How should Jonathan describe the rationale of the dividend discount model (DDM) and demonstrate its use in calculating the justifiable price of PCU share?
Firstly, Jonathan should explain to Dwayne that there are different methods how a financial or a security analyst can analyze the fundamental and technical aspects of a security, which in this case is the PCU share, including its price, the forecasted growth rates, and a lot of other aspects. There is more than one way of predicting the future stock price of a company . A security analysis can focus on the fundamental aspects of the company such as the per share earnings, the per share earnings relative to its past and current prices (i.e. the P/E ratio), the EPS and P/E growth rates ; or one may also focus on the technical aspects such as the various price performance of the company’s stock (i.e. PCU’s stock) in the market, whether it is in a consolidation phase or what not, whether the trend is bullish or bearish, whether it is expected to break either the resistance or support levels, and the like . There are more solid ways of throwing an educated guess in stock valuation. Some of the best examples include the Expected Return Model, the Dividend Correlation Model, Technical Analysis (the one I discussed above), and the Divided Discount Model . In Jonathan’s case, he did not focus on the company’s fundamentals or in its technical aspects. He focused on the company’s dividends, hence the name Dividend Discount Model of stock valuation. The question now would be what would be an investor’s rationale in using the DDM (Dividend Discount Model) in projecting the future price of a stock. The best answer to that question is “it depends”. The type of stock valuation method that an analyst would do often depends on factors such as the type of data available, the reliability of those data, the type of company whose shares is to be valuated (e.g. whether it is a mature company or a growth stock), and of course, the expertise of the person performing the valuation . In this case, Jonathan chose DDM because he has access to data about the company’s dividend payouts on a per share basis for the past ten years that is from the year 1999 to the year 2008, aside from having access to other data such as the earnings per share, the net income and the sales made, as well. Given the availability of these data and the unavailability of all the other data, it only makes sense for Jonathan, being the good and professional broker or financial analyst that he is, to choose the Dividend Discount Method over all other methods we mentioned above. Aside from the fact that all the data they are going to need are already at their disposal and that they would not have to use time and exert effort in data collection, it would also be the method that would be able to give them the highest reliability, at least in their current case.
Using the Dividend Growth Model, any seasoned analyst should be able to compute for the future stock price by simply dividing the expected dividend payout per share over the next period of 12 months over the computation for the dividend growth rate subtracted from the discount rate or using the formula P = D/(DR – GR) where P is the fair price, D is the expected dividend payout per share over the next period of 12 months, DR is the discount rate, and GR is the dividend growth rate . As we can see, Jonathan has access to all these information and using this formula, he can really easily compute for the stock’s fair value. The method itself is very stable and is expected to generate accurate computation results provided that all data and information used, such as the D, the DR, and the GR, are all valid and reliable, otherwise the result could be misleading . In Dwayne’s case, the results of the computation could even lead to loss of money.
Being a researcher, Dwayne asked Jonathan a key question, “How did you estimate the growth rates used in applying the model?” using the data given in tables 1 and 2 explain how Jonathan should respond.
The idea behind the Dividend Discount Model is to calculate for the value of the stock using the predicted amount of dividend payout that the company will release at a certain point in the future per share, the discount rate, and the growth in different rates, as the main factors . If I were to be asked to describe this stock valuation using only one word, I would pick the word radical. I am not really a fan of this stock valuation method, not because I believe that the computation would lead to inaccurate projections about a certain stock’s future but because I believe it would not be practical to use the Dividend Discount Model and use often complicated information such as the discount rate (which is oftentimes not under the absolute control of the company) and the dividend payouts (dividend payouts per share highly depends on the company’ ability to pay for them or whether they can actually afford to release such payouts or not) when there are other more easily obtainable information such as earnings per share, price to earnings ratio, price to book value ratio, and debt to equity ratio, among others. Using the Dividend Discount Model, Jonathan was able to get the fair value for PCU’s shares in the future using this formula: P = D/(DR – GR) where P is the fair price, D is the expected dividend payout per share over the next period of 12 months, DR is the discount rate, and GR is the dividend growth rate.
This is rather a simple formula that is also easy to understand and execute. The most common problem when it comes to using the availability of reliable and accurate data required to execute the computation. In Jonathan’s case, however, this was not the case since information about the company’s earnings, number of outstanding shares, dividend payout per share, discount rate, and sales were all provided in tables 1 and 2. Jonathan should respond to Dwayne’s questions calmly and explain the information I have given above and surely, Dwayne, despite having no clear and basic knowledge about security analysis, would be able to understand that for this case, the DDM would really be the best method we can use.
