(Hint: Use the asset value, DDM, and earnings multiplier approaches.)

American Tobacco S&P 500

Recent price $54.00 $1160

Book value per share $12.10

Liquidation value per share $ 9.10

Replacement cost of assets per share $19.50

Anticipated next year™s dividend $ 2.10 $ 23

Estimated annual growth in dividends and earnings 10.0% 5.0%

Required return 13.0%

Estimated next year™s EPS $ 4.80 $ 50

P/E ratio based on next year™s earnings 11.3 23.2

Dividend yield 3.8% 2.0%

13. The risk-free rate of return is 10%, the required rate of return on the market is 15%, and

High-Flyer stock has a beta coefficient of 1.5. If the dividend per share expected during

the coming year, D1, is $2.50 and g 5%, at what price should a share sell?

14. Imelda Emma, a financial analyst at Del Advisors, Inc. (DAI), has been asked to assess

the impact that construction of a new Disney theme park 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 park 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 assumption 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 coming year (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

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discount model, calculate the intrinsic value of Disney stock.

c. After calculating the intrinsic value of Disney stock using her new assumptions and

DAI™s dividend discount model, Emma finds her recommendation for Disney should

be changed from a “buy” to a “sell.” Explain how the construction of the new theme

park could have such a negative impact on the valuation of Disney stock, despite

Emma™s assumption of sharply higher growth rates (25%).

15. Phoebe Black™s investment club wants to buy the stock of either NewSoft, Inc, or

Capital Corp. In this connection, Black prepared the following table. You have been

asked to help her interpret the data, based on your forecast for a healthy economy and a

strong stock market over the next 12 months.

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12 Equity Valuation

NewSoft, Inc. Capital Corp. S&P 500 Index

Current price $30 $32

Industry Computer Software Capital Goods

P/E ratio (current) 25 14 16

P/E ratio (5-year average) 27 16 16

Price/book ratio (current) 10 3 3

Price/book ratio (5-year average) 12 4 2

Beta 1.5 1.1 1.0

Dividend yield .3% 2.7% 2.8%

a. Newsoft™s shares have higher price“earnings (P/E) and price“book value (P/B) ratios

than those of Capital Corp. (The price“book ratio is the ratio of market value to book

value.) Briefly discuss why the disparity in ratios may not indicate that NewSoft™s

shares are overvalued relative to the shares of Capital Corp. Answer the question in

terms of the two ratios, and assume that there have been no extraordinary events

affecting either company.

b. Using a constant growth dividend discount model, Black estimated the value of

NewSoft to be $28 per share and the value of Capital Corp. to be $34 per share.

Briefly discuss weaknesses of this dividend discount model and explain why this

model may be less suitable for valuing NewSoft than for valuing Capital Corp.

c. Recommend and justify a more appropriate dividend discount model for valuing

NewSoft™s common stock.

16. Your preliminary analysis of two stocks has yielded the information set forth below. The

market capitalization rate for both stock A and stock B is 10% per year.

Stock A Stock B

Expected return on equity, ROE 14% 12%

Estimated earnings per share, E1 $ 2.00 $ 1.65

Estimated dividends per share, D1 $ 1.00 $ 1.00

Current market price per share, P0 $27.00 $25.00

a. What are the expected dividend payout ratios for the two stocks?

b. What are the expected dividend growth rates of each?

c. What is the intrinsic value of each stock?

d. In which, if either, of the two stocks would you choose to invest?

17. Janet Ludlow™s firm requires all its analysts to use a two-stage DDM and the CAPM to

value stocks. Using these measures, Ludlow has valued QuickBrush Company at $63

per share. She now must value SmileWhite Corporation.

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a. Calculate the required rate of return for SmileWhite using the information in the

following table:

December 1999

QuickBrush SmileWhite

Beta 1.35 1.15

Market price $45.00 $30.00

Intrinsic value $63.00 ?

Note: Risk-free rate 4.50%; expected market return 14.50%.

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446 Part FOUR Security Analysis

b. Ludlow estimates the following EPS and dividend growth rates for SmileWhite:

First three years: 12% per year

Years thereafter: 9% per year

Estimate the intrinsic value of SmileWhite using the table above, and the two-stage

DDM. Dividends per share in 1999 were $1.72.

c. Recommend QuickBrush or SmileWhite stock for purchase by comparing each

company™s intrinsic value with its current market price.

d. Describe one strength of the two-stage DDM in comparison with the constant growth

DDM. Describe one weakness inherent in all DDMs.

