Imelda Emma, a financial analyst at Del Advisors, Inc. (DAI), has been asked to assess the impact that construction of Disney’s new theme parks might have on its stock. DAI uses a dividend discount valuation model that incorporates beta in the derivation of risk-adjusted required rates of return on stocks. Until now, Emma has been using a five-year earnings and dividends per share growth rate of 15% and a beta estimate of 1.00 for Disney. Taking construction of the new theme parks into account, however, she has raised her growth rate and beta estimates to 25% and 1.15, respectively. The complete set of Emma’s current assumptions is:
Current stock price $37.75 Beta 1.15 Risk-free rate of return (T-bill) 4.0% Required rate of return on the market 10.0% Short-term growth rate (five years) for earnings and dividends 25.0% Long-term growth rate (beyond five years) for earnings and dividends 9.3% Dividend forecast for 1994 (per share) $.287
a. Calculate the risk-adjusted required rate of return on Disney stock using Emma’s current beta assumption.
b. Using the results of part (a), Emma’s current assumptions, and DAI’s dividend discount model, calculate the intrinsic, or fair, value of Disney stock at September 30, 1993.
c. After calculating the intrinsic value of Disney stock using her new assumptions and DAI’s dividend discount model, Emma finds that her recommendation for Disney should be changed from a “buy” to a “sell.” Explain how the construction of the new theme parks could have a negative impact on the valuation of Disney stock, despite
Emma’s assumption of sharply higher growth rates (25%).