1. Discounted Dividend Valuation Model I
AlphaDog Corp Ltd. is a company with a remarkably stable dividend paying policy. It also chooses not to reinvest any of its earnings and all profits are paid out as dividends to its investors.
You have found from past records that the yearly dividend per share was $100 and there is no expectation of increase in the profits or in the dividends.
You are considering buying 1000 shares and holding them for period of 3 years, with an expected value at the end of $885 per share. The discount rate is given by the required rate of return, which is equal to 11.3%. What is the maximum amount you should be willing to pay?
Discussion Points:
1. What is the maximum amount you should be willing to pay?
2. What would be the maximum amount you should be willing to pay, in the case where the required rate of return would be 5%?
2. Discounted Dividend Valuation Model II
You are considering a purchase of NotSoGreat Company Inc.'s stock, currently available on the NYSE for $70 a share.
You have calculated that for this investment the required rate of return is 11.3% and the past dividends were growing in accordance with GDP growth. The economy is expected to grow 2.5% in the foreseeable future. The latest dividend was $5 per share.
How much is the stock worth?
Discussion Points:
1. How much is the stock worth?
2. What if the GDP growth suddenly increased to 3%?
3. Free Cash Flow Models
SuperComplicated Ltd. depends on two sources of financing: bond issues and common stock. In the following table, you can see the market value of these two sources as well as required rates of return:
|
|
Market Value
|
Required Return
|
|
Bonds
|
$400,000,000
|
8.00%
|
|
Common stock
|
$600,000,000
|
12.00%
|
|
Total
|
$1,000,000,000
|
|
Other Financial information:
|
Net income available to common shareholders
|
$88,000,000
|
|
Interest expenses
|
$50,000,000
|
|
Depreciation
|
$32,000,000
|
|
Investment in fixed capital
|
$56,000,000
|
|
Investment in working capital
|
$16,000,000
|
|
Net borrowing
|
$20,000,000
|
|
Tax rate
|
30%
|
|
Stable growth rate of FCFF
|
2%
|
|
Stable growth rate of FCFE
|
2.5%
|
Let's answer the following questions:
1. Calculate the company's WACC?
2. From the information above, calculate the company's latest FCFF?
3. Using FCFF, what is the present value of the firm, and the present value of the equity?
4. From the information above, calculate the company's latest FCFE?
5. Using FCFE, what is the present value of the equity?
HeadAche Inc. depends on two sources of financing: bond issues and common stock. In the following table, you can see the market value of these two sources as well as required rates of return:
|
|
Market Value
|
Required Return
|
|
Bonds
|
$480,000,000
|
8.00%
|
|
Common stock
|
$720,000,000
|
12.00%
|
|
Total
|
$1,200,000,000
|
|
Other Financial information:
|
Net income available to common shareholders
|
$105,600,000
|
|
Interest expenses
|
$60,000,000
|
|
Depreciation
|
$38,400,000
|
|
Investment in fixed capital
|
$67,200,000
|
|
Investment in working capital
|
$19,200,000
|
|
Net borrowing
|
$24,000,000
|
|
Tax rate
|
30%
|
|
Stable growth rate of FCFF
|
2%
|
|
Stable growth rate of FCFE
|
2.5%
|
Discussion Points:
1. Using FCFF, what is the present value of the firm, and the present value of the equity?
2. Using FCFE, what is the present value of the equity?
4. Residual Income Valuation Models and Private Company Valuation
Notlonglived Inc.'s expected earnings per share are $1.50, $1.80, and $5.00 for the following three years. Dividends are estimated at $1.00, $1.50, and $5.00 for the same period. The company plans to liquidate after the third year, with the last dividend distributing all remaining value to the shareholders. The book value of Notlonglived's shares is $7, and the required rate of return on equity is 10%.
Here we will attempt to estimate per-share book value and residual income in all three years. We will also estimate the present value of the stock using residual income.
Discussion Points:
1. Estimate per-share book value and residual income in all three years.
2. Estimate the present value of the stock using residual income.
5. Tutorial
This article from The Economist looks at a situation in August 2014 on the stock and bond markets. The author of the piece notes the connections between the market movements and company profits, GDP growth, and the changes in central bank policies.
It is important to focus on the following points:
- The market expectation for 2014 was that as company profits grew, shares would gain, while government bonds would lose value (and their yields would go up). The opposite happened, however. Dow Jones was flat, while the FTSE 100, DAX and Topix 500 lost value. Government bonds soared in value and their yields sank (especially in Germany, but also in the U.S.).
- The author finds three reasons for these developments:
- Stock prices grew strongly in the previous year 2013
- GDP growth was very disappointing in 2014, with first quarter GDP falling in the U.S., and in the second quarter falling in Japan. Italy was back in recession in 2014.
- Inflation stayed stubbornly low, which resulted in bond market strength. If yields are positive in nominal terms when inflation is very low, they stay positive even in real terms.
- The stock market stumbled on several occasions due to global political instability, such as the conflicts in Ukraine, Syria, and Iraq.
- Most likely, however, the main reason behind poor market performance was the anticipated end of quantitative easing in the U.S. and Britain.
- The author notes that quantitative easing made asset valuation almost irrelevant. A survey of investor opinion found that 55% believed stocks were overvalued, which was still low compared to government bonds (75% believed them overvalued) and corporate bonds (72%).
