Chapter 10: CHAPTER OVERVIEW

Common Stock Valuation

Similar to the two chapter sequence on bonds, there are two chapters on common stocks involving first the valuation of the asset, followed by analysis and management. In addition, the chapter on efficient markets has been moved to Part IV because the concept is almost entirely concerned with stocks as far as students in a beginning Investments course are concerned. Chapter ! is one of the most important chapters in the te"t. It covers the valuation of common stocks in detail, including both the discounted cash flow approach and the P#$ ratio approach. Clearly, students should know how to find the intrinsic value of a stock using the capitali%ation of income approach&&that is, they should know how to use the 'ividend 'iscount (odel. )he eighth edition has been e"panded to discuss other discounted cash flow approaches. )he chapter opens by e"plaining the present value approach again *this was also done in Chapter + with bonds,. )his capitali%ation of income method seeks to determine the value of a security *its intrinsic value, by discounting all e"pected future cash flows using a required rate of return. )his discussion also includes a brief consideration of the required rate of return *e"plained in detail in Chapter , and the e"pected cash flows. )he chapter emphasi%ed the classic 'ividend 'iscount (odel, which is fully developed, including the three growth rate casesno growth, constant growth, and multiple growth. .owever, some of this material has been moved to an /ppendi". 0umerous e"amples are provided throughout. )he purpose of this analysis is to provide students with the necessary knowledge to work valuation problems, which are found at the end of the chapter. 1elative valuation models are discussed, with primary emphasis on the P#$ ratio model. )he P#$ ratio approach is e"plained as an alternative way of doing fundamental analysis, and one that many practicing analysts use. )he determinants of the P#$ ratio, using the constant growth model, are e"amined. )he relationship between P#$ ratios and interest rates is 135

considered. 2inally, this approach is contrasted to the 'ividend 'iscount (odel. 3ther valuation techniques are briefly e"amined, including price to book and price#sales ratio. )hese other techniques deserve some discussion, but the principal focus remains on the discounted cash flow techniques and the P#$ ratio model. CHAPTER OB ECTIVES

)o e"plain the nature of fundamental security analysis as it applies to common stocks. )o e"plain discounted cash flow models in general, and the 'ividend 'iscount (odel in particular. )o e"plain relative valuation techniques, with special emphasis on the P#$ ratio model. )o establish a framework for fundamental analysis that is used in the three chapter sequence on fundamental analysis *the first three chapters in Part V,.

136

!A OR CHAPTER REA"I#$S %Content&' "i&counte( Ca&h )lo* Techni+ue& 4the discounted cash flow *present value, equation5

)he 1equired 1ate of 1eturn 4brief description of what it is6 more detail in Chapter 5 )he $"pected Cash 2lows 4brief description of what is involved5 )he 'ividend 'iscount (odel 4the equation6 the 7 growth rate cases5 'ividends, 'ividends&&8hat /bout Capital 9ains: 4how dividends plus a terminal price are equivalent to the estimated stream of all future dividends5 Intrinsic Value and (arket Price 4what it is and what it means6 rules for stock selection5 )he 'ividend 'iscount (odel in Practice 4an e"ample of real&world use of this model5 3ther 'iscounted Cash 2low /pproaches 4Streetsmart Guide to Valuing a Stock5

The P,E Ratio or Earnin-& !ultiplier Approach to Valuation 4model6 definition6 importance5

)he Valuation (odel 4how this information is presented5 'eterminants of the P#$ 1atio 4factors that affect the P#$ ratio6 how affected6 e"amples5 ;nderstanding the P#$ 1atio 4P#$s reflect investor e"pectations about growth prospects and the risk involved5 P#$ 1atios and Interest 1ates

P#$ ratios and interest rates are inversely related5 Relati.e Valuation Techni+ue& 4based on making comparisons in order to determine value5

P#$ 1atios 4is the P#$ for a stock lower or higher than <ustified by its prospects:6 e"ample5 Price#=ook Value 4P#$ ratios and interest rates are inversely related5 P#S 1atio *P1S, $conomic Value /dded

Which Approach to /&e0 4both approaches, discounted cash flow techniques and relative valuation techniques, can be used and both involve sub<ective <udgments5 Bur&tin- the Bu11le on #e* Econom2 Stock&3A 4e&&on in Valuation 4the debacle in dot.com companies6 valuation methods do apply5 Some )inal Thou-ht& on Valuation 4sub<ective nature of valuation5 Appen(i5 106A Appen(i5 106B The Con&tant $ro*th Ver&ion o7 the ""! The Anal2&i& an( Valuation o7 Pre7erre( Stock

