Read the whole question through carefully before attempting to solve.]
You are an equity analyst trying to determine if the stock of a company, currently trading in a range of $90 – $100 a share, is over-valued. You feel that investor sentiment has driven the price per share higher than a fundamental valuing of the companyâ€™s discounted cash flows to equity justifies.
The company has a capital structure of 90% equity and 10% debt. There are 5278789 common shares outstanding. There are no preferred shares.
The stock has a beta ÃŸÃŸ of 1.2, and the equity risk premium is 4.375%. The risk free rate is 2.25%.
Their pre-tax cost of debt is 4.5%, and the corporate tax rate is 30%.
You estimate their cash flows to equity for the next three years as follows:
Given that it can be hard to forecast with reasonable accuracy past this time frame, you decide that in Year 4, you will estimate the “terminal value” of the cash flows to equity owners. You estimate its Year 4 cash flow to equity owners will increase 2% over its Year 3 cashflow, and do so into infinity.
To estimate the terminal value, you use what is known as the “present value of a perpetuity” formula, which is:
Where “CF” is the cash flow for the year in which terminal value is estimated, and Re is the expected return on equity, which you have calculated given the information above. As you are not trying to calculate the Enterprise Value of the combined cash flows to debt and equity, the appropriate discount rate is the expected return on equity.
Once you have estimated the terminal value, you discount it the appropriate number of years, as you have done for the cash flows from 2022 to 2024.
Adding up the sum of the discounted cash flows provides you the equity value of the company; that is, what their equity should be valued at based cash flows to equity owners.
How much would you be willing to pay for one of their common shares, in 2021? (Two decimal places.)