Answer to Question #161141 in Macroeconomics for Hellen

Question

1.              Consider the stock of Aviva PLC. The beta of the stock is 1.25. The earnings per share (EPS) in the coming year is 55p. The expected Return on Equity (ROE) is 11%. The expected return on the market portfolio is 9%. The risk-free rate is 5%. The dividend pay-out ratio is 50%. What is the fair price of Aviva stock? 

Answer 1

Solution:

The Cost of Capital (k) = $Risk\; free\; rate + Beta \;coefficient \times (Expected\; market\; return - Risk\; free \;rate)$

k = $0.05 + 1.25 \times (0.09 - 0.05)$ 0.05 + 1.25*(0.09 – 0.05)

Derive dividends per share:

Dividend payout ratio =$\frac{DPS}{EPS}$

$0.05 = \frac{DPS}{55}$

DPS =$0.05\times 55 = 2.75$

Dividend growth rate (g) = $(1 - Dividend\; Payout\; Ratio)\times ROE$

g =$(1 - 0.5)\times 0.11 = 0.5 \times0.11 = 0.055$

Fair value of stock =$\frac{DPS}{Required \;return\; of \;return\; (k) - Dividend\; growth\; rate\; (g)}$

FVS = $\frac{275}{(0.1-0.055) }$

FVS = $\frac{275}{0.45} = 61$

Fair Value of Stock = 61