Xcel CFA Open Workbook Series

Master CFA Concepts Using MS Excel

Equity investment
Reading 54 Discounted Dividend Valuation Important tip for CFA Exam: CFA institute loves to test candidate on this topic, so you should expect a case study on the same.

Learn the following in this sheet: Value of common stock using the DDM for one, two and multiple periods

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Question

John Orton recently joined a large pension fund as an equity analyst. Being a fresh hire from campus, he went through a 4 weeks the project work.

As a part of training, he had to value stocks of following companies using appropriate model and come up with suitable recomme

Rocking Roller is a ball bearing manufacturing firm which is expected to pay dividends of $2.1, $2.25 and $2.45 at the end of next investors required rate of return is 8%. The current market price of shares is $134 while the investor expects it to be $149

Starter Motors is an automobile manufacturing firm with the required rate of return of 10%. For the past 10 years, they have bee their earnings. As per their policy, rest of the earnings get invested in growth opportunities with high expected returns. Presently $108 with expected earnings of $8 per year. As per the industry experts, shares of this company are properly priced.
Kool Kola is a new player in the beverage market. Company is currently in its initial growth phase and management plans to pull With the reported earnings of $1.80 per share, company is expected to grow at 18% for the next three years. Presently, no div dividend with 30% payout ratio starting from year 4. As per the analyst, this future dividend will continue to grow with the rate of return is 12%. The current market price of the shares is $8.

During the initial stages, John faced some conceptual doubts and approached his supervisor, Mr. Martin to get them resolved. H statements and asked him to keep them in mind while choosing DDM model. Statement 1: DDM takes the perspective of controlling shareholder. Statement 2: DDM should be applied only if the firms dividend policy is consistent with the profitability trend. After having conversation with his supervisor, John decided to discuss this topic during lunch with his fellow members, who w could begin, one of his friends, Bob asked him if any relation existed between justified leading P/E and justified trailing P proper thought, John reached on to the correct solution.

Q1. Out of the two statements made by Mr. Martin, he was correct with respect to: Options A. Statement 1 B. Statement 2 C. Both statements 1 and 2 Q2. Based on multi-period DDM, the current value of Rocking Roller shares is closest to: Options A. 124.10 B. 112.19 C. 120.86 Q3. Comparing fundamental value with current price, comment whether Rocking Roller is: Options Overvalued A. Undervalued B. Properly Valued C. Q4. Starter Motor's leading P/E ratio attributable to PVGO is closest to:

Options A. B. C.

35.0% 74.1% 25.9%

Q5. Based on two-period DDM, comment whether Kool Kola is: Options Overvalued A. Undervalued B. Properly Valued C. Q6. Correct reply for Bob's query, depicting relation between justified leading P/E and justified trailing P/E for a growth firm is: Options Justified leading P/E is more than Justified trailing P/E A. Justified leading P/E is less than Justified trailing P/E B. C. Data Insufficient

from campus, he went through a 4 weeks training before being assigned

and come up with suitable recommendation.

of $2.1, $2.25 and $2.45 at the end of next three consecutive years. The e the investor expects it to be $149 at the end of three years.

10%. For the past 10 years, they have been paying dividends linked to ties with high expected returns. Presently, their shares are trading at company are properly priced.

wth phase and management plans to pull in huge funds for expansion. r the next three years. Presently, no dividend is paid but it plans to roll out dend will continue to grow with the long-term rate of 4% and the required

rvisor, Mr. Martin to get them resolved. His supervisor made two

lunch with his fellow members, who were also fresh recruits. Before he eading P/E and justified trailing P/E for a growth firm. After giving it a

stified trailing P/E for a growth firm is:

Rocking Roller Required return on equity Dividend expected to be received at end of Year 1 ($) Dividend expected to be received at end of Year 2 ($) Dividend expected to be received at end of Year 3 ($) Price expected upon sale at end of Year 3 ($) Current Price ($) r D1 D2 D3 P3 P0 8% 2.10 2.25 2.45 149 134

Starter Motors Required return on equity No growth earnings level ($) Current Price ($) r E P0 10% 8 108

Kool Kola Required return on equity Earnings per share ($) Short-term growth rate Duration of short-term growth (yrs) Dividend payout ratio, from year 4 Long-term growth rate Current Market Price ($) r E0 gS TS 1-b4 gL P0 12% 1.8 18% 3 30% 4% 8

Ans 1: Correct Option B

Statement 1 is wrong as DDM takes the perspective of an investor who and cannot control the dividend policy

Ans 2: Fundamental Value Correct Option = A D1/(1+r) + D2/(1+r) + (D3 + P3)/(1+r)

1 2 3

124.10

Ans 3: Correct Option A

Since fundamental value ($124.10) is less than the current price ($134)

Ans 4: For properly priced shares, fundamental value is equal to market price i.e. $108 V0 E/r PVGO = = P/E firm P/E PVGO = = 13.5 3.5 = 3.5/13.5

28.00

Leading P/E ratio attributable to PVGO Correct Option C

Ans 5: Earnings in year 3, after the short-term growth period Earnings in year 4 Dividend in year 4 Terminal Value in year 3 Fundamental Value = = = = = E0*(1+gS) E3*(1+gL) E4*(1-b4) D4/(r-gL) V3/(1+r)TS
TS

Since fundamental value ($8.21) is greater than the current market pric
Correct Option B

Ans 6:

For a growing firm, E1 will be greater than E0 by the factor of (1+g). So,

Correct Option

For a growing firm, E1 will be greater than E0 by the factor of (1+g). So, be smaller than the justified trailing P/E (P 0/E0).

perspective of an investor who owns a minority stake in the firm

$124.10) is less than the current price ($134), shares are overvalued

25.9%

= = = = =

2.96 3.08 0.92 11.53 8.21

8.21) is greater than the current market price ($8), shares are undervalued

by the factor of (1+g). So, the justified leading P/E (P0/E1) will

by the factor of (1+g). So, the justified leading P/E (P0/E1) will /E0).