If you plan to buy the stock, hold it for 3 years, and then sell it for $27.05, what is the most you should pay for it?

Homework set Fin-534 number 3.

You should not pay more than the intrinsic value, or the current value of future expected cash flows, if you intend to hold the stock for three-years and then sell for $27.05. This figure is calculated by taking into consideration factors such as the market price at present, current interest rates and earnings per share.

For example, let’s say a particular stock is currently trading at $20 and has a dividend yield of 4% per annum while inflation rate is 2%. The real return after inflation is then 2%. We can calculate the current value of an expected return using a discounted cashflow (DCF). What price should we be prepared to pay now for the stock in order to earn an annualized return rate of 2% on that investment for three years.

In this case assuming a discount rate of 8%, then our DCF calculation would suggest that we should not pay more than $22.94 ($20 + 3 x 0.04 x 1.02^3) which represents an intrinsic value slightly higher than the intended selling price after 3 years so that we can benefit from capital gains as well as income derived from dividends during our holding period.