Question

Question 6 You are considering an investment in ABC company and compile the following information on its stock • The market price for the stock is $225/share • The LTM EPS is $15. • Over the past year, ABC paid dividends per share of $12. • The company's P/E is 15, P/B is 15, and P/S is 0.8. • The ROE is 20%, and the profit margin on sales is 10%. • The Treasury bond rate is 4%, the equity risk premium is 5%, and ABC's beta is 1.5. Assume that the constant growth model is appropriate and the earnings growth rate is 3%. What stock recommendation should you provide based on comparing the current P/S ratio to the justified P/S ratio? ABC is undervalued ABC is fairly valued ABC is overvalued Ned

Answer 1

Solution- (CORRECT answer: ABC is overvalued)

To tell whether the stock is under valued, fairly valued or over valued we first need to find the intrinsic value of the stock using dividend discount model and then we can compute justified P/S ratio and compare it with market P/S ratio.

According to Dividend discount model:

Intrinsic Price of the stock = Current dividend * (1+ growth rate) / (required return - growth rate)

Current Dividend = $12
Growth Rate = 3%
Required return using CAPM formula = risk free rate + Beta * (Equity Risk Premium)= 4% + 1.5*(5%) = 11.5%

Intrinsic Price of the stock = [Current dividend * (1+ growth rate)] / (required return - growth rate) = [12*(1+0.03)] / (0.115 - 0.03) = $145.412

Given, Current P/S = 0.8 and current market price = $225/share. So, Sales = 225/0.8 = $281.25/share

Justified P/S = Intrinsic Price of the stock / Sales = 145.412/281.25 = 0.517

As Current P./S (0.8) is greater than Justified P/S *0.517) so the stock is over-valued.