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# 11 a the formula for the constant growth discounted

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11. a. The formula for the constant growth discounted dividend model is: g k ) g 1 ( D P 0 0 + = For Eastover: 20 . 43 \$ 08 . 0 11 . 0 08 . 1 20 . 1 \$ P 0 = × = This compares with the current stock price of \$28. On this basis, it appears that Eastover is undervalued. b. The formula for the two-stage discounted dividend model is: 3 3 3 3 2 2 1 1 0 ) k 1 ( P ) k 1 ( D ) k 1 ( D ) k 1 ( D P + + + + + + + = For Eastover: g 1 = 0.12 and g 2 = 0.08 D 0 = 1.20 D 1 = D 0 (1.12) 1 = \$1.34 D 2 = D 0 (1.12) 2 = \$1.51 D 3 = D 0 (1.12) 3 = \$1.69 D 4 = D 0 (1.12) 3 (1.08) = \$1.82 67 . 60 \$ 08 . 0 11 . 0 82 . 1 \$ g k D P 2 4 3 = = = 03 . 48 \$ ) 11 . 1 ( 67 . 60 \$ ) 11 . 1 ( 69 . 1 \$ ) 11 . 1 ( 51 . 1 \$ ) 11 . 1 ( 34 . 1 \$ P 3 3 2 1 0 = + + + = This approach makes Eastover appear even more undervalued than was the case using the constant growth approach. 19-6

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c. Advantages of the constant growth model include: (1) logical, theoretical basis; (2) simple to compute; (3) inputs can be estimated. Disadvantages include: (1) very sensitive to estimates of growth; (2) g and k difficult to estimate accurately; (3) only valid for g < k; (4) constant growth is an unrealistic assumption; (5) assumes growth will never slow down; (6) dividend payout must remain constant; (7) not applicable for firms not paying dividends. Improvements offered by the two-stage model include: (1) The two-stage model is more realistic. It accounts for low, high, or zero growth in the first stage, followed by constant long-term growth in the second stage. (2) The model can be used to determine stock value when the growth rate in the first stage exceeds the required rate of return. 12. a. In order to determine whether a stock is undervalued or overvalued, analysts often compute price-earnings ratios (P/Es) and price-book ratios (P/Bs); then, these ratios are compared to benchmarks for the market, such as the S&P 500 index. The formulas for these calculations are: Relative P/E = P/E of specific company Relative P/B = P/B of specific company To evaluate EO and SHC using a relative P/E model, Mulroney can calculate the five-year average P/E for each stock, and divide that number by the 5-year average P/E for the S&P 500 (shown in the last column of Table 19E). This gives the historical average relative P/E. Mulroney can then compare the average historical relative P/E to the current relative P/E (i.e., the current P/E on each stock, using the estimate of this year’s earnings per share in Table 19F, divided by the current P/E of the market). For the price/book model, Mulroney should make similar calculations, i.e., divide the five-year average price-book ratio for a stock by the five year average price/book for the S&P 500, and compare the result to the current relative price/book (using current book value). The results are as follows: P/E model EO SHC S&P500 5-year average P/E 16.56 11.94 15.20 Relative 5-year P/E 1.09 0.79 Current P/E 17.50 16.00 20.20 Current relative P/E 0.87
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11 a The formula for the constant growth discounted...

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