Dwayne sat at his desk wondering what he should do$.$ Having opted for early

retirement, six months ago, he knew that he needed to make some changes in the way

his investment portfolio was structured. However, being primarily focused on science

during his career, he had a fairly limited knowledge of stock selection and portfolio

management. One thing was certain, though, Dwayne had an eagerness to learn and

that$$s exactly what he planned to do during his appointment with his broker, Jonathan

Price.

Dwayne Stevenson, aged $58,$ had joined the Pharmacopia Company

approximately thirty years ago, as a post$-$doctoral researcher in the field of

immunology. His strong work ethic and knowledge of science enabled him to

progress steadily along the research track of the company. He won a number of

awards and earned many promotions along the way. Five years ago, Dwayne earned

the coveted title of $$Research $5$ Scientist$$ enjoyed by only $4$ other individuals in the

corporation. One of the main advantages of gaining the $$Research $5$ status was that

he was given stock options as part of his remuneration package. At that time, shares of

Pharmacopia $($PCU$)$ were trading at $$20$ per share. The company had annual sales in

excess of $$5$ billion and the sales and earnings growth forecasts for the next few years

were good. The company had applied for Food and Drug Administration $($FDA$)$

approval for two highly promising drugs and had a number of others in the pipeline.

However, as luck would have it$,$ about $3$ years later, the firm suffered a few

setbacks. The FDA did not approve a couple of its application and the Environmental

Protection Agency $($EPA$)$ was investigating Pharmacopia for possible dumping

violations. Besides, the patents on two of its best selling drugs had expired and

generic versions began to flood the market. Needless to say, the firm$$s sales began to

suffer and profits began to shrink sending its stock price into a downward spiral.

$$Downsizing$$ and cost cutting were buzzwords that could be heard throughout the

firm and on Wall Street.

About a year later, Dwayne was offered the option to take early retirement,

primarily because his project was one that had not gained FDA approval. The

severance package offered by the company was too good to turn down so Dwayne

opted for early retirement. Part of the retirement package included a significant

amount of company stock, which was trading at $$12$ at the time.

As a result of having exercised stock options and his early retirement package,

Dwayne had accumulated over $100,000$ shares of PCU$$s common stock. This caused

his investment portfolio to not be well diversified and Dwayne knew that he needed to

$2$

restructure it$.$ With PCU$$s stock price having declined to $$5$ per share in recent

months, Dwayne wondered whether he should sell the stock or hold it until it reached

a better price. Having had very little financial and investment training, Dwayne

contacted his broker, Jonathan Price, for some advice. His main question to Jonathan

was, $$How low can it go$?$

Jonathan told him to hold on to the stock because his calculations showed that

it was significantly undervalued at $$5$ per share and should rise to about $$10$ per share

in a few months. He felt that the company was having temporary regulatory problems

and should be able to weather the storm quite well. He said that the current intrinsic

value of the stock, in his opinion, was in the range of $$8-$ $$15.$ Not convinced,

Dwayne asked him to explain how he arrived at that range. Jonathan replied that he

used alternate forms of the divided discount model, to which Dwayne responded,

$$Dividend what?$$ Jonathan realized that he would have to give Dwayne a primer on

stock valuation and set up an appointment for the following week.

In preparation for the appointment, Jonathan prepared Table $1$ showing the

sales, net income, earnings per share, and dividend per share data for the prior $10-$year

period. In addition, he estimated that the required rate of return is $15\%.$ Jonathan

knew that he would have to keep his explanations simple, yet convincing, and

expected to be faced with many difficult questions. Question: $$Why are you using dividends and not earnings per share, Jonathan?$$ asked

Dwayne. What do you think Jonathan would have said