- The earnings per share ratios continued to climb since the financial crisis as company profits increased. On the other hand, revenue per share stayed flat - production didn't increase and profits were made by increases in margins.
- More worryingly, companies decided to use extra profits to buy back their shares instead of investing.
The situation on the market has not changed much since publication of this article. Inflation has stayed very low, making government bonds even more expensive since. The stock market has stayed almost flat since 2014, with the exception of European shares which rallied temporarily after the ECB announced its quantitative easing policy. Quantitative easing has ended in the U.S., but is ongoing in the Eurozone. Both the U.S. and the EU are growing, albeit very slowly, and even Italy returned to growth in 2015.
Discussion Points:
1. The author of this article makes a connection between the anticipated end of quantitative easing and the stock market stumble. How would you explain this connection?
2. The ECB announced quantitative easing of €60 billion a month in January 2015, and a further increase to €80 billion in March 2016. Go to Yahoo Finance and find the DAX index for the periods following these announcements. What can you observe?
SUPPORTING DOCUMENT: SEE CAUGHT OUT FROM THE ECONOMIST.
6. Tutorial
Carefully read the article from the link above. The article explores the probabilities of mutual funds beating the market, based on Morningstar Independent Investment Research. It makes a few interesting points:
While betting your money in roulette gives you 18:38 (and 18:37 in Europe) odds of success, the likelihood of a mutual fund beating the market (after management fees) is only 1:4, at least based on the previous 20 years.
Mutual funds beat the market in only 5 of 20 years during the period 1995-2014. All investments made by all investors (professional or not) together make up the index. But because professional fund managers own the majority of the stocks, they essentially form the index. While investment in a passive index-based fund carries almost no fees, mutual fund managers do. And these fees are the main reason why mutual funds tend to underperform the market.
On average, active funds underperformed the market by around 1.6%.
Passive funds also charge fees, but these are much smaller, so the under-performance is not so large.
The article proposes a few solutions:
- If you are to invest, choose a fund (active or passive) with low fees.
- Or invest in a fund with only performance-based fees.
The comparison to roulette odds at the beginning of the article is a bit facetious. After all, mutual fund investors are still more likely to earn money that lose it, even when not beating the market. Bet long enough in roulette, and statistically you are likely to lose everything.
The point of the article is that large investment fees cause mutual funds to underperform on the market. Index investing is boring and most investors tend to favour managers successful in the past, even if they are likely to underperform in the future. The proposed performance fees, as charged by Patience Trust, would make a difference only if levied on the difference between the fund's over-performance on the market.
Discussion Points:
1. With all the sophisticated evaluation tools at a mutual fund managers' disposal, why do you think they are still unlikely to beat the market?
2. The article mentions that dozens of managers monitor every stock on the market, with the likelihood of any of them discovering anything sooner being very small. What do you think would happen if the number of managers decreased? What impact would that have on the index?
SUPPORTING DOCUMENT: SEE BUTTONWOOD'S NOTEBOOK FROM THE ECONOMIST.
7. Tutorial
Carefully read the article above, posted in September 2013, which chronologically explains the unraveling of the international markets towards the credit crunch.
The article makes these interesting points:
- Subprime mortgage loans served as a trigger for the financial crisis. During the years leading to the credit crunch, a flood of irresponsible mortgage lending occurred in the U.S. Financial engineers argued that by pooling the mortgages into large portfolios and creating mortgage-backed securities based on these large pools of assets would make them safe. Property markets in different American cities were considered independent, a belief which turned out to be very wrong. Securitization of mortgages by pooling them together didn't really work in the case of the economy-wide property slump.
- The rating agencies are to be blamed, too, as they wrongly assessed MBS risk, providing them with triple-A rating long after the economy-wide property slump occurred in 2006.
- Investors were very keen on buying MBSs and CDOs because they provided higher interest than alternative investments and were still considered safe. There is lasting and wide disagreement among economists about the result of low rates issued by the Fed, as well as the result of global imbalances in current account deficits.
- When property prices started decreasing, the MBSs turned out not to be safe, and their values deteriorated. CDOs become worthless. In the confusion that followed, mortgage-backed securities became impossible to sell and banks started doubting each other's exposure to the losses. This resulted into the halt of all inter-bank lending and the credit crunch. Banks encountered liquidity problems soon afterwards, with the first casualty the British Northern Rock. The default of Lehman Brothers followed, after which full market panic erupted.
- Investors are sure to be blamed for their recklessness, but the main blame is with regulators. Because they allowed Lehman Brothers to go bankrupt, the size of government intervention needed to counter market-wide panic was much bigger. Also, low interest rates in the US resulted in the property bubble. Banks were overexposed because of the low required equity to lending ratios and global account imbalances, especially between the U.S. and China.
- European banks were also exposed to the credit crunch, as they invested heavily in the U.S. mortgages.
- Some of the problems were corrected via the Basel II and Basel III Accords, which increased the minimum required equity to be held by banks.
The article also mentions global current account imbalances since the financial crisis, which is a lasting problem. Setting interest rates too high when inflation is too low due to the flow of cheap goods from newly-globalized, developing countries is close to impossible. In fact, this may cause deflation and leaving the rates too low can cause asset bubbles.
Discussion Points:
1. Why do you think liquidity played such a large role during the credit crunch?
2. Why do you think it was difficult for banks to set their reserves higher than the minimum amounts required by regulators?
SUPPORTING DOCUMENT: SEE CRASH COURSE FROM THE ECONOMIST.