POI#TS TO #OTE ABO/T CHAPTER 10 Ta1le& an( )i-ure&

)able !&> shows the relationship between yields on bonds and P#$ ratios. )he general point is that interest rates are directly related to required rates of return, and that as the required rate of return increases *decreases,, other thin-& e+ual, the P#$ ratio decreases *increases,. )herefore, bond yields and P#$ ratios are usually inversely related. 2igure !& is designed to illustrate the present value approach to valuation for organi%ational purposes. )he emphasis is on the determination of intrinsic value, which can then be compared to current market price. 2igure !&> illustrates the valuation process for a multiple growth company and could be used as a transparency for the purpose of working through these calculations in class. (ost students have genuine difficulty in understanding supergrowth *multiple growth, models. $"hibit !& shows an actual stock recommendation based on P#$ ratios and earnings. Students can clearly see how this information is presented by the investment industry to subscribers of investment advisory services. 2igure !&7 shows stock market capitali%ations and P#$ ratios for groups of stocks for the year ??+. In this particular case, the largest stocks commanded the highest P#$s. 2igure !& / */ppendi", illustrates the constant growth model using a specific e"ample developed in the te"t *see )able !& /,. )he point here is to show how the nominal value of dividends grows over time as compared to the present value of the dividends. )able !& / illustrates in detail the constant growth version of the 'ividend 'iscount (odel by showing year&by&year results for a particular set of inputs. Shown are the dollar dividend, the PV factor, and the PV of the dollar dividend. =ecause of the format of the equation, many students fail to recogni%e that the constant growth version involves a present value process and accounts for all dividends from now to infinity. Bo5 In&ert

=o" !& is an interesting popular press discussion of the ''( and how it can be used to select stocks, particularly with regard to equation !&?.

A#SWERS TO E#"6O)6CHAPTER 8/ESTIO#S 10619 )he intrin&ic .alue of an asset is its fair economic value as estimated by investors. )his value is a function of underlying economic variables&&specifically, e"pected returns and risk. )raditionally, intrinsic value is determined through a present value process. )he future e"pected cash flows on an asset are discounted at a required rate of return. 106:9 )he re+uire( rate o7 return 7or a &tock is the minimum e"pected rate of return necessary to induce an investor to purchase a stock. It accounts for opportunity cost and the risk involved for a particular stock. If an investor can e"pect to earn the same return elsewhere at a lesser risk, why buy the stock under consideration: 3r, put another way, if your opportunity cost for a given risk level is @A, you should not purchase a stock with that risk level unless you can e"pect to earn @A or more from that stock. $arnings cannot be used directly in the present value approach because reinvested earnings would be double counted, first as earnings reinvested currently and later as dividends paid. If properly defined and separated, these two variables will produce the same results. 'ividends, however, can be used directly. )he "i.i(en( "i&count !o(el is a widely used method to value common stocks. / present value process is used to discount e"pected future dividends at an appropriate required rate of return. )he equation is' PVcs B CCCCC * Dk, 106=9 D '> CCCCCC * Dk,> '7 ' D CCCCCC D ... D CCCCCC * Dk,7 * Dk,

106;9

106<9

)he problems encountered in the dividend discount model stated as $quation !&> in the te"t, and shown above in answer number !&E, include*a, *b, *c, )he last term indicates we are dealing with infinity. )he dividend stream is uncertain. )he required rate of return has to be determined.

106>9

)he three possibilities for dividend growth are*a, *b, *c, no growth&&the dollar dividend will remain fi"ed. constant growth&&the dividend will grow at a steady *constant, rate over time. multiple *super growth,&&at least two different growth rates are involved. (any multiple&growth& rate companies grow rapidly for some years and then slow down to a more normal growth rate.

