Phoebe Blackâ€™s investment club wants to buy the stock of either NewSoft, Inc, or Capital Corp. In this connection, Black prepared the following table. You have been asked to help her interpret the data, based on your forecast for a healthy economy and a strong stock market over the next 12 months.
a. Newsoftâ€™s shares have higher priceâ€“earnings (P/E) and priceâ€“book value (P/B) ratios than those of Capital Corp. (The priceâ€“book ratio is the ratio of market value to book value.) Briefl y discuss why the disparity in ratios may not indicate that NewSoftâ€™s shares are overvalued relative to the shares of Capital Corp. Answer the question in terms of the two ratios, and assume that there have been no extraordinary events affecting either company.
b. Using a constant-growth dividend discount model, Black estimated the value of NewSoft to be $28 per share and the value of Capital Corp. to be $34 per share. Briefl y discuss weaknesses of this dividend discount model and explain why this model may be less suitable for valuing NewSoft than for valuing Capital Corp.
c. Recommend and justify a more appropriate dividend discount model for valuing NewSoftâ€™s common stock.