Janet Ludlow’s firm requires all its analysts to use a two stage dividend discount model (DDM) and the Capital Asset Pricing Model (CAPM) to value stocks. Using the CAPM and DDM, Ludlow has valued Quick Brush Company at $63 per share.
She now must value Smile White Corporation.
a. Calculate the required rate of return for Smile White by using the information in the following table:
|
Quick Brush |
Smile White |
|
|
Beta |
1.35 |
1.15 |
|
Market price |
$45.00 |
$30.00 |
|
Intrinsic value |
$63.00 |
? |
|
Notes: |
||
|
Risk free rate |
4.50% |
|
|
Expected market return |
14.50% |
b. Ludlow estimates the following EPS and dividend growth rates for Smile White:
|
First 3 years |
12% per year |
|
Years thereafter |
9% per year |
Estimate the intrinsic value of Smile White by using the table above, and the two stages DDM. Dividends per share in the most recent year were $1.72.
c. Recommend Quick Brush or Smile White 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.