AG, an investment firm requires its analysts to use a two-stage dividend discoun

Question

AG, an investment firm requires its analysts to use a two-stage dividend discount model and the CAPM to value stocks. Using this approach, AG has valued XYZ Inc. at $63 per share. Now AG must value ABD Inc.

Calculate the required rate of return for ABD, Inc. by using the information below:

                                                XYZ                           ABD

Beta                                         1.35                             1.15

Market Price                            $45                             $30

Intrinsic value                          $63                                 ?

Risk-free rate                           4.50%

Expected market return            14.50%

AG estimates 12% growth rate for ABD’s EPS and dividends per share for the first three years, and 9% thereafter. ABD’s dividends per share in the most recent year were $1.72. Using the two-stage dividend discount model estimate the intrinsic value of ABD.

Recommend ABD or XYZ stock for purchase by comparing each firm’s intrinsic value with current market price.

Explanation / Answer

Cost of Equity of ABD = Risk free rate + Beta * ( Market return - Risk Free Rate)
= 4.5% + 1.15 * ( 14.50% - 4.5%) = 16%

Instrinsic value of stock = D*(1+g1)/(1+r) + D*(1+g1)2/(1+r)2 + D*(1+g1)3/(1+r)3 + D*(1+g1)3*(1+g2)/[r-g2)(1+r)3]
=1.72*(1+12%)/(1+16%) + 1.72*(1+12%)2/(1+16%)2 + 1.72*(1+12%)3/(1+16%)3 + 1.72*(1+12%)3 * (1+9%)/[16% -9%) *(1+16%)3 = 28.92
XYZ stock should be bought beacuse market price of XYZ is less than intrinsic value of the firm.
ABD stock should not be bought because market price of ABD is more than the instrinsic value of the firm.

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