CFA Level IEquity InvestmentsHard
An analyst is valuing a stock using a two-stage dividend discount model with a terminal value based on an exit P/E multiple. The stock just paid a dividend (D0) of $2.00, expected to grow at 10% annually for the next 3 years. At the end of Year 3, the analyst expects the stock to trade at 15 times its Year 4 forecasted EPS, which is projected to be $5.00. The required rate of return on equity is 10%. What is the estimated intrinsic value of the stock today?
- A$58.35
- B$77.66
- C$62.35
- D$68.00
Show answer & explanationAnswer & explanation
Correct answer: C. $62.35
D1 = 2.00(1.10) = 2.20; D2 = 2.20(1.10) = 2.42; D3 = 2.42(1.10) = 2.662. Terminal value at end of Year 3 = 15 × $5.00 = $75.00. PV = D1/1.10 + D2/1.10^2 + (D3+TV)/1.10^3 = 2.00 + 2.00 + (2.662+75.00)/1.331 = 2.00 + 2.00 + 58.35 = $62.35.
Why the other options are wrong
- A. This is only the PV of Year 3 dividend plus terminal value, omitting Years 1 and 2 dividends.
- B. This is the undiscounted sum of Year 3 dividend and terminal value (no time value adjustment).
- D. This results from an arithmetic error in discounting the terminal value.
Terminal Value via Exit Multiple (DDM)
A valuation approach combining explicit dividend forecasts with a terminal sale price estimated by applying a market multiple (e.g., P/E) to a forecasted future fundamental (e.g., EPS).
- Terminal value = Multiple × Forecasted fundamental in the terminal year.
- All cash flows, including terminal value, must be discounted back to present at the required return.
- This hybrid approach blends fundamental (DDM) and relative (multiples) valuation.
Memory trick: Discount each dividend, then discount the final selling price too — nothing skips the time machine.