Reference no: EM132390818

(a) You are a stock analyst in charge of valuing high-technology firms, and you are expected to come out with buy-sell recommendations for your clients. You are currently analyzing a firm called etalk.com that specializes in internet-based communication. You are expecting explosive growth in this area. However, the company is not currently profitable even though you believe it will be in the future. Your projections are that the firm will pay no dividends for the next 2 years. Three years from now, you expect the stock to pay its first dividend of $1.50 per share. You expect dividends to increase at a rate of 10 percent per year for two years after that. At that point, the industry will start to mature and slow down; dividends will continue to grow but only at a rate of 5 percent per year for the foreseeable future. The stock is priced in the market at $15 per share. If you believe that a fair rate of return on a stock of this type is 12 percent, what is your estimate of the value of the stock, and should you issue a recommendation to buy or to sell?

b) The day after you make your estimate in part (a), new information indicates that things are not going as smoothly as predicted for this business. Your estimates have changed: You expect no dividends for the next 3 years. Four years from now, you expect the stock to pay its first dividend of $1. You estimate dividends will grow at 8% for two years after that. Thereafter, you expect dividends to grow indefinitely at 4%. Given a rate of return of 12 percent, what is your new estimate of the value of the stock, and should you change your recommendation (assuming the stock is still priced in the market at $15)?