Equity - Study Session 10
Main approaches to forecasting dividends problems
- Can assign the entire stream of expected future dividends to one of several stylized growth patterns. - Can forecast a finite number of dividends individually up to a terminal point and value the remaining dividends either by assigning them to a stylized growth pattern or by forecasting share price as of the terminal point of the dividend forecasts.
Factors influencing the choice of the explicit forecast horizon
- the projected holding period, an investor's average portfolio turnover - cyclicality of an industry, company specific factors - employer preferences
Transition Phase
. In this phase, which is a transition to maturity, earnings growth slows as competition puts pressure on prices and profit margins or as sales growth slows because of market saturation. In this phase, earnings growth rates may be above average but declining toward the growth rate for the overall economy. Capital requirements typically decline in this phase, often resulting in positive free cash flow and increasing dividend payout ratios (or the initiation of dividends).
"market growth and market share" approach to forecasting revenue
... the analyst combines forecasts of growth in particular markets with forecasts of a company's market share in the individual markets. then considers the company's current market share, and how that share is likely to change over time.
Inflation (deflation) impacts what?
...pricing strategy depending on: - industry structure - competitive forces - nature of consumer demand.
Growth relative to GDP Approach of Revenue Forecasting
...the analyst forecasts industry and company growth relative to forecasted nominal GDP growth. then considers how the growth rate of the specific company being examined will compare with nominal GDP growth. The analyst may use a forecast for real GDP growth to project volumes and a forecast for inflation to project prices. Analysts often think in terms of percentage point premiums or discounts derived from a company's position in the industrial life cycle (e.g., embryonic, growth, shakeout, mature, or decline) or business cycle sensitivity. Thus, an analyst's conclusion may be that a health care company's revenue will grow at a rate of 200 bps above the nominal GDP growth rate. The forecast may also be in relative terms.
Return on invested capital (ROIC)
= (net operating profit - adjusted taxes) / (operating assets - operating liabilities) - is an after-tax measure of the profitability of investing in a company. - High and persistent levels of ROIC are often associated with having a competitive advantage.
Alternative streams of expected CFs that can be used to value equities
A discounted dividend approach is most suitable for: - dividend-paying stocks in which the company has a discernible dividend policy that has an understandable relationship to the company's profitability - investor has a noncontrol (minority ownership) perspective. The free cash flow approach (FCFF or FCFE) might be appropriate when - the company does not pay dividends, dividends differ substantially from FCFE, free cash flows align with profitability, - investor takes a control (majority ownership) perspective. The residual income approach can be useful when: - the company does not pay dividends (as an alternative to a FCF approach) - free cash flow is negative. no single perfect pick, just by context
Consider the impact of a company's hedging strategy
Although companies usually do not disclose their hedging positions, their general strategy is often revealed in the footnotes of the annual report.
Top-down, bottom-up
Analysts can use a top-down, bottom-up, or a hybrid approach to forecasting income and expenses. Top-down approaches usually begin at the level of the overall economy. Bottom-up approaches begin at the level of the individual company or unit within the company (e.g., business segment). Hybrid approaches include elements of top-down and bottom-up approaches.
Uncertainty of Cost Estimates
Analysts must also be aware of any uncertainty surrounding estimates of costs. For example, banks and insurance companies create reserves against estimated future losses, and companies with large pension plans have long-duration liabilities, the true costs of which may not be known for many years. Other aspects affecting the uncertainty of cost estimates include competitive factors and technological developments. This impact will be discussed in later sections.
DuPont and Div Growth Rates
Dividend growth rates can be obtained from: - analyst forecasts - statistical forecasting models - company fundamentals. The sustainable growth rate depends on the ROE and the earnings retention rate, b: g = b × ROE. This expression can be expanded further, using the DuPont formula, as g= ((Net income − Dividends) / Net income) × (Net income/ Sales) ×(Sales /Total assets) × (Total assets / Shareholders' equity)
Residual income
Earnings for a given time period, minus a deduction for common shareholders' opportunity cost in generating the earnings. Also called economic profit or abnormal earnings.
