You work for an arm of a major merchant bank specialising in Australian equity stocks.It is company policy to use the earnings capitalisation model for valuation purposes and to calculate EPS forecasts using two approaches;a random walk (RW) and a random walk with $0.05 drift (RWD) .The EPS for PF Corporation is currently $0.50,and in the previous year EPS was $0.52.PF Corporation has a current share price of $5.60 and a cost of capital of 8%.Which of the following best represents your recommendation about PF Corporation under each approach?

Question

Quizplus · Accepted Answer

Under the random walk model,the expected next period EPS is simply the most recent EPS figure.In this case,that is $0.50.Using the EPS model (equation 11.21)gives a valuation for PF Corporation of 0.50 / 0.08 = $6.25,which suggests that PF Corp.is undervalued at the current price of $5.60.Using the random walk with drift model results in an expected next period EPS of $0.55 gives a valuation for PF Corp.of 0.55 / 0.08 = $6.88 (approximately),which also suggests that PF Corp.is undervalued at the current price of $5.60.Therefore,both the random walk (RW)and random walk with drift (RWD)models suggest that the shares in PF Corp are underpriced.Hence the recommendation is that we should buy the stock.

You Work for an Arm of a Major Merchant Bank