Finance 3050 Homework 2 Autumn 2012 Due Thursday 11/29/12

Finance 3050 Homework 2 Autumn 2012due Thursday 112912 15 Poi

Calculate the required rate of return for Questar, determine the growth rate of dividends based on reinvestment return, estimate stock value using dividend growth model, compare it with current stock price to assess over- or underpricing, project earnings at the end of 2017 assuming growth, determine the future stock price based on P/E ratio, and compute the internal rate of return of a simulated investment considering dividends and sale price, based on data collected for Questar (ticker: STR).

Paper For Above instruction

Understanding stock valuation and return calculations is vital for investors aiming to make informed investment decisions. This paper explores multiple financial metrics and valuation models based on data for Questar (ticker: STR), including the required rate of return, dividend growth rate, intrinsic stock value, comparison with current market price, projected earnings, future stock price, and internal rate of return (IRR) of a hypothetical investment strategy.

Introduction

Stock valuation involves assessing the value of a company's shares based on its financial performance, growth prospects, and market conditions. Critical to this process are tools like the Capital Asset Pricing Model (CAPM), dividend discount models, and ratios such as the P/E ratio. Accurate calculations can reveal whether a stock is undervalued or overvalued in the market, guiding investment strategies. This paper applies these concepts to Questar, a publicly traded company, integrating real data to examine its financial standing and investment attractiveness.

Data Collection and Initial Assumptions

First, key data points are gathered from Questar's financial reports and market information. These include:

• Closing stock price on Tuesday, November 20th (assumed as given or obtained from market sources)
• Next year's projected annual dividend
• Current analysts' EPS estimates for the current year and the following year
• Analysts' estimated five-year EPS growth rate

For the purpose of this analysis, assume the following data based on latest available market information and analyst reports:

• Closing price on 11/20: $40.50
• Next year's projected dividend (D1): $1.80
• EPS estimate for current year: $2.20
• EPS estimate for next year: $2.40
• Estimated 5-year EPS growth rate: 8%

Note that these values should be replaced with actual data for precise calculation, but for illustrative purposes, these figures are used here.

Calculation of the Required Rate of Return (Part a)

The required rate of return, using the Capital Asset Pricing Model (CAPM), is given by:

 R = Rf + β (E(rm) - Rf)

where Rf = 1.0%, E(rm) = 8.5%, and β = 0.44. Substituting these values:

 R = 0.01 + 0.44  (0.085 - 0.01) = 0.01 + 0.44  0.075 = 0.01 + 0.033 = 0.043 or 4.3%

Thus, shareholders should require approximately 4.3% return on their investment based on the given risk profile.

Dividend Growth Rate Calculation (Part b)

The dividend growth rate (g) can be estimated using the retention ratio and the return on reinvested earnings:

 g = b * ROE

where b = retention ratio = 44% = 0.44, and ROE = 3% = 0.03. Therefore:

 g = 0.44 * 0.03 = 0.0132 or 1.32%

This indicates dividends are expected to grow at approximately 1.32% indefinitely under reinvestment assumptions.

Intrinsic Stock Valuation Using the Gordon Growth Model (Part c)

The Gordon Growth Model states:

 P0 = D1 / (r - g)

Where D1 = next year's dividend ($1.80), r = required rate of return (4.3%), g = dividend growth rate (1.32%). Plugging these in:

 P0 = 1.80 / (0.043 - 0.0132) = 1.80 / 0.0298 ≈ $60.40

This suggests the intrinsic value per share is approximately $60.40, assuming dividends grow at 1.32% annually.

Comparison with Current Market Price (Part d)

The current market price per share on 11/20 was assumed at $40.50. Comparing this with the intrinsic value of $60.40 indicates the stock is undervalued, offering potential upside for investors.

Projected Earnings at End of 2017 (Part e)

The estimated EPS for 2012 is $2.20, with an 8% growth rate over five years:

 EPS at 2017 = EPS2012  (1 + g)^5 = 2.20  (1.08)^5 ≈ 2.20 * 1.4693 ≈ $3.23

This projection indicates EPS will grow to approximately $3.23 by 2017.

Projected Stock Price at End of 2017 (Part f)

Applying the P/E ratio of 16.1 at that time:

 Future stock price = EPS2017  P/E = 3.23  16.1 ≈ $52.05

This is the estimated price at which the stock should sell in 2017 based on future earnings and P/E ratio.

IRR of a Buy-and-Hold Strategy (Part g)

Assuming dividends remain constant over five years, and then the stock is sold at the projected price, the rate of return is found by solving:

 P0 = $40.50, D1 = $1.80, D2 = $1.80, D3 = $1.80, D4 = $1.80, D5 = $1.80, P5 = $52.05

The internal rate of return (IRR) can be calculated by equating the present value of dividends and sale price to the initial investment:

0 = -P0 + D1/(1 + IRR) + D2/(1 + IRR)^2 + D3/(1 + IRR)^3 + D4/(1 + IRR)^4 + D5/(1 + IRR)^5 + P5/(1 + IRR)^5

Calculations show an approximate IRR of about 8-10%, indicating the annualized return on this investment strategy, incorporating dividends and sale proceeds, lies in this range, assuming the above parameters.

Conclusion

This comprehensive analysis demonstrates the valuation process for Questar's stock, incorporating fundamental data, growth assumptions, and valuation models. The stock appears undervalued given the data, with projected growth supporting a positive investment outlook. Investors should consider these calculations alongside market trends and company fundamentals before making investment decisions.

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