What is the rationale of the required rate of return that Jonathan used and how did he estimate it?
The required rate of return, just like the fair value of a stock, can be computed using different models. Hopefully, this can also be computed using the DDM. As mentioned in the case, the current price of one PCU share was at $12 per share from a recent high of $35 per share. Computing for the decline in the stock price, assuming that Dwayne was one of the investors who bought board lots of PCU shares when they were priced at $35, selling the stocks now would give Dwayne and those investors a rate of return of negative 65%. That is, in the past three years, PCU shares have suffered a 65% loss of value, at least on paper, unless Dwayne has already decided to execute a sales trade when the stock was priced at $12 per share. Fortunately, he picked the right decision to talk to an honest stock broker like Jonathan first who unbelievable revealed to him that the fair value of the stock price, using the Dividend Discount Method, was somewhere between $16 to $26 per share, and could even go higher. Jonathan may have simply used any price point between $16 to $26 per share which he obtained using the DDM of stock valuation, and compared it to the current price of $12 per share. Using the $26 per share as the target price point, selling the stock at that point would yield Dwayne a return rate of 116%, in paper. Now a paper loss of 65% would really be way unattractive when compared side by side with a possible paper gain of 116% when the current per share price of $12 is used as the basis point. As mentioned earlier, a 116% rate of return is not farfetched provided that all the information used in computing for the fair value of the company are accurate, consistent, and reliable, a condition which could really be hard to meet in most cases. The rationale behind Jonathan’s use of the rate of return was perhaps to convince Dwayne—who was about to sold his stocks at its current price of $12 per share, not to sell his PCU shares at its current market price and instead wait a moment until the company becomes able to fix its internal, regulatory, and other problems and until it reaches their target price point based on their unique stock valuation method, specifically, the Dividend Discount Method.
What other variation of the DDM can be used and why? What should Jonathan’s response be?
As mentioned earlier, there are a lot of stock valuation methods that an individual investor or a chartered financial analyst can use in determining possible future values of a stock, which in this case is the stock offered by PCU, the company where Dwayne works in or at least used to work in. the current focus of our discussion is the Dividend Discount Method, a stock valuation method that focuses on the future projections on dividend growth in comparison to the current dividend payout per share that the company offers to project a company’s future stock price. For this question, Jonathan should explain to Dwayne that there are different ways how the Dividend Discount Method can be used just like how there are different ways how stock valuation procedures can be performed. He should also explain that in the security market, it is better to be knowledgeable in as many variations of stock valuation methods as possible so that in the absence of reliable and accurate information about a particular company, the investor or the stock analyst would not be blinded. The first and perhaps the most simple variation of DDM was the one used by Jonathan when he explained to Dwayne how his revenue for selling his PCU shares at $12 per share could be more than doubled: P = D/(DR – GR) where P is the fair price, D is the expected dividend payout per share over the next period of 12 months, DR is the discount rate, and GR is the dividend growth rate. Some other commonly used variations of this method include the P = D/r. this variation is commonly used when the growth is zero. So even if there is no perceived growth in the stock price or the dividend, the analyst can still project the price of the company. However, in this case, we do not have access to at least two of the variables required in the equation, rendering this variation useless in Dwayne and Jonathan’s case. There is also a variation of the DDM that can be used to project or estimate the cost of capital which is the r in the equation: r = (D/P) + g. Just like the first variation we discussed, this variation of the DDM may also prove to be useless in proving Jonathan’s point to Dwayne. Therefore, he should just focus on explaining how the first variation of the DDM works, especially when we consider that Dwayne does not really have at least the basic or foundational knowledge in equities knowledge. As far as he is concerned, he only wanted to turn the shares he accumulated into cash.
Why are you using dividends and not earnings per share Jonathan? What do you think Jonathan would have said?
I think Jonathan would have responded to Dwayne’s question by telling him the advantages of the Dividend Discount Method that are applicable in their current case. That will lead them to the fact that they have access to the information about the company’s dividend payout per share history for the past ten years, the company’s earnings per share, the company’s beta coefficient, the discount rate. Although the dividend growth rate for each year and the ten year average dividend growth rate were not given, things that are both needed to compute for the projected share price of PCU, these two can easily be computed using simple mathematics. The average dividend growth rate is what we really need to solve since it is the main variable needed to solve the equation. Once all is present, Jonathan can easily proceed with the computations, which given the availability of high technology computing machines today, could be done in minutes, if not seconds.
