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Solution to Case 9

Application of Stock Valuation Methods

How Low Can It Go?

1.

How should Jonathan describe the rationale of the dividend discount model (DDM) and demonstrate its use in calculating the justifiable price of common stock? Jonathan should explain that the price of common stock (or any asset for that matter) is equal to the discounted value of the future cash flows emanating from the asset, where the discount rate is the rate that investors require to bear the risk of owning that stock or asset. In the case of common stock, investors expect to receive dividends from the stock either in the short run or at some point in the future. Thus discounting the forecasted dividend, which is what the dividend discount model does, would be a logical method of calculating the justifiable price of common stock. Click here for spreadsheet calculations of intrinsic values

2.

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. Growth rates can be determined by calculating the average compound rate of growth of the dividends or earnings between two time periods. For example, as per Table 1, In 1992 the dividend per share was $0.6 and in 2001 the dividend had increased to $0.94 per share. PV = -$0.60; FV = 0.94; n=9; PMT = 0; CPT I = 5.11% i.e. 0.6(1.0511)9 = 0.94 growth rate

3.

What is the rationale of the required rate of return that Jonathan used and how did he estimate it? The required rate of return is based on the security market line equation, which is as follows: Required rate of return = Risk-free rate + Average Risk Premium*Beta Where risk-free rate is what an investor can earn with almost certainty (e.g. the rate on a Treasury securities). The average risk premium is the difference between the rate expected on the market index, e.g. S&P 500 and the risk-free rate. Beta is a measure of the systematic risk of the stock, i.e. it is a measure of the sensitivity of the stocks return to the market index return. Thus the equation says that an investor must earn at least the risk-free rate plus the proportional risk premium over and above the risk-free rate. Required rate of return for Pharmacopia = 5.1% + (9%)*1.1 = 15%

4.

What other variations of the DDM can one use and why? asked Dwayne. What should Jonathans response be? Besides the constant growth model, one could use the non-constant growth model (most realistic) and the zero-growth model. The pattern of past and future expected dividends would determine which model is applicable to a particular case. Click here for spreadsheet calculations.

5.

Why are you using dividends and not earnings per share, Jonathan? asked Dwayne. What do you think Jonathan would have said? Jonathan should have explained to Dwayne that either variable could be used. Since dividends are what shareholders typically receive as returns from their stock investments, it is logical that dividends are used as the relevant cash flow. However, in the case of companies not paying dividends, the retained earnings are expected to translate into future dividends or a higher selling price via a higher growth rate.

6.

Dwayne wondered whether Pharmacopias preferred stock would be a better investment than its common stock, given that it was paying a dividend of $1.5 and trading at a price of $15. He asked Jonathan to explain to him the various features of preferred stock, how it differed from common stock and corporate bonds, and the method that could be used for estimating its value. The rate of return on Preferred stock is calculated as follows: Rate of return on preferred stock = Dividend on Preferred/Price = $1.5/$15 = 10% Although the dividend paid on preferred is higher it is taxable and will not vary over the life of the investment. Thus if the company does phenomenally well later due to the development of some successful products, the preferred stock holders will not share in

the residual profits. These residual profits are only distributed to the common stockholders. Thus return and risk are related. Price of Preferred = Dividend/Required Rate of return Preferred stockholders have no voting rights, no pre-emptive rights, and their dividends are not a binding obligation for the issuing firm. However, they can be issued with a cumulative dividend feature, which means that the dividends in arrears will have to be paid before common stock dividends are paid.