Question

Mini case from the book - Introduction to Corporate Finance 3rd Ed. pg 179 - Valuing stocks

Case - your investment adviser has sent you three analyst reports for a young, growing company named Vegas Chips Inc.. These reports depict the company as spectulative, but each one poses different projections of the company's future growth rate in earning and dividends. all three reports show that vegas chips earned $1.20 per share in the year just ended. There is consensus that a fair rate of return to investors for this common stock is 14% and that management expects to consistently earn a 15% return on the book value of equity (ROE = 15%).

1. Discuss the features(s) that drive the differing valuations of vegas chips. what additional information do you need to garner confidence in the projections of each analyst report?

Answer 1

1.

The various features that initiates the differing valuations of Vegas chips are as mentioned below:

•   Report A uses a different method for valuation of shares. They use a zero-growth method for valuation of shares. In this method, all the profits are distributed by the organization to their shareholders in the form of dividend. In this method, organization does not invest in their earnings to grow their business.

•   Report B uses a different method for valuation of shares that is constant growth method. In this method, it is considered that the rate of shares is grown at a constant rate. Under this method, organization invest its 60% earnings for growing their business.

•   Report C uses a different method for valuation of shares that is variable method. In this method, an organization expects a high level of earnings at initial level and continuous growth in several coming years. Under this method, organization invest its 60% earnings for growing their business.

Additional information needed for garner confidence in the projections of each project are as mentioned below:

The information related with the rate of return is needed because rate of return indicates the value of earnings which is earned by an organization. So, the growth and valuation of shares are totally depends upon the return on equity.