)he constant growth model is probably the most applicable to the typical large common stock, and certainly is more often used, rightly or wrongly *because of its simplicity,. )he no&growth case is the least likely to apply. 106?9 /lthough dividends are paid to infinity, they can be modeled as either *ignoring the no&growth case, a constant growth rate or a supergrowth situation involving rapid growth for some years plus a constant growth situation for the remainder. In either case, the infinity sign is eliminated. 3n a practical basis, after 7! or E! years dividends discounted at rates of !A to >!A *or higher, will have insignificant value and can be ignored. 106@9 )he dividend discount model can be stated as P! B tB 't CCCCCC * Dk,t

*a,

where P! is the current market price of the stock. /lternatively, we could say *b, n P! B tB 't CCCCCC * Dk,t Pn D CCCCCC * Dk,n

In *b,, Pn is a function of all dividends to be paid from nD to infinity, or

*c,

Pn B nD

't CCCCCC * Dk,t

Substituting the right&hand side of *c, into *b, for Pn produces *a,, putting us back to where we started. )herefore, the combination of a specified number of dividends and a terminal price is e"actly equivalent to an infinite number of dividends because the terminal price takes up where the specified number of dividends stopped *i.e., it is equal to the discounted value of all future dividends,. 106A9 )he two investors are likely to derive different prices because*a, *b, )hey will probably use different estimates of g, the e"pected growth rate in dividends. )hey are likely to use different required rates of return.

106109 Investors compare intrinsic value *IV, to the current market price *C(P, of the stock. If IV F C(P, the stock is undervalued && buy If IV G C(P, the stock is overvalued && sell If IV B C(P, the stock is correctly valued and in equilibrium. 106119 P#$ ratios shown daily in The Wall Street Journal reflect the current market price of the stock divided by the latest > month earnings. )herefore, they show only the current multiple for a stock. 8hile this can be a useful reference point, investors seeking to value a stock will need an estimate of the future multiplier.

1061:9 )he P#$ ratio is affected by*a, *b, )he e"pected dividend payout ratio *'#$,. )he required rate of return.

*c,

)he e"pected growth rate of dividends.

)he P#$ ratio is quite sensitive to a change in these factors. / one percentage point change in the required rate of return, for e"ample, can easily change the price of a stock 7! or E!A. / one percentage point change in g, the e"pected growth rate of dividends, also has a significant impact, but not as large as a change in the required rate of return. =oth of these factors usually have more impact than the payout ratio. 1061;9 Some analysts argue that the dividend discount model is unrealistic because it requires a forecast of dividends into the distant future *technically, infinity,. /lso, many investors are seeking capital gains, while this model seemingly focuses on dividends. In response, it should be noted that the dividend growth rate can be modeled in a workable manner, avoiding the infinite hori%on problem. 2urthermore, investors can structure a stream of dividends and a terminal price *which allows for capital gains, and have an alternative that is equivalent to the basic model. Perhaps the most important point here is that either model, the dividend discount model or the multiplier model, requires estimates of the future. )hese estimates cannot be avoidedH 8hether the inputs for one model as opposed to the other model are more realistic is probably an unresolvable argument. 1061<9 )his analysis is based on the equation *'#$,#*k&g,. *a, *b, *c, *d, decline decline increase increaseI Ithe riskless rate of return is a component of the required rate of return, which has an inverse relationship with the P#$.

A#SWERS TO E#"6O)6CHAPTER PROB4E!S 10619 ;sing the constant growth version of the 'ividend 'iscount (odelk B ' #P! D g B J>.!!#JE@ D .!? B . 7EE or 106:9 7.EEA

1eversing the formula used in answer !& to solve for price, and recogni%ing that we must compound the stated dividend, '!, up one period to obtain ' , P! B ' #*k&g, B '!* Dg,#*k&g, B J>.>@* D.!+, # *. 7&.!+, B J>.E7#.!@ B JE+.K!

106;9

/gain using the constant growth version of the 'ividend 'iscount (odel, solve for g k k&g &g g g g @!g @7g @7g g B B B B B B B B B B ' ' ' k k #P! D g #P! #P! & k & ' #P! & 4*'!* Dg,,#P!5

3r)herefore-

. @ & 4*J7.!!* Dg,,#@!5 L.@! & 7 & 7g L.@! & 7 E.@! !+.E? or +.E?A

106<9 106=9

P B '!#k B *a,

.@!#. @ B J !.!!

k B '!#P! B J7.!!#JE! B L.@A

*b,

)he price will decline because required rates of return rise while dividends remain fi"ed. Specifically, P B J7.!!#.!? B J77.77

106>9

9iven a one year hori%on, this problem can be formulated as P! B J>@ * Dk,>@ Dk k B B B B ' CCCCCCC * Dk, D P CCCCCCC * Dk,

J7.!!#* Dk, D J7!#* Dk, 7 D 7! 77#>@ B .7> 7>A

106?9

*a,

* ,

Stock /

k/ B 12 D M/ *1(&12, B . ! D .!*. @ &. !, B . @ k= B . ! D B . +@ .L*. @&. !,

*>, *7,

Stock = Stock C

kC B . ! D .+*. @&. !, B . E

*b,

If 12 increases to . >, required rates of return arek/ B . > D k= B . > D .!*.!7, B . @ .L*.!7, B . L

kC B . > D !.+*.!7, B . EE *c, If 1( increases to LA, the required rates of return also rise. )he new results arek/ B . ! D k= B . ! D kC B . ! D .!*. L&. !, .L*. L&. !, B . L B .> ?

