This case illustrates how the abnormal earnings valuation model described in Appendix 7A of this chapter can be combined with security analysts’ published earnings forecasts and used to spot potentially overvalued stocks.

Required:

1. Use the abnormal earnings valuation model from Exhibit 7.8 of Appendix 7A of this chapter to derive an estimate of McCord Company’s stock price as of December 20X0.

• The book value of McCord’s equity at December 31, 20X0, was $10.00 per share.

• Actual EPS for 20X0 was $1.00.

• No stock is expected to be issued or bought back during the next five years (20X1–20X5).

• McCord has no Other comprehensive income.

• McCord does not pay dividends.

• Analysts were forecasting EPS to be $1.25 and $1.60 in 20X1 and 20X2, respectively. The estimated EPS growth rate for 20X3 through 20X5 is 8%.

• McCord’s equity cost of capital is 9%, and the long-term growth rate (beyond 20X5) is assumed to be 3%.

2. Why might your value estimate from Requirement 1 differ from the company’s actual stock price in December 20X0?