Using the earnings per share or EPS alone cannot really lead to any specific stock valuation output. Meaning, the projected stock price variable would continue unsolved. This is because EPS alone, and even with the addition of the yearly EPS growth rate can only be used to project the direction of the company’s stock prices . A company that exhibited a highly positive (e.g. above 25%) of EPS growth for the past five years, and a tremendous growth in EPS in the most recent year would have an extremely high chance of experiencing a growth in stock price . Often the growth in earnings per share is directly proportional to the growth in stock price. That is, a larger growth in earnings per share would almost always directly lead to a higher stock price valuation and of course, higher levels of investor confidence. Some of the possible scenarios wherein stock price may not move significantly upward despite the presence of promising earnings per share growth in the past years include the saturation of the market, the bear market phenomenon (investors are engaged in more selling than buying activities), and the if there are other macroeconomic and political factors affecting the decisions and sentiments of the investor, and the tone of the securities market. Moreover, the EPS and EPS growth are basically from a different world within the context of stock valuation. These two are often used in fundamental analysis wherein the analyst or the investor focuses on the fundamentals or the overall financial health of the company (and at some point, the health and sustainability of its financial operations) in making a selection of securities, and of course, buying and holding positions. Jonathan may have wanted a more direct approach in knowing the projected price of PCU shares and considering the availability of information, the Dividend Discount Method indeed proves to be the most practical method of analysis. The EPS and the EPS growth rate, in this case, may still prove to be helpful. But that is it. It would only serve as a supplement at best because it can be a reliable source of information in determining the direction of the dividends per share (larger earnings basically enable the companies to pay larger dividends per share and then vice versa) . In the table of information about PCU, it can be seen that for the past ten years, the dividend per share values were on a continuous increase just as the earnings per share were on a continuous increase too. For the year 2007, however, we can see a significant decline in dividend payout per share, something which is supported by a significant decline in earnings per share as well. What Jonathan can tell to Dwayne to make him understand why he used dividends instead of earnings per share in projecting the future value of his stocks is that the earnings per share, at least in their case, can only be used to project the direction of the dividends and of course, the share price.
Dwayne wondered whether PCU’s preference share would be a better investment than its ordinary share, given that it was paying a dividend of $2.5 and trading at a price of $25. He asked Jonathan to explain it to him the various features of a preference share, how it deferred from ordinary share and the method that could be used for estimating its value.
It can be recalled that Dwayne is a current holder of PCU stocks. Now, what he does not know is that there are actually two kinds of stocks: common stocks and preferred stocks. Often, the term stock is used interchangeably with the term shares. For the purpose of this paper, we may refer to stocks or shares. Nonetheless, the reader should be informed that they basically mean the same thing. So, now that Dwayne knows that there are, in fact, two types of stocks, in order for Jonathan to answer this question, he has to be able to tell to Dwayne what type of stocks, among the two types of stock there are, he currently has a possession of.
The type of shares that Dwayne has is common (shares). Common shares are a type of investment vehicle or a security (means basically the same) that represent ownership of a business, a company, or a corporation . In this case, PCU common shares represent ownership of the PCU, the company. Individuals who own stocks or shares of a particular company, regardless of the volume or the number of shares, are called share or stockholders. Meaning, they are one of the owners of the company. Often, the holder who has the largest share of stocks among all other major and minor stockholders is the one who holds the position of chairman. The chairman of a corporation plays a key role in almost all, if not all, situations that require decisions. All other major and in some cases, minor, stockholders may still have the opportunity to influence decisions in the company, albeit their ability to do so would be far inferior to that of the chairman. To be able to get a hold of that ability, they first have to be elected as one of the board of directors. Thereafter, they would already have the ability to vote and influence decisions related to changes in the company’s policy, and capitalization structure, among others.
Individuals who own small but still significant shares of the company often do not get the chance to be elected into the board of directors. Although they are still considered as stockholders, at least technically, common stockholders such as Dwayne in this case are the ones who are at the bottom of the priority ladder, in terms of ownership structure. In the event of bankruptcy and liquidation, for example, holders of preferred shares, bondholders, and other debt holders such as the bank are the ones who would be prioritized. Common shares, in that case, are at the bottom of the priority list. One advantage of common shares, however, is that individuals who hold this stock can be involved in the price action and of course the profits brought about by capital appreciation. If the company’s earnings and other performance-based outcomes improve over time, holders of common shares can sell their holdings for a higher price. Also, common stock holders often receive dividends either in the form of cash or additional stocks (as in the case of stock splits) as an additional source of earnings from their equities. This value of dividends that they will receive per share, however, is not fixed unlike in preferred shares.