!.+*. L&. !, B . @K

106@9

*a,

It is necessary to calculate the growth rate since it is not given. 1eferring to the future *compound, value table at the end of the te"t, and reading across the > year row, we find a factor of about >.! *actually, >.! >>, at the intersection of the KA column *or, using the rule of L>, L># > B KA,. )herefore g B KA and k B 4J7.!!* .!K,5#JK! D .!K B !@7 D .!K B . 7 or .7A

*b,

;sing the same table to find a factor of 7.! on the K year row, we find g to be appro"imately >!A *the e"act factor at >!A is >.?+K,. )herefore, using g B >!A, k B 4J7.!!* .>!,5#JK! D .>! B .!K D .>! B .>K or >KA

106A9

*a,

Solving for k as the e"pected rate of return, k B 4J .+!* .!+,5#J7K D .!+ B .!@E D .!+ B . 7E or 7.EA Since the e"pected return of 7.EA is less than the required rate of return of EA, this stock is not a good buy.

*b,

P! B ' #*k&g, B 4J .+!* .!+,5#4. E&.!+5 B J7>.E! /n investor should pay no more than J7>.E! if his or her required rate of return is EA. If the required rate of return is @A, the ma"imum an investor should pay is obviously less than in the previous problem. Specifically, P! B 4J .+!* .!+,5#4. @&.!+5 B J>L.LL

106109 *a, *b,

)he current P#$ ratio is J7>#JE B + $! B JE $ B $!* Dg, B JE* D. !, B JE.E! 8ith an unchanged P#$ of +, the new price will be + " JE.E! B J7@.>!

*c,

'#$ B @!A && payout ratio g B !A && e"pected growth rate of dividends k B KA && required rate of return e"pected rate of return B ' #P! D g B J>.>!#J7> D . ! B . K? or K.?A /lternatively, P! B ' #*k&g, B J>.>!#*. K&. !, B J7K.KK )his stock is a good buy because the e"pected return e"ceeds the required return or, alternatively, the estimated value *price, of the stock e"ceeds the current market price.

*d,

If interest rates are e"pected to decline, the likely effect is an increase in the P#$ ratio for Noy Nuice as well as other stocks.

106119

J .7! * . , CCCCCCCCCCCC B J7!.7+ @.L@ & .

1061:9

J .7! * . K, CCCCCCCCCCCC B no solution @.L@ & . K )his problem cannot be solved using this equation because the growth rate is greater than the discount rate *required rate of return,.

1061;9 ;sing any computer package that solves stock valuation problems, the correct price of J7>.>? should be produced. 1061<9 )his problem is a 7&stage growth model, which is solved e"actly as in !& 7 e"cept three growth rates and the time periods covered are entered rather than two. )he program will produce a price for this stock of J>L.@!. 1061=9 Oowering the growth rate in the first supernormal growth period from 7!A to >@A will clearly result in a lower price because of the lesser growth rate in dividends and the lesser dollar value of the resulting dividend stream. (aking this one change*obviously, no other changes are necessary, results in a new price of J>7.!+. 1061>9 '! B J .K!6 k B J .K! * .!+, P! B CCCCCCCCCCCC . K & .!+ KA6 g B +A B J .L7 CCCCC .!+ B J> .K7

1061?9 J>.!! *.E!, B J!.+! B ' )he correct growth rate to use is the e5pecte( growth rate of LA. P! J!.+! CCCCCCC .!+ B J !

1091@9 P! B J!.K! *.+EL, D J . ! *.L +, D J .>@ *@.@@K, *.L +, B J!.@ D J!.L? D JE.?? B JK.>?

