Question

XYZ Corp. reported a per share book value of $12 in its balance sheet on December 31, 2019. Analysts are forecasting consensus earnings per share of $1.80 for 2020 and $2.40 for 2021. The required return for common equity is 10 percent. The dividend payout is expected to be 50 percent of earnings.

a) Calculate the intrinsic value per share in early 2020 with a forecast that residual earnings will grow at a long-term GDP growth rate of 4% after 2021.

b) What is the market’s forecast of the residual earnings growth rate after 2021 that is implied by the $36 market price in early 2020?

c) Briefly explain the advantages and disadvantages of the residual earnings valuation model.

Answer 1

a. The dividend in the year 2021 is 2.4/2 = 1.2. So, now we use the Gordon growth formula to calculate the terminal value.

TV = D x (1+g)/(r-g) = 1.2 x (1.04)/0.06 = 20.8. Now we discount all the cash flows to get the intrinsic value.

Intrinsic Value = 1.8/2/1.1 + 1.2/1.1^2 + 20.8/1.1^2 = 19

b. Since the market is pricing it at 36, the growth is going to be more. We use the same discounting formula we used above to calculate the terminal value.

TV/1.1^2 + 1.8/2/1.1 + 1.2/1.1^2 = 36

TV = 34.19 = D x (1+g)/(r-g) = 1.2 x (1+g)/(0.1-g)

g=6.27%

c. The advantage of the residual model is that by just knowing the dividend rate and growth rate, we can calculate the intrinsic value. We don't need projections for each and every parameter in the balance sheet. Also, it takes into account the opportunity cost of tying up assets in the business. The minimum rate of return can vary depending on the riskiness of the division.

Disadvantage is that the growth percentage figure is not easy to deduce. It requires many assumptions on our part. Also, it is an absolute measure of return. Absolute measures of return make it difficult to directly compare the performance of divisions