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Essentials Of Investments
Found in: Page 439
Essentials Of Investments

Essentials Of Investments

Book edition 9th
Author(s) Zvi Bodie, Alex Kane, Alan Marcus, Alan J. Marcus
Pages 748 pages
ISBN 9780078034695

Short Answer

Phoebe Black’s investment club wants to buy the stock of either NewSoft, Inc. or Capital Corp. In this connection, Black prepared the following table. You have been asked to help her interpret the data, based on your forecast for a healthy economy and a strong stock market over the next 12 months.

New soft Inc.

Capital Corp.

S & P 500 index

Current Prices

$30

$32

Industry

Computer Software

Capital Goods

P/E ratio (current)

25

14

16

P/E ration (5 yr average)

27

16

16

Price/book ratio (current)

10

3

3

Price/book ratio (5-year average)

12

4

2

beta

1.5

1.1

1.0

Dividend yield

.3%

2.7%

2.8%

a. Newsoft’s shares have higher price–earnings (P/E) and price–book value (P/B) ratios than those of Capital Corp. (The price–book ratio is the ratio of market value to book value.) Briefly discuss why the disparity in ratios may not indicate that NewSoft’s shares are overvalued relative to the shares of Capital Corp. Answer the question in terms of the two ratios, and assume that there have been no extraordinary events affecting either company.

b. Using a constant-growth dividend discount model, Black estimated the value of NewSoft to be $28 per share and the value of Capital Corp. to be $34 per share.

Briefly discuss weaknesses of this dividend discount model, and explain why this model may be less suitable for valuing NewSoft than for valuing Capital Corp.

c. Recommend and justify a more appropriate dividend discount model for valuing New- Soft’s common stock.

a. growing market with abundant opportunities

b. (i) assumes a constant growth rate of dividends (ii) Dividend growth may not be realistic about NewSoft

c. Use a multi-stage DDM

See the step by step solution

Step by Step Solution

Step 1: Explanation on disparity in ratios ‘a’

Higher selling and earnings of NewSoft is justified by its higher expected growth of earnings and dividends. It is in a growing market with abundant opportunities. Capital has lower growth prospect because of maturing market. Price earning and price book ratio reflect growth opportunity implying that this might not be mispriced.

Step 2: Explanation on weakness of dividend discount model ‘b’

(i) It assumes a constant growth rate of dividends.

(ii) Dividend may be on the growth path but this may not be realistic about NewSoft.

Step 3: Recommendation on appropriate dividend discount model ‘c’

Use a multi-stage DDM to value Newsoft to allow rapid growth in initial years. This will also ultimately slow to a sustainable rate.

Most popular questions for Business-studies Textbooks

Use the following case in answering Problems 26 – 28:

Institutional Advisors for All Inc., or IAAI, is a consulting firm that primarily advises all types of institutions such as foundations, endowments, pension plans, and insurance companies. IAAI also provides advice to a select group of individual investors with large portfolios. One of the claims the firm makes in its advertising is that IAAI devotes considerable resources to forecasting and determining long-term trends; then it uses commonly accepted investment models to determine how these trends should affect the performance of various investments. The members of the research department

of IAAI recently reached some conclusions concerning some important macroeconomic trends. For instance, they have seen an upward trend in job creation and consumer confidence and predict that this should continue for the next few years. Other domestic leading indicators that the research department at IAAI wishes to consider are industrial production, average weekly hours in manufacturing, S&P 500 stock prices, M2 money supply, and the index of consumer expectations.

In light of the predictions for job creation and consumer confidence, the investment advisers at IAAI want to make recommendations for their clients. They use established theories that relate job creation and consumer confidence to inflation and interest rates and then incorporate the forecast movements in inflation and interest rates into established models for explaining asset prices. Their primary concern is to forecast how the trends in job creation and consumer confidence should affect bond prices and how those trends should affect stock prices.

The members of the research department at IAAI also note that stocks have been trending up in the past year, and this information is factored into the forecasts of the overall economy than they deliver. The researchers consider an upward-trending stock market a positive economic indicator in itself; however, they disagree as to the reason this should be the case.

Which of the domestic series that the IAAI research department listed for use as leading indicators is least appropriate?

a. Industrial production

b. Manufacturing average weekly hours

c. M2 money supply

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