Investment and Portfolio Management

TOPIC 6 – TUTORIAL 6
SUMMARY
1. Constant dividend DDM
2. Constant Growing Dividend DDM
3. N-fixed holding time frame DDM
4. Multi-stage DDM
5. PVGO
6. P/E ratio
Justified Trailing P/E = P0/E0 = D0 * (1 + g) / (r – g) * 1/E0
= E0 * (1 – b) * (1 + g) / (r -g) * 1/E0 = (1 – b) * (1 + g) / (r -g)
Justified Leading P/E = P0/E1

1. Briefly discuss what actions the U.S. Federal Reserve would likely take in pursuing a
contractionary monetary policy using each of the following three monetary tools:
a. Reserve requirements.
b. Open market operations.
c. Discount rate.
a. Raising reserve requirements would make banks keep more money in the reserve account
and lend out a lower fraction of deposits and thus decrease the money supply.

b. The Fed would sell Treasury securities, thereby decreasing the money supply.

c. The discount rate would be raised, making banks lend out additional funds at a higher rate.

2. Deployment Specialists pays a current (annual) dividend of $1.00 and is expected to grow
at 20% for 2 years and then at 3% thereafter. If the required return for Deployment
Specialists is 8.5%, what is the intrinsic value of its stock?

0 1 2 3 …

Dividend = 1 * (1 + 20%)^2
= 1 * (1 + 20%) = 1 * (1 + 20%)^2
1 * (1 + 3%)
= 1.2 = 1.44
= 1.483
 Investment and Portfolio Management

Terminal !.#$%
=
Value ($.'%)%%)
= 26.97

!.+ !.## +-../

Intrinsic value =
(!,$.'%) ! + (!,$.'%) " + (!,$.'%)"
= 25.37

3. Jand, Inc., currently pays a dividend of $1.5, which is expected to grow indefinitely at 5%.
If the current value of Jand’s shares based on the constant-growth dividend discount model
is $33, what is the required rate of return?

!.'∗(!,'%)
Price = = $33
(121)'%)
ð RoR = 9.77%

4. Tri-coat Paints has a current market value of $44 per share with earnings of $3.64. What is
the present value of its growth opportunities (PVGO) if the required return is 9%?

The PVGO is
$3.64
PVGO = $44 − 9% = 3.56

5. Computer stocks currently provide an expected rate of return of 16%. MBI, a large
computer company, will pay a year-end dividend of $2 per share.

a. If the stock is selling at $50 per share, what must be the market’s expectation of the
dividend growth rate?

D1
k= +g
P0
$2
0.16 = + g Þ g = 0.12, or 12%
$50
 Investment and Portfolio Management

b. If dividend growth forecasts for MBI are revised upward to 5% per year, what will happen
to the price of MBI stock?
D1 $2
P0 = = = $18.18
k - g 0.16 - 0.05
c. What (qualitatively) will happen to the company’s price–earnings ratio?
The price falls in response to the more pessimistic dividend forecast. The forecast for
current year earnings, however, is unchanged. Therefore, the P/E ratio falls. The lower
P/E ratio is evidence of the diminished optimism concerning the firm's growth
prospects.

6. The market consensus is that Analog Electronic Corporation has an ROE = 9%, a beta of
1.25, and plans to maintain indefinitely its traditional plowback ratio of 2/3. This year’s
earnings were $3 per share. The annual dividend was just paid. The consensus estimate of
the coming year’s market return is 14%, and T-bills currently offer a 6% return.
a. Find the price at which Analog stock should sell.
b. Calculate the P/E ratio.
c. Calculate the present value of growth opportunities.
d. Suppose your research convinces you Analog will announce momentarily that it will
immediately reduce its plowback ratio to 1/3. Find the intrinsic value of the stock.
e. The market is still unaware of this decision. Explain why V0 no longer equals P0 and why V0
is greater or less than P0.

a. k = rf + b ´ [ E (rm ) - rf ] = 6% + 1.25 ´ (14% - 6%) = 16%

2
g= ´ 9% = 6%
3
1
D1 = E0 ´ (1 + g ) ´ (1 - b) = $3 ´ (1.06) ´ = $1.06
3
D1 $1.06
P0 = = = $10.60
k - g 0.16 - 0.06

b. Leading P0/E1 = $10.60/$3.18 = 3.33

Trailing P0/E0 = $10.60/$3.00 = 3.53

E1 $3.18
c. PVGO = P0 - = $10.60 - = -$9.275
k 0.16
 Investment and Portfolio Management

The low P/E ratios and negative PVGO are due to a poor ROE (9%) that is less than the
market capitalization rate (16%).

