Question

Monica Dubois, an ABC investment advisor, has a new client, Mr. Jack Klein. Mr. Klein is a conservative investor who is interested in a required rate of return of 10% on his stock investments while assuming lower market risk. You are asked to help Monica make a suitable portfolio recommendation backed by risk-return calculations. The 3 possible stock choices for Mr. Klein and their respective betas are as follows: Stock Expected Return Beta ABC 10% 0.75 XYZ 11% 1.0 WHY 12% 1.25 Part I Determine the expected returns and beta for a portfolio consisting of one third of Mr. Klein's funds in each stock. Part II Assume the following: Each ABC stock pays current dividends of $1.50 annually with 6% expected annual increases. The current market stock price for ABC is $30 per share. Each XYZ stock pays current dividends of $1.75 annually with 6% expected annual increases. The current market stock price for XYZ is $27 per share. Each WHY stock pays current dividends of $2.25 annually with 7% expected annual increases. Current market stock price for WHY is $35 per share. Complete the following for this assignment: Using the constant dividend growth model, determine whether ABC and WHY are over- or undervalued. For what types of companies is the constant growth model an appropriate analysis tool? What are the limitations of the constant growth model?

Answer 1

Part I

Expected return of the portfolio = 1/3*return of ABC + 1/3*return of XYZ + 1/3*return of WHY

= 1/3*10% + 1/3*11% + 1/3*12%

= 11.00%

Beta of the portfolio = weighted average of betas of all stock.

Weighted average = weight of a stock*its beta

Thus portfolio beta = 1/3*0.75 + 1/3*1 + 1/3*1.25

= 1.00

Part II:

ABC stock: Intrinsic value = D1/r-g = D0*(1+g)/r-g

= 1.5*(1+6%)/(10%-6%)

= $39.75

Current stock price of ABC = $30. As ABC’s current market price is less than its intrinsic value ABC is undervalued.

Intrinsic value of XYZ = 1.75*(1+6%)/(10%-6%) = $46.38

Current stock price of XYZ = $27 and as current market price<than its intrinsic value XYZ is undervalued.

Intrinsic value of WHY = 2.25*1.07/10%-7% = $80.25

Current market price of WHY = $35. Thus WHY is also undervalued.

The constant growth model is appropriate for those companies whose dividend amounts are expected to grow at a constant rate in future years. In other words it is suitable for companies whose earnings are expected to grow at a stable and constant rate and hence dividend payouts will remain fixed.

Limitations of constant growth model is that it completely disregards non-dividend and qualitative factors like brand royalty, retention of customers, sustainable competitive advantage of the company etc. Secondly the assumption that a company’s dividend growth rate is stable and known does not hold most of the times.