Digital Growth Corporation the Digital Growth Corp.

Digital Growth Corporation

The Digital Growth Corp. is seeking to determine its intrinsic value per equity share. The future value as well as the present value must be determined in order to observe the intrinsic value. The intrinsic value of the stock is calculated by obtaining the increase in underlying asset value of the company due to the retention of earnings per share outstanding, which is a function of the market capitalization rate of 15% per year. The earnings are reinvested over the first 5 years and there are no cash dividends distributed to shareholders.

The firm is also expected to grow at 20% per year over the next 5 years. This is to say, earnings per share will grow at a compounded rate of 1.20 per year over 5 years. FV = 1.20^5. The following year, or year 6, the firm will start distributing dividends to shareholders equivalent to 40% of its earnings. Earnings are growing at 20% per year on a base of 10 and after five years, the earnings per share is $24.88. 40% of this amount is paid out as cash dividends and the new EPS reinvestment rate is 15% per year.

The intrinsic value of the stock after the first five years is equivalent to its earnings per share, the reinvestment rate, less dividends, which is $50.00 per share (estimated). From year six and beyond, the intrinsic share price changes due to the dividend paid to shareholders, and the lower rate of return on new investments. The intrinsic value of the stock from year six and beyond is $40.00 per share. Therefore, the estimated intrinsic value of the stock is $45.00 per equity share.

If one were to assume the current market price to be equal to the intrinsic value, the market price is expected to then increase over the intrinsic value, all else being equal. Given the strength of the underlying fundamentals of DG, the market price should be trading at a 20% premium to the intrinsic value over the first few years given the earnings per share and the growth rate. As year five approaches, the intrinsic value drops due to the lower cash flow projections as well as the increase in the liability due to the increase in the dividend rate. The stock price at the market will at that point trade lower and will attempt to retract toward a lower intrinsic value. However, there is an opportunity for arbitrage should there be a deviation between the market price and the intrinsic price.