John Castle recently joined a large pension fund as an equity analyst. Being a fresh hire from graduate school, he went through a 4-week training session before being assigned the project work. As a part of training, he had to value stocks of the following companies using the appropriate model and come up with suitable recommendations.

Rockway Co. is a ball bearing manufacturing firm which is expected to pay dividends of $2.1, $2.25 and

$2.45 at the end of next three consecutive years. The investors required rate of return is 8%. The current market price of shares is $134 while the investor expects it to be $149 per share at the end of three years.

Motorway Co. is an automobile manufacturing firm with the required rate of return of 10%. For the past 10 years, they have been paying dividends linked to their earnings. As per their policy, the rest of the earnings get invested in growth opportunities with high expected returns. Presently, their shares are trading at $108 with expected earnings of $8 per year. As per the industry experts, shares of this company are properly priced.

Papa Cola is a new player in the beverage market. The company is currently in its initial growth phase and management plans to pull in huge funds for expansion. With reported earnings of $1.80 per share, the company is expected to grow at 18% for the next three years. Presently, no dividend is paid but the company plans to roll out dividend with 30% payout ratio starting from year 4. As per the analyst, this

future dividend will continue to grow with the long-term rate of 4% and the required rate of return is 12%. The current market price of the shares is $8.

During the initial stages, John faced some conceptual doubts and approached his supervisor, Mr. Morrisey to get them resolved. His supervisor made two statements and asked him to keep them in mind while choosing the dividend discount model (DDM).

Statement 1: the DDM takes the perspective of controlling shareholder.

Statement 2: the DDM should be applied only if the firms dividend policy is consistent with its

profitability trend.

After having a conversation with his supervisor, John decided to discuss this topic during lunch with his fellow members, who were also fresh recruits. Before he could begin, one of his friends, Jacob, asked him if any relation existed between justified leading P/E and justified trailing P/E for a growth firm. After giving it a proper thought, John reached on to the correct solution. Based on the data given in the case, answer the questions below.

Based on the two-period DDM, comment whether Papa Cola is overvalued, undervalued or properly valued. Justify your answer. Show your calculations.