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Assignment - Equity Valuation 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. a. Calculate the required rate of return for SmileWhite using the information in the following table: December 2007 QuickBrush Beta SmileWhite 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% 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 2007 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. a) k=rf + INITIALS OF INVESTMENTS [E ( rM )rf ]=4.5 +1.15 (14.5 4.5 ) =16 b) Year 2007 2008 2009 2010 2011 Dividends $1.72 x 1.12 $1.72 x 1.122 $1.72 x 1.123 $1.72 x 1.123 x 1.09 $1.72 = $1.93 = $2.16 =$2.42 =$2.63 C) Present Value of dividends paid in years 2008 to 2010 Year 2008 2009 2010 Total: PV of Dividends $1.93/1.161=$1.66 $2.16/1.162 =$1.61 $2.42/1.163= $1.55 $4.82 P2010 = D 2003 $ 2.63 = 0.160.09 = $37.57 kg PV(in 2007) of P2010 =$37.57/(1.163)=$24.07 Intrinsic value of stock= $4.82 +$24.07 = $28.89 c) The table presented in the problem indicates that Quick Brush is selling below intrinsic value, while we have just shown that Smile White is selling somewhat above the estimated intrinsic value. According to this analysis, Quick Brush offers the potential for considerable abnormal returns, while Smile White offers slightly below-market risk-adjusted returns. d) The two-stage model allows for separate valuation of two distinct periods in a company's future. This approach can accommodate life cycle effects. It can avoid the difficulties posed when initial growth rate is higher than the discount rate The two-stage model allows for an initial period of above sustainable growth. It provides the analyst to make use of his or her expectations as growth may shift to a more sustainable level. A weakness of all DDMs is their sensitivity to all input values. Moreover, small changes in k or g can imply large changes in estimated intrinsic value. Thus makes it more difficult to measure