The Generic Genetic (GG) Corporation pays no cash dividends currently and is not expected to for the next 3 years. Its latest EPS was $10, all of which was reinvested in the company. The firm's expected ROE for the next 3 years is 15% per year, during which time it is expected to reinvest all of its earnings. Starting in year 4, the firm's ROE on new investments is expected to fall to 12%, and the plowback ratio is 1/2, which it will continue to do forever after. The risk-free rate is 5%, the expected market return is 8%, and the stock of GG has a beta coefficient of 1.4. A competitor in the market trades with a price-earnings (PE) ratio of 16 in the market.
a. What is the intrinsic value of a share of GG stock based on DDM?
b. Do you think it is important to use multistage dividend discount model to value a firm? in what circumstances? and does it have any limitations, eg. compared to FCFE model?
c. If a stock is underpriced, what is the relationship between market capitalization rate and its expected rate of return?
d. What is the relative valuation of GG based on the PE ratio?
e. Comment on the differences in the estimated value of GG if any and the merits of each method of valuation. f. Assuming the company is the target of a hostile takeover and the acquirer is offering to pay $165 for a share in GG. On the basis of your two calculations to value the firm, should you accept the offer giving reasons for your recommendation?