Two-Stage Dividend Discount Model
A. (Method 1): Form an estimate for g1, the growth rate in dividends based on the average annual historical growth in dividends over the past five (5) years. The assumption in this method is that the historical average growth rate in dividends over the past five years is a good estimate for g1 over the number of years of that you have assumed for stage 1.
B. (Method 2): Use the formula provide in the AAII article “Methods for Valuing a Stock” for estimating the sustainable growth rate in EACH of the past five years then take a simple average of these five annual sustainable growth estimates in order to arrive at a second estimate for g1. The assumption in this method is essentially that the historical average sustainable growth rate, which is essentially the expected sustainable growth rate in net income for a given level of ROE and a given retention ratio, is a good estimate for g1 (the growth rate in dividends). The sustainable growth rate formula assumes the capital structure remains constant and no new common stock is issued.
Sustainable growth rate = ROE x retention ratio
Write a short paragraph (at least three sentences) that COMPARES and CONTRASTS your two estimates for g1. Are the similar? Are they extremely different? Give your thoughts on why there are similarities or differences.
You can also provide a subjective adjustment to the average value estimates of g1 above based on any other information you feel is relevant (new products, increased competition, DuPont analysis, etc.).
C. SELECT the one (1) single estimate from Q1A and Q1B above that YOU believe is the most appropriate value of g1 for valuing KO using the Two-Stage DDM. Further, LIST the number of years, n, you expect g1 to persist. Provide a short paragraph (at least three sentences) that EXPLAINS your reasoning for selecting these values of g1 AND n.
*IMPORTANT: A Key Learning Point here is that any estimate of the future growth in dividends will generally NEVER equal the actual growth that results after time passes. All financial valuation estimates are subject to forecast error, which is also referred to as estimation risk.
Q2. The Second Step in using the Two-Stage DDM is to estimate an annual required return on equity, Re. While not absolutely necessary, for the purpose of this assignment you may assume that Re remains constant in stage 1 and stage 2. Four (4) popular methods for estimating Re that were discussed in class are:
A. (Method 1): Calculate the arithmetic average of realized historical annual returns over the past five (5) years. The assumption in this method is that the historical average annual return is a good estimate of future annual returns. This is not a law of nature. It is an assumption. To do this you will need to calculate annual total returns from the most recent 5-year period using Monthly Historical Prices. Calculate the annual total returns based on theDecember-ending Adj Close* price found under Historical Prices on the www.finance.yahoo.com website.
Annual Total Return = [Adj Close* Price December (t) – Adj Close* Price December (t-1)] / Adj Close* Price December (t-1)
Example:
Annual Total Return 2017 = [Adj Close* Price December 2017 – Adj Close* Price December 2016] / Adj Close* Price December 2016
The Adj Close* price is adjusted for dividends and splits, so this price is all that you need to calculate a total return.
B. (Method 2): Use a factor return generating model such as the CAPM to estimate Re.
E(Re) = Rf + Beta x [E(Rm) – Rf]
As you know, the CAPM requires an estimate Rf, Beta and an appropriate expected Market Risk Premium (MRP = E(Rm) – Rf). Once again, more estimation risk!
i) EXPLAIN your estimate of Rf ii) EXPLAIN your estimate of Beta iii) EXPLAIN your estimate of the MRP = [E(Rm) – Rf)
*IMPORTANT: Keep in mind that you are estimating a value for Re the will hold forever (or at least over the life of the firm). As such, current values for Rf, Beta and MRP MAY NOT BE APPROPRIATE for the long-term. Consider the long-term average value for Rf, Beta and MRP.
C. (Method 3): Use the implied Re for a similar firm derived from the Constant Growth DDM (CGDDM).
The CGDDM is written as P(0) = D(1) / (Re – g). To solve for an estimate of an implied Re, find the current price P(0) for a comparable firm, estimate the next dividend for that firm, D(1), estimate a growth rate (forever since this is the constant growth DDM) then solve for the implied Re that will generate P(0) given your assumptions for g and D(1).
Re = [D(1) / P(0)] + g = Expected Dividend Yield + Expect Dividend Growth (forever)
Example:
If you believe that Molson Coors Brewing (TAP) is in the same risk class as KO and that it will grow at 4% annually forever (extreme assumption), the current price is $90 per share and the current dividend is $1.63 per share then the implied Re is,
Re = [D(1) / P(0)] + g = $1.63/90 + .04 = 5.81%
*IMPORTANT: You must select a firm that you believe is in the same risk class as KO. Realize also that your estimate of Re using this method also relies on your estimate of a growth value, g, that you expect will hold forever! Once again, you cannot avoid estimation risk!
D. (Method 4) Add a 3% – 4% equity risk premium (ERP) to the YTM on a KO long-term bond that has at least 20 years to maturity. The rationale for this method is that the required return on equity must be greater than the required return on debt for any firm. If KO does not have a 20-year bond outstanding, then add 3% to the YTM on a 20-year corporate bond with the same bond rating (i.e. A, AA, or AAA). You must find the YTM on a KO 20-year bond or the YTM on a comparable corporate 20-year bond. Realize that a risky 20-year corporate bond must have a YTM that is greater than the YTM on a risk-free 20-year Treasury bond.
E. SELECT the one (1) single estimate of Re from Q2A – Q2D above that YOU believe is the most appropriate for valuing KO using the Two-Stage DDM and provide a short paragraph (at least three sentences) that EXPLAINS your reasoning.
Websites for bond information:
FINRA Bond Market Data www.finra.org/marketdata
Click on Bonds Click on Search
Click on Corporate in the Quick Search box
Type Coca Cola in the Issuer Name box If no 20+ year bonds for KO are shown then try Pepsi
*You must find the YTM on a corporate bond with 20+ years to maturity and with a similar rating (A or AA). Do NOT use the YTM on a 20-year Treasury bond. Why?
