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You have been asked to perform a stock valuation prior to the annual shareholders meeting next week. The two models you’ve selected to value the firm are 1) the dividend discount model and 2) the discounted cash flow model. Explain why the estimates from the two valuation methods differ. Address the assumptions implicit in the models themselves as well as those you made during the valuation process. Also, explain why these prepared estimates may differ from the actual stick price today, or any given day.

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Tod Thiel
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8 Mar 2019

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a. Describe the underlying assumptions and differences for the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT). Provide an example in which type of situation each would be most appropriate to the task. Is there any situation in which using either method would be acceptable? Or neither, and if so, which pricing model would then be most appropriate? Explain.

b. You have been asked to perform a stock valuation prior to the annual shareholders meeting next week. The two models you’ve selected to value the firm are 1) the dividend discount model and 2) the discounted cash flow model. Explain why the estimates from the two valuation methods differ. Address the assumptions implicit in the models themselves as well as those you made during the valuation process. Also, explain why these prepared estimates may differ from the actual stick price today, or any given day.

c. In a "perfect world" capital market, how important is a firm’s decision to pay dividends versus repurchase shares? Under what conditions would you have a tax preference for share repurchase rather than dividends? Would managers acting in the interests of long-term shareholders be more likely to repurchase shares if they believed the stock to be either undervalued or overvalued? Lastly, explain how you would respond to firm’s decision to cut its dividend.

Sabrina Gupta, an investment advisor with a major brokerage firm, was examining Wal-Mart Stores, Inc. (Wal-Mart) stock and its valuation. Gupta wondered whether to recommend the stock to any of her new clients or to existing clients who did not currently have Wal-Mart in their portfolios.

Her key task was to use an intrinsic value approach to price the shares and to then compare the resulting price with the price at which the stock was traded in the market. Gupta wanted to use alternative valuation methods and assumptions to produce intrinsic value estimates for Wal-Mart stock.

She was interested in seeing if the alternative methods would point to a consensus regarding the valuation of the stock and to see if the valuations suggested an investment opportunity given the current market price. Methods she contemplated to use were:

Multi-stage growth model

Price Earnings Multiple

Most valuation methods Gupta considered required a common set of inputs:

Future Cash Flows to Wal-Mart Investors

Growth rate of future cash flows

Discount factor or required rate of return by Wal-Mart investors

Gupta gathered data to determine each of the above.

Gupta thought that Dividends to Wal-Mart shareholders would adequately capture the cash flows to Wal-Mart shareholders; she also thought that this approach would simplify her task and she would revisit more complex valuation models if she felt the need.

Gupta thought that CAPM would provide her a relatively reliable estimate of the required rate of return. CAPM based required rate of return can be estimated by using a risk free rate, systematic risk of the firm and equity market risk premium. Gupta thought that in a valuation exercise that involve long term cash flows, 10-year government bond yield would be an appropriate risk free rate of return estimate. She checked the 10 year note rate and found out that it was about 3.68%. Gupta searched for Wal-Mart beta in Bloomberg. Bloomberg estimates betas by regressing the S&P 500 returns on the firm returns over the past two years and arrives at a “raw” beta estimate. Bloomberg makes an adjustment in raw beta based on some academic research. Gupta is confident that Bloomberg adjustment is justified and she uses Wal-Mart beta estimate of 0.66 in her analysis.

While Gupta is aware of the importance of EMRP assumption, she thinks that Bloomberg’s historical estimate of 5.05% is a safe assumption. She is aware of the fact that some studies suggest a larger risk premium of approximately six per cent, while others suggest a much lower forward-looking premium of less than four per cent. She is mindful of the arbitrariness of her assumption, and she takes a note to revisit this issue if her valuations produce unreasonable estimates.

Anticipated dividend growth (g) is often estimated in a variety of ways.

First, observed historical dividend growth can be assumed to continue in a perpetual fashion.

Second, future dividend growth can be estimated on the basis of recent estimates of analysts.

Gupta noted that the consensus annual Wal-Mart dividend for fiscal year 2011 was $1.21, and one respected analyst had estimated the expected constant dividend growth (in perpetuity) at approximately 3%.