Earnings: Dividends + Reinvestment

ROE (Return on reinvestment) < Cost of equity (Cost of reinvestment)
ð V with reinvestment < V without reinvestment
ð Reinvestment is not adding Value to the firm => it actually reduces V firm
ð Should not reinvest
ð Pay more dividends
ð Value of the firm will increase in this case
• ROE < ke
ð PVGO < 0
ð Reinvestment will not lead to growth
ð Value will increase if b decreases
• ROE = ke
ð PVGO = 0
ð Reinvestment will not lead to growth
ð Value will not change if b decreases/increases
• ROE > ke
ð PVGO > 0
ð Reinvestment will lead to growth
ð Value will increase if b increases

d. Now, you revise b to 1/3 => pay more Dividends => Share value should increase
g = 1/3 ´ 9% = 3%, and D1 to:
E0 ´ (1 + g) ´ (2/3)
$3 ´ 1.03 ´ (2/3) = $2.06
Thus:
V0 = $2.06/(0.16 – 0.03) = $15.85

The market is still unaware of this decision.

ð Price is still unchanged = $10.6
ð V0 no longer equals P0 and why V0 is greater than P0
ð V0 increases because the firm pays out more earnings instead of reinvesting a poor ROE.
This information is not yet known to the rest of the market.

7. The Digital Electronic Quotation System (DEQS) Corporation pays no cash dividends
currently and is not expected to for the next five years. Its latest EPS was $10, all of which
 Investment and Portfolio Management

was reinvested in the company. The firm’s expected ROE for the next five years is 20%
per year, and during this time it is expected to continue to reinvest all of its earnings.
Starting in year 6, the firm’s ROE on new investments is expected to fall to 15%, and the
company is expected to start paying out 40% of its earnings in cash dividends, which it
will continue to do forever after. DEQS’s market capitalization rate is 15% per year.
a. What is your estimate of DEQS’s intrinsic value per share?
b. Assuming its current market price is equal to its intrinsic value, what do you expect to
happen to its price over the next year?
c. What do you expect to happen to price in the following year?
d. What effect would it have on your estimate of DEQS’s intrinsic value if you expected
DEQS to pay out only 20% of earnings starting in year 6?

a.
Time: 0 1 2 … 5 6 …
= $10 * = $10 * = $24.883 *
Et $10 $12 (1 + 20%)^2 (1 + 20%)^5 (1 + 9%)
= $24.883 = $27.123
Dt $0 $0 $0 $0 $0 $10.849
b 1 1 1 1 1 0.60
ROE 20.0% 20.0% 20.0% 20.0% 20.0% 15% 15%
g 20.0% 20.0% 20.0% 20.0% 20.0% 9.0% 9.0%

The year-6 earnings estimate is based on growth rate of 0.15 × (1-.0.40) = 0.09.
Terminal value at year 5: V5 represents for all the future CFs from year 5 onwards
D6 $10.85 V5 $180.82
V5 = = = $180.82 Þ V0 = = = $89.90
k - g 0.15 - 0.09 (1 + k ) 5
1.155

b. The price should rise by 15% next year.

Earnings: Dividends + Reinvestment
ð For shareholders, they will receive Dividends + Capital gains
ð For shareholders, Total Returns = Dividend yield + Capital Gains
ð From year 1 – 5, there is no Dividends
ð Total Return for shareholders = Capital gains = 15%
ð From year 1 – 5, price will increase by 15% p.a
ð Try to calculate V1 = 180.82 / (1.15)^4 = …
 Investment and Portfolio Management

c. The price should rise by 15% per year until year 6: because there is no dividend, the
entire return must be in capital gains.

d. The payout ratio would have no effect on intrinsic value because ROE = k = 15%

Intrinsic value: V
Market price: P
 Investment and Portfolio Management

Extra Exercises:
Helen Morgan, CFA, has been asked to use the DDM to determine the value of Sundanci, Inc.
Morgan anticipates that Sundanci’s earnings and dividends will grow at 32% for two years and
13% thereafter. Calculate the current value of a share of Sundanci stock by using a two-stage
dividend discount model and the data from Tables A and B.

Table A: Sundanci actual 2015 and 2016 financial statements for fiscal years ending May 31 ($
million, except per-share data)

Table B: Selected financial information

 Investment and Portfolio Management

Cost of equity = 14%

g for the first 2 years = 32%
g = 13%
D2016 = 0.286

2016 2017 2018 2019 …

= 0.286 * (1 + 32%)^2 *
= 0.286 * (1 + 32%) = 0.286 * (1 + 32%)^2
(1 + 13%)
Dividend 0.286 = 0.378 = 0.498
= 0.5631

Growth
32% 32% 13% 13%
rate

0.5631
Terminal =
14% − 13%
Value
= 56.31

8.%/$ 8.#.$ '-.%!

Intrinsic Value = + " + = $44.044
!,!#% (!,!#%) (!,!#%)"