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;one a random walk (RW) and the other a random walk with $0.05 drift (RWD) .The EPS for PF Corporation is currently $0.25,and in the previous year EPS was $0.25.PF Corporation has a current share price of $4.25 and a cost of capital of 12%.Which of the following best represents your recommendation about PF Corporation under each approach?

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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 $0.25.Using the EPS model (equation 11.21)gives a valuation for PF Corporation of 0.25 / 0.12 = $2.08 (approximately),which suggests that PF Corporation is overvalued at the current price of $4.25.Using the random walk with drift model results in an expected next period EPS of $0.30 gives a valuation for PF Corporation of 0.30/0.12 = $2.50,which also suggests that PF Corporation is overvalued at the current price of $4.25.Therefore,both the random walk (RW)and random walk with drift (RWD)models suggest that the shares in PF Corporation are overpriced.Hence the recommendation is that we should short-sell the stock.

You Work for an Arm of a Major Merchant Bank