#OTE- @.@@K is #. + *to account for the perpetuity,. )his value must then be discounted back to today using the >&year factor since the perpetuity is valued as of the beginning of year three, which is the same as the end of year two. 1061A9 ' B J .+! * .!K, B J .? B .?! *since the stock is market, k B @A D .? *LA, B J .? P! B CCCCCCCCCCCCCC . 7 & .!K 106:09 k B '! # P! J .!! k B CCCCCCC B +.77A J > 106:19 k B *' # P!,D g k B J>.!! * .!L, # JE! D LA B >.7@A B .7A J7K.!E !A less risky than the

106::9 P! B *J7.!!#.>@,*.7>+, B J7.?E 106:;9 k B ' #P! D g g B k & ' #P! g B . ! & J>.!!#J@! B .!K 106:<9 P! B J ! *E. ?>, D J @ *@.!!, *. K>, B JE .?> D J >. @ B J@E.!L #OTE- E. ?> is the present value of an annuity factor for ! periods at >!A. @.!! is the perpetuity factor for >!A, and . K> is the present value factor for ! periods, >!A.

106:=9 )his is a >&stage growth model, or supergrowth. 2ind the present value of all dividends from now to infinity. n P! B tB '!* Dg ,t 'n* Dgc, CCCCCCCCCCC D CCCCCCCCCC * Dk,t k&gc CCCCCCCC * Dk,n

where g is the supergrowth rate in dividends, gc is the constant growth rate, and n is the number of years of supernormal growth. Solving for the present value of the dividends for the first five years of supergrowth'! ' '> '7 'E '@ B J .!! B .!!* .>@, B B .!!* .>@,> B B .!!* .>@,7 B B .!!* .>@,E B B .!!* .>@,@ B PVI2. + .+EL .L + .K!? .@ K .E7L PV in J J .!K . > . ? .>K .77 J@.?K

J .>@ .@K .?@ >.EE 7.!@

PV of dividends for first @ years B

'@* Dgc, J7.!@* .!L, J7.>K P@ B CCCCCCCCCCCC B CCCCCCCCCCCCCCC B CCCCCCCCC B J>?.KL k&gc . + & .!L . 8e must discount P@ back to time period %ero and add this value to the present value of the first five years of dividends. #OTE- P@ is the price at the end of year five6 therefore, we use the discount factor for @ years, not K years. P@ discounted to time period %eroP@ *PVI2. +,@, B J>?.KL*.E7L, B J >.?L P! B J@.?K D J >.?L B J +.?7 106:>9 )his is in that rate is remains a three stage growth model. It is unusual in the second stage of growth, the growth equal to the discount rate. )he process the same.

'! B J>.!! PVI2.>! PV in J ' B >.!!* .7!, B J>.K! .+77 J >. L > 7!A B g '> B >.!!* .7!, B 7.7+ .K?E >.7@ '7 B >.!!* .7!,7 B E.7? .@L? >.@E &&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&& 'E B '7* .>!, B JE.7?* .>!, B J@.>L .E+> >.@E '@ B 'E* .>!, B @.>L* .>!, B K.7> .E!> >.@E >!A B g 'K B '@* .>!, B K.7>* .>!, B L.@+ .77@ >.@E 'L B 'K* .>!, B L.@+* .>!, B ?. ! .>L? >.@E '+ B 'L* .>!, B ?. !* .>!, B !.?> .>77 >.@E CCCCCC J ?.LK '+* .!K, J !.?>* .!K, J .@+ P+ B CCCCCCCCC B CCCCCCCCCCCC B CCCCCC B J+>.L .>! & .!K . E . E 'iscounting P+ back eight periodsJ+>.L *.>77, B J ?.>L P! B J ?.LK D J ?.>L B J7?.!7 106:?9 )his is a case of three years of %ero dividends, followed by a no&growth period of infinite length. 0ote that one year prior to the start of the no& growth period is year 7. )herefore, P7 B '#k B J #. E B JL. E P! B P7 *PVI2. C)A 106:@9 a.
!,7

, B JL. E *!.KL@, B JE.+>

' V/O;$! B &&&&&& P & g

' B ne"t yearQs dividend P B required rate of return g B constant growth rate ' B *$PS!,* D g,*P#!, B *E.@!,* .!E@,*.@@, B J>.@?

P B given at g B *13$,*

A or . & P#!, B *. !,* J>.@? CCCCCC .!K@ & .@@, B .!E@

J >.@? V/O;$! B CCCCCCCC . &.!E@ b.

J7?.+@

(ultistage 'ividend 'iscount (odel *where g B . @ and g> is .!E@,'> CCCCCC D * DP,> '7#*P&g>, CCCCCCCCC * DP,>

' V/O;$ B CCCCC D * DP, ' B *$PS!,* '> B *' ,*

D g ,*P#!, B *E.@!,* . @,*.@@, B J>.+@

D g , B *J>.+@,* . @, B J7.>L A or .

