If a security is underpriced (i.e., intrinsic value > price), then what is the relationship between its market capitalization rate and its expected rate of return?
If intrinsic value = price, the market capitalization = expected rate of return.
If intrinsic value > Price, the market capitalization rate > expected rate of return
A security with its price lower than its asset value or earning potential is known as underpriced security.
While the investor’s individual assessment is known as intrinsic value of a stock, market consensus on its expected rate of return is called market capitalization. If the former is equal to price, the latter is also expected to be equal to the expected rate of return. But if the intrinsic value > Price, the expected rate of return is greater than market capitalization rate.
Even Better Products has come out with a new and improved product. As a result, the firm projects an ROE of 20%, and it will maintain a plowback ratio of .30. Its earnings this year will be $2 per share. Investors expect a 12% rate of return on the stock.
a. At what price and P/E ratio would you expect the firm to sell?
b. What is the present value of growth opportunities?
c. What would be the P/E ratio and the present value of growth opportunities if the firm planned to reinvest only 20% of its earnings?
Use the following case in answering Problems 29 – 32:
Mary Smith, a Level II CFA candidate, was recently hired for an analyst position at the Bank of Ireland. Her first assignment is to examine the competitive strategies employed by various French wineries.
Smith’s report identifies four wineries that are the major players in the French wine industry. The key characteristics of each are cited in Table 12.6. In the body of Smith’s report, she includes a discussion of the competitive structure of the French wine industry. She notes that over the past five years, the French wine industry has not responded to changing consumer tastes. Profit margins have declined steadily, and the number of firms representing the industry has decreased from 10 to 4. It appears that participants in the French wine industry must consolidate in order to survive.
Smith’s report notes that French consumers have strong bargaining power over the industry.
She supports this conclusion with five key points, which she labels “Bargaining Power of Buyers”:
After completing the first draft of her report, Smith takes it to her boss, RonVanDriesen, to review. VanDriesen tells her that he is a wine connoisseur himself and often makes purchases from the South Winery. Smith tells VanDriesen, “In my report, I have classified the South Winery as a stuck-in-the-middle firm. It tries to be a cost leader by selling its wine at a price that is slightly below the other firms, but it also tries to differentiate itself from its competitors by producing wine in bottles with curved necks, which increases its cost structure. The end result is that the South Winery’s profit margin gets squeezed from both sides.” VanDriesen replies, “I have met members of the management team from the South Winery at a couple of the wine conventions I have attended. I believe that the South Winery could succeed at following
both cost leadership and a differentiation strategy if its operations were separated into distinct operating units, with each unit pursuing a different competitive strategy.” Smith makes a note to do more research on generic competitive strategies to verify VanDriesen’s assertions before publishing the final draft of her report.
Smith notes in her report that the West Winery might differentiate its wine product on attributes that buyers perceive to be important. Which of the following attributes would be the most likely area of focus for the West Winery to create a differentiated product?
a. The method of delivery for the product
b. The price of the product
c. A focus on customers aged 30 to 45
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