock Valuation Problems

(with answers)

Question #1

In addition to the bonds described above, you are considering the purchase of Danville’s common stock.
Danville’s common stock has a beta of 0.75. Assume that the current yield on 6-month Treasury bills is
6%. Your brokerage firm believes that the return on the overall market for the next three years should
average 14% per year.

You believe that the earnings of the company (which were $8.00 per share last year) and the dividends will
both grow at the rate of 8% per year over the next three years. After that, the growth rate of the firm is
expected to be 6% per year. You believe that the price/earnings ratio will be 10.6 times earnings at the end
of the next three years. The firm pays out 60% of its earnings in the form of dividends.

a. Determine the required rate of return for Danville, using the capital asset pricing model.

b. Determine the fair market price for Danville’s stock by using a dividend discount model that uses the
price-earnings ratio to predict the future price of the stock.

c. If the current market price of Danville’s stock is $81.00, should you be interested in buying the
stock? Why or why not?

Solution to Question #1
a. Determine the required rate of return, using the capital asset pricing model.

Required Rate of Return = R f + Beta (Return market - Rf )

= 6.0% + 0.75 (14.0% - 6.0%)
= 12.0%
b. Determine the fair price by using a dividend discount model that uses the price/earnings ratio to
determine the future price of the stock.

Year Dividends + Price * PVF = Present Value

0 $4.80
1 5.18 * 0.893 = $4.63
2 5.60 0.797 = 4.46
3 6.05 * 0.712 = 4.31
3 106.82 * 0.712 = 76.06
Fair Price = $89.46

where the future price in year 3 (of $106.82) is equal to:

Price 3 = (P/E)3 x E3
= 10.60 x $10.08
= $106.82

c. Would you be willing to buy the stock for a price of $81.00?

Yes, you would be willing to pay $81.00 for a stock that you believe is worth over $89.00 per share.
 Question #2

You looked in the Wall Street Journal this morning and found that the current yield on U.S. Treasury bills
is 2%. While you were reading the paper, one of your best friends (who works at a brokerage firm in
Nashville) called. Your friend told you that the brokerage firm had just revised its projections and that the
expected return on the overall market is now 8%.

You have been interested in Lavelle stock for some time now. The stock has recently dropped in price and
now sells at a price of $65.00 and has a P/E ratio of 23.2.

Last year, the company posted increased earnings for the eleventh year in a row, with earnings per share
being $2.80. Value Line Investment Survey estimates that earnings will grow 15.60% per year for the next
four years and that dividends will increase 13.62% per year. (Dividends last year were $0.60 per share.)

You are concerned about the volatility of the stock price. The stock has dropped over 15% during the last
three months alone. After consulting Value Line again, you find that the stock has a beta of 1.50. Value
Line also projects the P/E ratio to be 20 four years from now.

Is the stock attractively priced today? Answer by determining the fair price to pay for Lavelle’s stock.

Solution to Question #2

To calculate the stock’s fair price, we need to determine:

1. the required rate of return on the stock,
2. the estimated dividends for the next four years, and
3. the expected price of the stock four years from now [i.e., the future P/E ratio times the earnings per
share four years from now].

First:
Required Rate of Return = R f + Beta (Returnmarket - R f )
= 2.0% + 1.50 (8.0% - 2.0%)
= 11.0%

Second:
We know that last year’s dividends were $0.60. Using the forecasted growth rate of 13.62%, we calculate
the next four years’ dividends to be: $0.68, $0.77, $0.88, and $1.00.

Third, to estimate the selling price of the stock four years from now:
 The future P/E ratio is given in the problem to be a value of 20.
 Using last year’s earnings ($2.80) and the forecasted growth rate for earnings (15.60% per year), we
determine the earnings for the next four years: $3.24, $3.74, $4.33, and $5.00.
 The price four years from now is estimated to be (P/E) 4 * E4 (or 20 * $5.00); this is a price of $100.00.
The fair price to pay for the stock is:

Cash Outflows @11% Cash Inflows

(0) $65.00 (1) $ 0.68 * 0.9009 = $ 0.61
(2) $ 0.77 * 0.8116 = $ 0.63
(3) $ 0.88 * 0.7312 = $ 0.64
(4) $ 1.00 * 0.6587 = $ 0.66
(4) $100.00 * 0.6587 = $65.87
Fair Price = $68.42

Yes, the stock is attractively priced. You would be willing to pay $65.00 for a stock that you believe is
worth $68.42.

Question #3

Sysglen Corporation’s earnings for the past twelve months were $2.00 per share and are expected to grow
at a rate of 12% per year for each of the next three years. The company has a policy of paying out 50% of
its earnings in the form of dividends.

Sysglen’s current stock price is $64.00; the stock’s beta is 0.75. Analysts predict that the price/earnings
ratio will be 25 times earnings three years from now.

The U.S. Treasury bill rate is currently 5% and the expected market return is 9%.

Determine the fair price to pay for Sysglen’s stock and determine the expected rate of return that you would
earn on the stock if you pay the current price for the stock.

Solution to Question #3

Discount rate for the cash flows (i.e., CAPM value) = 8%

Fair price = $59.02
Expected return = 5.1%
 Question #4

Lanceco Corporation’s earned $3.00 per share last year and its earnings are expected to grow at a rate of
20% per year for each of the next three years. The company typically pays out 40% of its earnings in the
form of dividends.

Lanceco’s current stock price is $68.00; the stock’s beta is 1.25. Security analysts who follow the stock
expect the price/earnings ratio to be 20 times earnings three years from now.

The U.S. Treasury bill rate is currently 4% and the expected market return is 12%.

Determine the fair price to pay for Lanceco’s stock and determine the expected rate of return that you
would earn on the stock if you pay the current price for the stock.

Solution to Question #4

Discount rate for the cash flows (i.e., CAPM value) = 14%
Fair price = $73.92
Expected return = 17.3%