Question

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 QuickBrush Company at $63 per share. She now must value SmileWhite Corporation. a. Calculate the required rate of return for SmileWhite by using the information in the following table: Quick Brush SmileWhite 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 SmileWhite: First 3 years 12% per year Years thereafter 9% per year Estimate the intrinsic value of SmileWhite by using the table above, and the twostage DDM. Dividends per share in the most recent year were $1.72. c. Recommend QuickBrush or SmileWhite 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 constantgrowth DDM. Describe one weakness inherent in all DDMs.

Answer 1

Solution using DDM and CAPM model is as follows :

A)

B)

C)

D) The two stage DDM has a more realistic assumption that growth rate is higher during a few years before assuming a normal growth rate for the rest of the life.

Weakness : DDM models considers only dividends as only stream of flows. Thus, firms paying no dividend at all can't be valued using DDM model.

Hope it helps. Thank you :)