As the chart suggests, both earnings and dividend growth rates are declining but they seem to be higher than the “respected analyst’s” estimates. Gupta decides to use several alternative perpetual growth assumptions to see the impact on price. Since Gupta decided to use variants of dividend discount model (DDM), she checked the anticipated earnings for 2011. Analyst’s estimates suggested $4.10 earnings per share. Gupta decided to use 10% growth rate from 2011 to 2012 and assumed a steady decline to 3% in 13 years (until 2024) where the perpetual growth rate of 3% resumes. She also assumed that WalMart will increase its dividend payout ratio from 30% to 55% from years 2012 to 2024. You are asked to reproduce Gupta’s analysis of multi-stage growth model and double check her valuation by using an earnings multiple. You have all the data you need to conduct the multi stage discounted growth model analysis, but you will need to do some research about the multiples valuation.

home / study / business / finance / questions and answers / ***any assistance on this is greatly appreciated! ...

Question

***Any assistance on this is greatly appreciated! I am really struggling on figuring this out and it is due tomorrow!

As a new junior analyst for a large brokerage firm, you are anxious to demonstrate the skills you learned in college and prove that you are worth your attractive salary. Your first assignment is to analyze the stock of General Electric Corporation. Your boss recommends determining prices based on both the discounted free cash flow valuation method and the comparable P/E ratio method. You are a little concerned about your boss's recommendation because your finance professor has told you these two valuation methods can result in widely differing estimates when applied to read data. You are really hoping the two methods will reach similar prices.

1. Go to Yahoo! Finance (http://finance.yahoo.com) and enter the symbol for General Electric (GE). From the main page for GE, gather the following information and enter it into a spreadsheet:

a) The current stock price (last trade) at the top of the page.

b) The EPS (ttm).

2. Click on "Key Statistics" at the left side of the page. From the Key Statistics page, find the number of shares of stock outstanding and enter it into the spreadsheet.

3. Click on "Analyst Estimates" at the left side of the page. On the Analyst Estimates page, find the expected growth rate for the next five years and enter it into your spreadsheet. It will be near the very bottom of the page.

4. Click on "Competitors" at the left side of the page. The industry average P/E ratio is in the far right column, marked "Industry". Copy it into your spreadsheet.

5. Click on "Income Statement" near the bottom of the menu on the left. Copy and paste the entire three years' worth of income statements into a new worksheet in your existing Excel file. Repeat this process for both the balance sheet and the cash flow statement for GE. Keep all of the different statements in the same Excel worksheet.

6. To determine the stock value based on the discounted free cash flow method:

a) Forecast the free cash flows using the historic data from the financial statements downloaded from Yahoo! Finance to compute the three-year average of the following ratios:

i. EBIT/Sales

ii. Tax rate (income tax expense/income before taxes)

iii. Property, plant and equipment/sales

iv. Depreciation/property, plant, and equipment

v. Net Working Capital/Sales

b) Create an empty timeline for the next five years.

c) Forecast future sales based on the most recent year's total revenue growing at the five-year growth rate from Yahoo! Finance for the first five years.

d)Use the average ratios computed in part (a) to forecast EBIT, property, plant, and equipment, depreciation, and net working capital for the next five years.

e) Forecast the free cash flow for the next five years.

f) Determine the horizon enterprise value for year 5 and a long-run growth rate of 4% and a cost of capital for GE of 11%.

g) Determine the enterprise value of the firm as the present value of the free cash flows.

h) Determine the stock price. Note that your enterprise value is in $ thousands and the number of shares outstanding is in billions.

7. To calculate an estimate of GE's prices based on a comparable P/E ratio, mulitply the industy average P/E ratio by GE's EPS.

8. Compare the stock prices produced by the two methods to the actual stock price. What recommendations can you make as to whether clients should buy or sell GE's stock based on your price estimates?

9. Explain to your boss why the estimates from the two valuation methods differ. Specifically address the assumptions implicit in the models themselves as well as the assumptions you made in preparting your analysis. Why do these estimates differ from the actual stock price of GE?

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