Stock Growth and Valuation

Please consider the following employing stock valuation techniques used in our class discussion.

You are considering buying the stocks of two companies that operate in the same industry and have, therefore, highly correlated return. They are very similar in earnings and return on assets and both expect to earn $6.00 per share next year(D1). The two companies differ on their dividend policy.

The first company, Road Runner Consolidated, is expected to pay out all of its earnings in the form of a Dividend.

The second company, Acme Industries, is expected to pay only one-third (33.3%) of its earnings, or $2.00 per share next year (D1). Road Runner’s Stock Price is currently $50. Road Runner and Acme are equally risky and, therefore, have the same cost of capital.

Which of the following is most likely to be true? (Support your answer using valuation models)

A) Acme will have a faster growth growthrate than Road Runner. Therefore Acme’s stock price should be greater than $50.

B) Acme’s growth rate should exceed Road Runner’s, but Road Runner’s Dividend exceeds Acme’s, which should cause Road Runner’s price to be higher than Acme.

C) A long-time investor in Road Runner will get her money back faster because Road Runner pays out more of its earnings as dividends. Thus, Road Runner acts like a short-term bond and Acme is like a long-term bond. Therefore, if an increase in the Market Risk Premium causes an increase in both companies’ required rate of return and if the expected dividend streams from Road Runner and Acme remain constant, both stocks will decline, but Road Runner’s price should decline further.

D) Road Runner’s expected and required rate of return is 12%. Acme’s expected return will be higher because of its higher expected growth rate.

E) If Acme’s stock price is also $50, the best estimate of their growth rate is 8%