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8. Mike, an aggressive financial planner who claims to have a superior method for picking undervalued stocks is courting one of your clients. The planner

8. Mike, an aggressive financial planner who claims to have a superior method for picking undervalued stocks is courting one of your clients. The planner claims that the best way to find the value of a stock is to divide EBITDA by the risk-free bond rate. The planner is urging your client to invest in NewMarket, Inc. The planner says that NewMarkets EBITDA of $1,580 million divided by the long-term government bond rate of 7 percent gives a total value of $22,571.4 million. With 318 million outstanding shares, NewMarkets value per share found by using this method is $70.98. Shares of NewMarket currently trade for $36.50.

A. Provide your client with an alternative estimate of NewMarkets value per share based on a two-stage FCFE valuation approach. Use the following assumptions:

  • Net income is currently $600 million. Net income will grow by 20 percent annually for the next three years.
  • The net investment in operating assets (capital expenditures less depreciation plus investment in working capital) will be $1,150 million next year and grow at 15 percent for the following two years.
  • Forty percent of the net investment in operating assets will be financed with net new debt financing.
  • NewMarkets beta is 1.3; the risk-free bond rate is 7 percent; the equity risk premium is 4 percent.
  • After three years, the growth rate of net income will be 8 percent, and the net investment in operating assets (capital expenditures minus depreciation plus the increase in working capital) each year will drop to 30 percent of net income.
  • Debt is, and will continue to be, 40 percent of total assets.
  • NewMarket has 318 million shares outstanding.

B. Criticize the valuation approach that the aggressive financial planner used.

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