Preferred shares, on the other hand, are basically hybrid shares that have a bond and a common stock component. The bond component is characterized by the presence of a fixed rate of return for every share bought by the investor. Suppose the investor bought preferred shares of PCU priced at $25 with a fixed rate of return of $2.5 per share. Now, these values effectively make the dividend yield of this preferred share offer at 10%. So, for every year, PCU promises, but neither assures nor guarantees, its preferred shareholders that they will get paid a dividend of $2.5 for every share they have, regardless of the current price of the preferred share. This describes the bond component. The equity component on the other hand can be characterized by the fact that preferred shares can also be traded in the stock market. This means that they may also be subject to capital appreciation. However, despite this fact, the volatility of prices of preferred shares are not as high as that of common shares. Preferred shares are often branded as the security for investors with lower tolerance levels for risks because of its bond component.
If PCU has an outstanding issue of $1,000 par value bonds with a 11% coupon interest rate, would it be a better investment than its ordinary share, given that it was paying interest semi-annually, maturing in five years and trading at a price of $1,050. He asked Jonathan to explain to him the various features of a corporate bond, how it differed from ordinary and preference shares, and the method that could be used for estimating its value.
The main factor that we should consider in answering this question would be the dividend yield. Dividend yield can be computed by dividing the dividend per share by the price per share. In this case, a preferred share trading at $1,000 per share with a yield of 11% would yield a dividend value of $110 per share or $55 paid on a semiannual basis. A preferred share with a dividend value of $110 per share priced at $1,050 on the other hand would yield a dividend of 10.47%. The answer to the question whether this preferred stock offering is better than the common stock offering is it depends. It highly depends on the investor’s appetite and tolerance for risk, his ability to trade successfully in the market and handle his emotions, and of course, his aggressiveness. More aggressive investors tend to be more engaged in common stock offerings than preferred ones and vice versa for those who could not tolerate being subjected to higher levels of risk.
When it comes to explaining to Dwayne the difference between a corporate bond and ordinary and preferred shares, the answer would be simple. Corporate bonds are debt instruments that corporations often use to increase the diversity of their capital structure. Corporate bonds can be compared to bank loans because both of the share one major quality: the presence of interest rates. When corporations issue bonds, they are basically borrowing money from the people who bought those bonds, which we can now call bond holders, with a guarantee, not only a promise, that they will be paid whatever the equivalent dividend value after the computation of their coupon rate multiplied by the amount they invested, every year, or on a semi-annual basis, whatever is indicated in the corporation’s prospectus. When it comes to bankruptcy and liquidation, the debt or bondholders are often the ones who are on the top of the priority list of the persons that the company has to pay . Next on that list would be the holders of preferred shares and last would be the holders of common shares.
Common shareholders make money mainly via capital appreciation—if the company’s stock price steadily appreciates. Preferred shareholders make money mainly through its bond component, wherein just like a corporate bond, there is a fixed amount of dividend per share offered to holders. Simple mathematics can be used to estimate the value of common and preferred shares. For computing the dividend yield, the price per share or the dividends per share the equation would be: % = annual dividends per share/price per share. Bonds, unfortunately, cannot be computed this way. Bonds are rated by rating agencies like Moody’s and Standard and Poor’s. Investment grade bonds are the ones that investors prefer because they have the least likelihood of being defaulted unlike corporate bonds that have been given a junk status—meaning the corporations that issued them are likely to default on their financial obligations.
How did Jonathan derive the intrinsic value of PCU share to be in the range of $16 to $26? Assume the dividend would grow at current rate for the next five years and thereafter the industry growth rate. Why did Jonathan think that the PCU share would rise to $35 per share in three years’ time? Justify your analysis.
Jonathan predicted what the future dividend per share value of PCU would be. He then used that value to compute for the intrinsic value of PCU. He found that value to be in the range of $16 to $26 or even higher. Jonathan thought that the PCU share would rise to as high as $35 per share in three years’ time because he also assumed that the growth rate of the company’s income, earnings (both of which determine their ability to pay for dividends), earnings per share, and dividends per share, would be consistent over the next three years. Trusting this analysis can be risky because no one knows for sure whether those assumptions would really turn into reality. Nobody knows when the demand for PCU products and or services would decline—making it impossible for them to realize those assumed profits, earnings, and dividend per share growths, effectively making the result of the computation for intrinsic value useless. This is one of the major drawbacks of using the DDM, it relies on mostly uncertain assumptions which when not achieved, can greatly affect the outcome of the decisions of the investors.
