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Search Energy Inc. is a rapidly growing oil and gas company. You have been entrusted by your portfolio manager to evaluate Search Energy Inc. for possible inclusion in the portfolio. As the company has been growing at a very high rate in recent times, you have concluded that a two-stage dividend discount model (DDM) is the most appropriate for valuing the stock. The company's current stock price is $17 and it paid a dividend of $0.175 last year. Search Energy Inc. has a beta of 0.84, the risk-free rate is 4.1%, and the equity risk premium is 5.5%.
Required: Present all calculation step by step.
Estimate the value of the firm for each of the following approaches separately:
a. The dividend growth rate will be 14% throughout the first stage of five years. The dividend growth rate thereafter will be 7 percent.
b. In contrast to the first approach in which the growth rate declines abruptly from 14% in the fifth year to 7% in the sixth, the growth rate would decline linearly from 14 percent in the first year to 7 percent in the sixth. (Hint: Use the H model)
c. What is your recommendation for Search Energy Inc. and why? What is the implied growth rate at the current stock price assuming a constant growth rate for the foreseeable future?
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