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 twostage 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.
196
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View Full Documentc.
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 twostage model include:
(1) The twostage model is more realistic.
It accounts for low, high, or zero growth
in the first stage, followed by constant longterm 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 priceearnings ratios (P/Es) and pricebook 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
fiveyear average P/E for each stock, and divide that number by the 5year
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 fiveyear average pricebook 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
5year average P/E
16.56
11.94
15.20
Relative 5year 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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 Spring '13
 Ohk
 Generally Accepted Accounting Principles

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