Value one stock using the dividend discount model of stock valuation with two periods of constant growth (not the simple one period growth model). See chapter 18 of the textbook, the problems 18.4 and 18.17 we did in class, or problem 27(f) from the practice problems for Exam I for a review of this model. Make the following assumptions:
- For the growth rate during the first period (g) use the analyst 5-year growth forecast. From Yahoo! Finance go to Analyst Estimates and then Growth Estimate Next 5 years--this is EPS growth, but assume DPS growth = EPS growth. Assuming that the DPS will grow at this annual rate (g) so you can find D1, D2, and so on out to D5. For D1use the Forward Annual Dividend Rate (a $ amount) on the Yahoo! website (with Key Statistics). The value of D1 must be ≥ $1 for the results to be good. Then D2 = D1(1 + g), D3 = D2(1 + g), and so on out to D5. Note that g is in decimals (like 0.07), not percent (7%), when using this formula.
- After 5 years assume that growth will permanently be a conservative value of 0.03 per year (3%) thereafter. In other words, the year 6 dividend estimate, D6 = D5(1.03), and therefore the year 5 value estimate, V5, is = D6/(k - 0.03), because we are now in constant growth forever.
- For the market capitalization rate (k) use the capital asset pricing model (CAPM) as in Project 1. For the risk-free rate, rF, use the 10-year Treasury Bond rate from the Yahoo! Finance website homepage (look under MARKET SUMMARY). This is about 2% now, but use this in decimal form (so would be something around 0.02). For the market risk premium, [E(rM) - rF], use 0.06 (6%). Use the beta that Yahoo! shows for the corporation with Key Statistics (but calculate the adjusted beta using the beta Yahoo shows as in Project 1 and use this adjusted beta to get k). Be sure that you use the decimal value for k, not the percent value (so use 0.15, not 15%) when you calculate the present values below.
What value do you find for the stock today with the DDM? That is, what is the sum of : the present value of D1 + the present value of D2 + the present value of D3 + the present value of D4 + the present value of D5 + the present value of V5? The sum of these will be your stock value estimate today, V0. How does V0 compare with the current stock price? Unless it's an amazing coincidence, these two values will be different. Does what you find imply that this stock would be a "buy" or a "sell" recommendation? Why? By what percent is the value you find with the DDM above or below the current market price? If your answer is outside of the range of +/- 5% of the current market price (not unlikely), continue with the next part.
Suppose now that you want to "prove" that the market price is correct. Change ONE of the following 3 assumptions until you can get your valuation to "equal" the current market price*: (1) the assumed [E(rM) - rF] value (make it higher or lower than 0.06 as needed), OR (2) the 5-year assumption of the first stage of growth (make it higher or lower than 5 years as needed), OR (3) the constant growth rate after 5 years (i.e., make it higher or lower than 0.03 as needed). You will be able to make it work (after some trial and error--use Excel!) by changing ONE of these.
When you get an answer that is within +/- 5% of the current market price this is close enough to say "equal to" the current market price.
Summarize all of your answers and calculations to the parts above in a spreadsheet.