Question

QUESTION 3 – Valuing Stocks – 20 marks

Your CFO has sent you three analyst reports for a young, growing company that you are interested in acquiring. These reports depict the company as speculative, but each one poses different projections of the company’s future growth rate in earnings and dividends. All three reports show that the company recorded an earnings per share (EPS) of $1.20. The company just paid 40% of its earnings as dividends. There’s consensus that market rate of return (expected rate of return) to investors for this share is 14 percent, and that company’s management expects to consistently earn a 15 percent return on equity (ROE = 15 percent).

REPORT A  

The analyst who produced report A makes the assumption that the company will remain a small, regional company that, although profitable, is not expected to grow. Therefore, the company expects to pay the same dividend per share in future years.

1. Based on this report, what model can you use to value a share in the company? Using this model, what is the value of a share?

REPORT B

The analyst who produced report B makes the assumption that the company will enter the national market and grow at a constant rate i.e. at the company’s current sustainable growth rate.

1. Based on this report, what model can you use to value a share in the company? Using this model, what is the value of a share?

REPORT C

The analyst who produced report C also makes the assumption that the company will enter the national market but expects a high level of initial excitement for the product that is then followed by growth at a constant rate.

Earnings and dividends are expected to grow at a rate of 50 percent over the next year (i.e. year 1), 20 percent for the following two years (year 2 and year 3), and then revert back to the company’s constant growth rate which is the company’s current sustainable growth rate.

1. Based on this report, what model can you use to value a share in the company? Using this model, what is the value of a share?

Comment on the different valuations you have just done

Answer 1

Report A]

The perpetual dividend model can be used to value the share. Value of share in perpetual dividend model = dividend / required return of shareholders

Value of share = ($1.20 * 40%) / 14% = $3.43

Report B]

The constant growth model can be used to value the share

Value of share in constant growth model = next year dividend / (required return of shareholders - constant growth rate)

sustainable constant growth rate = retention ratio * ROE = 60% * 15% = 9%

Value of share = ($1.20 * 0.40 * (1 + 9%)) / (14% - 9%) = $10.46

Report C]

The multi-stage model can be used to value the share. In this model, the dividends grow at a high rate initially before falling to a constant growth rate.

value of share = present value of dividends during high-growth stage + present value of terminal value

terminal value is the value of the share at the end of the high-growth stage. The terminal value is calculated using the constant-growth model as the dividend growth rate is expected to remain constant after the high-growth stage. The constant growth rate is 9% as calculated in Report B.

The dividends for year 1 to 4 are as below :

Year	Dividend
1	0.72
2	0.86
3	1.04
4	1.13

Terminal value at end of year 3 = year 4 dividend / (required return of shareholders - constant growth rate)

Terminal value at end of year 3 = $1.13 / (14% - 9% ) = $22.6

Present value of terminal value = $22.6 / 1.14³ = $15.25

Present value of dividends = ($0.72 / 1.14) + (0.86 / 1.14²) + ($1.04 / 1.14³) = $2.00

Value of share = $15.25 + $2.00 = $17.25

Value of share as per the perpetual dividend model is lowest as the dividends are constant with no growth

Value of share as per the constant growth model is higher as dividends grow every year at a constant growth rate

Value of share as per the multi-stage growth model is highest as dividends grow at a higher rate for 3 years before settling at a constant growth rate