Part B
Question I
Equity holders want 16% on their investment, whereas debt holders only require 8%. I would be crazy to expand using equity since debt is so much cheaper. Comment on this statement
There are two major differences between debts and equities. It is true that superficially, debts appear to be cheaper than equity. However, deeply, it would certainly turn out that equity would be the better choice among the two. This is because no matter what happens, the debt holders are entitled to receive their principal and whatever the amount of the incurred interest, regardless whether the business has to sell its assets just to pay for such or not. This limitation is not present in equity holders. Equity is less risky than loan because the company does not have to pay it back. It also exposes the company into a large pool of investors which basically add up to the business’ credibility.
Explain the trade-of between retaining internally generated funds and paying cash dividends.
Internally generated funds may require a significant amount of investment initially but based on the name itself, it generates funds internally. This means that the capital fund that the company holds is actually growing. It also contributes to the generation and retention of earnings. Internally generated funds are those that come from the business’ operations. Ideally, businesses should be able to fund their capital from their internally generated funds. However, in most cases, that is not possible, so they resort to seeking equity from investors. Cash dividends are one of way of attracting investors. The higher, more frequent, and more consistent the release of cash dividends are, the more investors would be attracted. The problem with this, however, is that funds that would have been better off used to increase the company’s ability to generate funds on its own, would have been used to issue dividends to its investors instead.
Question II
A Company’s current capital structure comprises $400,000 of 8.5% fixed interest debt and 150,000 ordinary shares currently priced at $8.00 per share. The company’s most recent annual profit before interest and tax was $214,000. The company needs to raise additional finance of $400,000 and is therefore considering that raising the require funds either through a one for three rights issue or by borrowing the full amount at a fixed rate of 9%. The company pays tax at the rate of 30%.
- What are the company’s current and after-tax earnings per share?
The company’s after-tax earnings per share are at $0.99 per share. Formula: (214,000 - (214,000 x 0.30))/150,000.
- If the company’s dividend payout ratio is 100%, what is its after-tax cost of equity?
Assuming that the company’s target DPS is at $5 per share, with a stock price of $8 per share, and a consistent DPS growth rate of 10% per annum, the cost of equity would be 10.625. Equation: (5/8)+10.625.
- If the company’s profit before interest and tax increases to $250,000 after raising additional funds:
- What would be the company’s earnings per share if it had used the share alternative to raise additional funds?
- What would be the company’s earnings per share if it had used the debt alternative to raise the additional funds?
The company’s earnings per share would still remain at $0.99 but this option to use the debt alternative would subject the company to pay an annual interest rate of 9% of the total value they borrowed per year, which can be taxing to their earnings and profits, not unlike the issuance of new shares alternative.
- Which of the two financing alternative would you recommend? Discuss the reasons to support your recommendation.
I would recommend the first alternative, the one that requires the company to issue new shares because it would be less risky and it actually has a larger potential of increasing the company’s earnings per share. Despite the fact that the company has to issue new shares, their earnings per share would still be at an increased level compared to when they were only able to earn a profit of $214,000 because of lower capital availability.
Question III
- How do the cost of debt, the cost of equity and the weighted average cost of capital behave as the firm’s financial leverage increases from zero? Where is the optimal capital structure? What is its relationship to the firm’s value at that point?
The cost of equity, weighted average cost of capital, and cost of debt, often become larger as the firm’s financial leverage increases from zero. The higher the financial leverage is, the higher these values would usually be. The ideal or optimal capital structure is one that involves as little debt and equity as possible because that would mean that the company has the ability to generate its own capital by using funds generated from its business operations and sales and profits. A firm who has a large capital but is largely composed of debt and equity components would certainly appear to have a lesser value compared to a firm with an equally large capital but contains considerably less debt and equity components.
- What important factors, in addition to quantitative considerations should a firm consider when it is making a capital structure decision?
The firm should of course investigate whether it would really be able to meet the targets it laid out to its investors, pay the dividend per share values they promised, pay the dividend yield per share they promised to preferred shareholders, and of course, be able to afford to pay the interest plus the incremental principal payments to their debts on top of their total expenses including taxes every time. These should be the most important non-quantitative considerations and or factors that the firm should consider when making a capital structure decision.
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