In August 2003, Krispy Kreme’s common stock was trading at $44 per share. Several analysts and investors believed at the time that its shares were worth considerably less. They appear to have been right because by November 2007, the stock was trading below $3 per share. This problem illustrates how the abnormal earnings valuation model described in Appendix A of this chapter can be combined with security analysts’ published earnings forecasts and used to spot potentially overvalued stocks.

1. Use the abnormal earnings valuation model from Exhibit 6.8 of Appendix A of this chapter to derive an estimate of Krispy Kreme’s stock price as of August 2003. A spreadsheet template is available on the textbook website. You will need this additional information:
• Actual EPS for 2001 and 2002 were $0.49 and $0.70, respectively.
• The per share amount of stock issued in 2001 and 2002 was $0.65 and $0.39, respectively.
No stock was expected to be issued or bought back during the next five years (2003–2007).
• Other comprehensive income per share was $0.32 in 2002 and zero in 2001. Analysts were forecasting other comprehensive income to be zero each year during the next five years.
• Krispy Kreme does not pay dividends.
• Return on equity, calculated using the beginning-of-year equity book value, was 21.1% and 20.2% in 2001 and 2002, respectively.
• Analysts were forecasting EPS to be $0.70 and $0.89 in 2003 and 2004, respectively.
The estimated long-term EPS growth rate was 13.25% for 2005 through 2007.
• Krispy Kreme’s equity cost of capital is 11%, and the long-term growth rate (beyond 2007) is assumed to be 3%.
2. Why might your value estimate from requirement 1 differ from the company’s $44 stock price in August 2003?

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