P B given at g> B .!E@ '7 B *'>,*

D g>, B *J7.>L,* .!E@, B J7.E>

V/O;$! B J>.+@ J7.>L 7.E>#*. &.!E@, CCCCCC D CCCCCCC D CCCCCCCCCCCCCCC * . , * . ,> * . ,> J>.+@ J7.>L J@>.K> CCCCCC D CCCCCCC D CCCCCCC * . , * . ,> * . ,> B B C)A 106:A9 BaC )he dividend discount model isP B d CCCCC k & g J>.@K D J>.K@ D JE>.L JEL.?>

8here P & value of the stock today d & annual dividend one year forward k & discount rate g & constant dividend growth rate Solving for kd d *k & g, B CCC6 then k B CCC D g p p

So k becomes the estimate for the long&term return of the stock. J.K! k B CCCCCC D +A B 7A D +A B J>!.!! B1C A

(any professional investors shy away from the dividend discount framework analysis due to its many inherent comple"ities. * , )he model cannot be used where companies pay very small or no dividends and speculation on the level of future dividends could be futile. *'ividend policy may be arbitrary., )he model presumes one can accurately forecast long term growth of earnings *dividends, of a company. Such forecasts become quite tenuous beyond two years out. */ short&term valuation may be more pertinent., 2or the variable growth models, small differences in g for the first several years produce large differences in the valuations. )he correct k or the discount rate is difficult to estimate for a specific company as an infinite number of factors affect it which are themselves difficult to forecast, e.g., inflation, riskless rate of return, risk premium on stocks and other uncertainties.

*>,

*7,

*E,

*@,

)he model is not definable when g F k as with growth companies, so it is not applicable to a large number of companies. 8here a company has low or negative earnings per share or has a poor balance sheet, the ability to continue the dividend is questionable. )he components of income can differ substantially, reducing comparability.

*K,

*L, BcC

)hree alternative methods of valuation would include* , *>, *7, *E, *@, Price#$arnings ratios Price#/sset value ratios *including market and book asset values, Price#Sales ratios Oiquidation or breakup value Price#cash flow ratios

C)A 106;09 /.

)he formula for the constant growth discounted dividend model is shown belowPrice B '! * D g, CCCCCCCCCCCC k & g

8here '! B current dividends per share 2or $astoverPrice B .>! I .!+ CCCCCCCCCCCCC B E7 !. & !.!+

)his compares with its current stock price of >+. 3n this basis, it appears that $astover is undervalued. =. )he formula for the two&stage discounted dividend model is as follows-

' '> '7 P7 Price- CCCCC D CCCCCCC D CCCCCCC D CCCCCCC Dk * Dk,> * Dk,7 * Dk,7 'E where P7 B CCCCCCCC k & g> 2or $astover'! ' '> '7 'E B .>! B .>! B .>! B .>! B '7 g B . > g> B .!+ I I I I . > * . >,> * . >,7 * .!+, B B B B .7E .@! .K? .+>

P7 B

.+> # *.

& .!+, B K!.KL

.7E .@! .K? K!.KL Price B CCCC D CCCCCCC D CCCCCCC D CCCCCCC . * . ,> * . ,7 * . ,7 B E+.!7 )his approach indicates that $astover is even more undervalued than was the case with the constant growth approach. /n alternative solution to two&stage model is' '> P> Price B CCCCC D CCCCCC D CCCCCC * Dk, * Dk,> * Dk,> '7 P> B CCCC k&g> B .K? CCCCCCC B @K.77 . &.!+

.7E .@! @K.77 Price B CCCC D CCCCCCC D CCCCCCCC . * . ,> * . ,> B .> D .>> D [email protected]>

B E+. @

)his answer differs from previous answer because of round off error. C. Constant growth model, >, 7, 'isadvantages, >, 7, E, @, K, L, +, logical, theoretical basis simple to compute inputs can be estimated very sensitive to inputs of growth g and k difficult to estimate accurately result is meaningless if g F k constant growth is an unrealistic assumption assumes growth will never slow down dividend payout must remain constant not usable for firms not paying dividends assumes stock price will increase at g

/dvantages-

Improvements with the two&stage model. )he two&stage model is more realistic. It accounts for low, high, or %ero growth in the first stage, followed by constant long&term growth in the second stage. )he model can solve for stock value when the growth rate in the first stage e"ceeds the required rate of return.

>.