Question

• Part A-Fundamental Valuation:
  1. Estimate a growth rate for your firm's Dividends per Share.
  2. Assume a 12.5% discount rate.
  3. Calculate an estimated value of a share of the stock using the constant-growth model (Eq. 8-6 in the textbook), also known as the Gordon growth model.
  4. Compare and contrast your valuation results with the current share price in the market.
  5. Respond to this question: What changes in the variables would be necessary in your valuation to best approximate the market valuation?
• Part B - Relative Valuation:
  1. Estimate a growth rate for your firm's Earnings per Share (EPS).
  2. Determine an applicable Price-Earnings (P/E) ratio for your firm in 5 years.
  3. Calculate an estimated value of a share of the stock in 5 years using the P/E ratio model (Eq. 8-10 in the textbook).
  4. Respond to this question: Would you characterize your stock as undervalued or overvalued? Explain.
  5. Respond to this question: Based on your valuations in parts A and B, would you invest in this stock? Explain.

the company I am using is XOM: I would like all the answers be based on that company please

Answer 1

PART - A: Fundamental Valuation:

a. Estimating the growth rate for XOM's dividend's per share.

Year	Dividend Payout Per Share ($)	Growth (%)
2014	2.70	0.00
2015	2.88	6.67
2016	2.98	3.50
2017	3.06	2.68
2018	3.23	5.55
2019	3.43	6.19

By taking an arithmetic mean of the dividend growth rate (%) for the past 5 years i.e. 2015 - 2019, growth rate for XOM's dividend's per share would be as follows:

Dividend growth rate = (6.67+3.50+2.68+5.55+6.19) / 5 = 4.92% ~ 5%

b. Calculation of estimated value of XOM's share using constant-growth model:

The formula for Gordon growth model is -

P1 = D1 / (r - g)

where, P1 = Estimated stock price,

D1 = Value of next year's dividend

r = Expected rate of return / discount rate

g = Expected dividend growth rate

Therefore in the present case, D1 = D (1 + g) = 3.43 (1 + 0.05) = 3.60

P1 = 3.60 / (0.125 - 0.05) = $ 48 per share

As per Gordon growth model, estimated stock price for XOM is $ 48 per share.

c. Current market price vs. estimated price and changes required in the variables for best approximation of the market valuation.

Current Market Price of XOM ~ $ 43 per share.

Estimated price as per Gordon growth model - $ 48 per share.

The variation in the prices between the above two is due to the following limitations of Gordon growth model:

1) Assumption of dividend growth rate - Gordon growth model assumes dividend growth rate to be constant regardless of the dynamic nature of business cycles, contingencies and financial stress. Further, the model only considers dividend growth rate for estimation of stock value, which restricts the changes in others variables important for valuation of stock value.

2) Discount factor vs. dividend growth rate - If the expected return is less than the dividend growth rate, then the resultant outcome of the model would be negative share price. Further, if the expected return is equal to the dividend growth rate, then the share price would tend to infinity.

Changes required in the variables for best approximation of the market valuation:

For arriving at the best approximation of market value, we need to reconsider the discount rate in the model.

P1 = D1 (r - g)

43 = 3.60 (r - 0.05)

r - 0.05 = 3.60 / 43

r = 13.37%

By taking discount rate at 13.40%, the estimated price would be $ 42.85 per share, which would be the best approximation of market value. Accordingly, the discount rate / required rate of return can be revised to arrive at the market valuation. Meaning thereby, for XOM the required return is higher in the market as compared to that given.

PART - B: Relative Valuation:

a) Estimation of growth rate for XOM's earnings per share (EPS):

Year	Earnings Per Share ($)	Growth (%)
2014	7.60	0.00
2015	3.85	- 49.34
2016	1.88	- 51.17
2017	4.63	146.28
2018	4.88	5.40
2019	3.36	- 31.15

By taking an arithmetic mean of the EPS growth rate (%) for the past 5 years i.e. 2015 - 2019, growth rate for XOM's EPS would be as follows:

EPS growth rate = (-49.34-51.17+146.28+5.40-31.15) / 5 = 4%

b) Price-Earnings (P/E) ratio of XOM for 5 years:

P/E Ratio = Market Price Per Share / Earnings per Share (EPS)

Date	Market Price Per Share ($)	EPS ($)	P/E Ratio
Dec. 31, 2015	68.87	3.85	17.89
Dec. 31, 2016	82.57	1.88	43.92
Dec. 31, 2017	79.44	4.63	17.16
Dec. 31, 2018	67.44	4.88	13.82
Dec. 31, 2019	69.78	3.36	20.77

XOM's P/E Ratio is 20.77 times ~ 21 times on the basis of current market price and EPS.

c) Calculation of estimated value of XOM's share in 5 years using the P/E ratio model:

Year	Earnings Per Share ($) (Growth rate @ 4%)	Estimated value of XOM's Share using P/E Ratio iof 21 times
2020	3.4944	73.38
2021	3.6342	76.32
2022	3.7795	79.37
2023	3.9307	82.54
2024	4.0879	85.85

d) Whether the stock is undervalued or overvalued?

In the past, XOM has delieverd good EPS as compared to that in the year 2019. Owing to this, XOM has a higher P/E Ratio on a lower EPS in 2019. However, in the past, XOM's P/E Ratio has remained as low as 14 times. Therefore, by taking P/E Ratio of 15 times, estimated stock value arrrives at $ 50.40 per share.

This estimated stock value is higher as compared to the market price of $ 37.97 as on March 31, 2020, which means the stock value of XOM is undervalued as compared to its intrinsic value and the stock is trading at a discount, which is in-line to the general market trends for all the companies due to the recent outbreak of COVID-19. Moreover, due to recent events, XOM's P/E ratio would have further declined to below 15 times.

e) Based on valuations in Parts A & B, whether investing in this stock is advisable?

By considering Gordon growth model, the estimated stock value is determined at $ 48 per share (discount rate of 12.50%), where as by considering P/E Ratio model, the estimated stock value was at $ 50 per share (P/E Ratio of 15 times).

Considering the market valuation of $ 37.97 as on March 31, 2020, it is advisable to invest in XOM's share, as the intrinsic value of XOM's share as per both Gordon growth model and P/E Ratio model are higher as compared to the market valuation. This means there is an opportunity to invest in this stock and wait for market correction / equilibrium to take place.