Session 14: Equity Analysis and Valuation Reading 60: Equity Valuation: Concepts and Basic Tools
LOS e: Calculate and interpret the intrinsic value of an equity security based on the Gordon (constant) growth dividend discount model or a two-stage dividend discount model, as appropriate.
Given the following estimated financial results, value the stock of FishnChips, Inc., using the infinite period dividend discount model (DDM).
- Sales of $1,000,000.
- Earnings of $150,000.
- Total assets of $800,000.
- Equity of $400,000.
- Dividend payout ratio of 60.0%.
- Average shares outstanding of 75,000.
- Real risk free interest rate of 4.0%.
- Expected inflation rate of 3.0%.
- Expected market return of 13.0%.
- Stock Beta at 2.1.
The per share value of FishnChips stock is approximately: (Note: Carry calculations out to at least 3 decimal places.)
A) |
Unable to calculate stock value because ke < g. | |
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Here, we are given all the inputs we need. Use the following steps to calculate the value of the stock:
First, expand the infinite period DDM: DDM formula: P0 = D1 / (ke – g)
D1> > |
= (Earnings × Payout ratio) / average number of shares outstanding> > |
>> |
= ($150,000 × 0.60) / 75,000 = $1.20> > |
ke> > |
= nominal risk free rate + [beta × (expected market return – nominal risk free rate)] |
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Note: Nominal risk-free rate |
= (1 + real risk free rate) × (1 + expected inflation) – 1 |
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= (1.04)×(1.03) – 1 = 0.0712, or 7.12%. |
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ke |
= 7.12% + [2.1 × (13.0% ? 7.12%)] = 0.19468 |
g |
= (retention rate × ROE) |
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Retention |
= (1 – Payout) = 1 – 0.60 = 0.40. |
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ROE |
= (net income / sales)(sales / total assets)(total assets / equity) |
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= (150,000 / 1,000,000)(1,000,000 / 800,000)(800,000 / 400,000) |
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= 0.375 |
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g |
= 0.375 × 0.40 = 0.15 |
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Then, calculate: P0 = D1 / (ke – g) = $1.20 / (0.19468 ? 0.15) = 26.86.
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