18. The Tennant Company, founded in 1870, has evolved into the leading producer of large-

sized floor sweepers and scrubbers, which are ridden by their operators. Some of the

firm™s financial data are presented in the following table:

TENNANT COMPANY

SELECTED HISTORIC OPERATING AND BALANCE SHEET DATA (000s OMITTED)

AS OF DECEMBER 31

1990 1995 2000

Net sales $47,909 $109,333 $166,924

Cost of goods sold 27,395 62,373 95,015

Gross profits 20,514 46,960 71,909

Selling, general, and administrative expenses 11,895 29,649 54,151

Earnings before interest and taxes 8,619 17,311 17,758

Interest on long-term debt 0 53 248

Pretax income 8,619 17,258 17,510

Income taxes 4,190 7,655 7,692

After-tax income $ 4,429 $ 9,603 $ 9,818

Total assets $33,848 $ 63,555 $106,098

Total common stockholders™ equity 25,722 46,593 69,516

Long-term debt 6 532 2,480

Total common shares outstanding 5,654 5,402 5,320

Earnings per share $ .78 $ 1.78 $ 1.85

Dividends per share .28 .72 .96

Book value per share 4.55 8.63 13.07

a. Based on these data, calculate a value for Tennant common stock by applying the

constant growth dividend discount model. Assume an investor™s required rate of return

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is a five percentage point premium over the current risk-free rate of return of 7%.

b. To your disappointment, the calculation you completed in part (a) results in a value

below the stock™s current market price. Consequently, you apply the constant growth

DDM using the same required rate of return as in your calculation for part (a), but

using the company™s stated goal of earning 20% per year on stockholders™ equity and

maintaining a 35% dividend payout ratio. However, you find you are unable to

calculate a meaningful answer. Explain why you cannot calculate a meaningful

answer, and identify an alternative DDM that may provide a meaningful answer.

19. You are a portfolio manager considering the purchase of Nucor common stock. Nucor is

the preeminent “minimill” steel producer in the United States. Minimills use scrap steel

Bodie’Kane’Marcus: IV. Security Analysis 12. Equity Valuation © The McGraw’Hill

Essentials of Investments, Companies, 2003

Fifth Edition

447

12 Equity Valuation

as their raw material and produce a limited number of products, primarily for the

construction market. You are provided the following information:

NUCOR CORPORATION

Stock price (Dec. 30, 1997) $53.00

1998 estimated earnings $ 4.25

1998 estimated book value $25.00

Indicated dividend $ 0.40

Beta 1.10

Risk-free return 7.0%

High-grade corporate bond yield 9.0%

Risk premium”stocks over bonds 5.0%

a. Calculate the expected stock market return. Show your calculations.

b. Calculate the implied total return of Nucor stock.

c. Calculate the required return of Nucor stock using the CAPM.

d. Briefly discuss the attractiveness of Nucor based on these data.

20. The stock of Nogro Corporation is currently selling for $10 per share. Earnings per share

in the coming year are expected to be $2. The company has a policy of paying out 50%

of its earnings each year in dividends. The rest is retained and invested in projects that

earn a 20% rate of return per year. This situation is expected to continue indefinitely.

a. Assuming the current market price of the stock reflects its intrinsic value as

computed using the constant growth rate DDM, what rate of return do Nogro™s

investors require?

b. By how much does its value exceed what it would be if all earnings were paid as

dividends and nothing were reinvested?

c. If Nogro were to cut its dividend payout ratio to 25%, what would happen to its

stock price? What if Nogro eliminated the dividend?

21. The risk-free rate of return is 8%, the expected rate of return on the market portfolio is

15%, and the stock of Xyrong Corporation has a beta coefficient of 1.2. Xyrong pays

out 40% of its earnings in dividends, and the latest earnings announced were $10 per

share. Dividends were just paid and are expected to be paid annually. You expect that

Xyrong will earn an ROE of 20% per year on all reinvested earnings forever.

a. What is the intrinsic value of a share of Xyrong stock?

b. If the market price of a share is currently $100, and you expect the market price to be

equal to the intrinsic value one year from now, what is your expected one-year

holding-period return on Xyrong stock?

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1. Find ROE and calculate the plowback ratio for 20 of the firms included in the

Market Insight Web page at www.mhhe.com/edumarketinsight. (Use the data in

the financial highlights section.)

a. Compute sustainable growth, g b ROE.

b. Compare the growth rates computed in (a) with the P/E ratio of the firms. (It

would be useful to plot P/E against g in a scatter diagram. This is easy to do in

Excel.) Is there a relationship between g and P/E?

c. What is the average PEG ratio for the firms in your sample? How much

variation is there across firms?

(continued)

Bodie’Kane’Marcus: IV. Security Analysis 12. Equity Valuation © The McGraw’Hill

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Fifth Edition

448 Part FOUR Security Analysis

(concluded)

d. Find the price-to-book, price-to-sales, and price-to-cash flow ratios for your

sample of firms. Plot a scatter diagram of P/E against these three ratios. What

do you conclude?

e. Calculate the historical growth rate of earnings per share, using the longest

possible historical period. Is the actual rate of earnings growth correlated with

the sustainable growth rate computed in part (a)?

a. Use the data from Market Insight to estimate the intrinsic value of a firm in the

2.

sample. You will need to calculate the beta from the historical return series,

and you will need to make reasonable judgments about the market risk

premium, long-term growth rates based on recent profitability, and plowback.