DCF Models
In DCF models, the value of any asset = PV(expected) FCFs V0=n∑t=1 CFt / (1+r)^t where V0 is the value of the asset as of t = 0 (today), CFt is the (expected) cash flow at time t, and r is the discount rate or required rate of return. For infinitely-lived assets such as common stocks, n runs to infinity.
Mature Phase
In maturity, the company reaches an equilibrium in which investment opportunities on average just earn their opportunity cost of capital. Return on equity approaches the required return on equity, and earnings growth, the dividend payout ratio, and the return on equity stabilize at levels that can be sustained long term. The dividend and earnings growth rate of this phase is called the mature growth rate. This phase, in fact, reflects the stage in which a company can properly be valued using the Gordon growth model, and that model is one tool for valuing this phase of a current high-growth company's future.
franchised retailing business
In the franchised retailing business model, most of the operating costs are incurred by the franchisee; the wholesaler offers products with only a small markup to these franchisees.
Invested Capital, Comp. Advg.
Invested capital can be measured at the beginning of an accounting period or as an average of the beginning and end of the accounting period. ROIC is a better measure of profitability than return on equity because it is not affected by a company's degree of financial leverage. In general, sustainably high ROIC is a sign of a competitive advantage.
PVGO
PV of growth opportunities (PVGO) is the part of a stock's total value, V0, that comes from profitable future growth opportunities in contrast to the value associated with assets already in place. The relationship is V0 = (E1/r) + PVGO, where (E1/r) is defined as the no-growth value per share. Increases in shareholder wealth occur only when reinvested earnings earn more than the opportunity cost of funds (i.e., investments are in positive net present value projects).
Multistage DDM Models
Multistage DDM models can accommodate a wide variety of patterns of expected dividends. Even though such models may use stylized assumptions about growth, they can provide useful approximations.
B/S Items from I/S vs. B/S items attached to I/S forecasted
Some balance sheet line items, such as retained earnings, flow directly from the income statement, whereas accounts receivable, accounts payable, and inventory are very closely linked to income statement projections. A common way to model working capital accounts is to use efficiency ratios.
No-growth value per share
The value per share of a no-growth company, equal to the expected level amount of earnings divided by the stock's required rate of return. A no-growth company (a term for a company without opportunities for profitable growth) should distribute all their earnings in dividends because earnings cannot be reinvested profitably and earnings will be flat in perpetuity, assuming a constant return on equity (ROE). This flatness occurs because earnings equal ROE × Equity, and equity is constant because retained earnings are not added to it. . E1 is the appropriate measure of earnings to use in estimating the no-growth value per share. E1 is t = 1 earnings, which is the constant level of earnings or the average earnings of a no-growth company if return on equity is viewed as varying about its average level.
Bottoms-Up!
Time-series approaches are considered bottom-up, although time-series analysis can be a tool used in top-down approaches. analysts may fit a trend line to historical data and then project sales over the desired timeframe. Note that time-series methods may also be used as tools in executing a top-down analysis, such as projecting GDP growth in a growth relative to GDP growth approach. Return on capital: forecasts based on balance sheet accounts, for example interest revenue for a bank may be calculated as loans multiplied by the average interest rate. Capacity-based measure: forecasts (for example, in retailing) based on same-store sales growth and sales related to new stores.
Forecasting cannibalization
When a technological development results in a new product that threatens to cannibalize demand for an existing product, a unit forecast for the new product combined with an expected cannibalization factor can be used to estimate the impact on future demand for the existing product.
top down and bottom up of costs
analysts can take a top-down, bottom-up, or hybrid view of costs. In a top-down approach, analysts may consider such factors as the overall level of inflation or industry-specific costs before making assumptions about the individual company. In contrast, in a bottom-up approach analysts would start at the company level, considering such factors as segment-level margins, historical cost growth rates, historical margin levels, or the costs of delivering specific products. analysts should pay particular attention to fixed costs. Variable costs are directly linked to revenue growth, and may be best modeled as a percentage of revenue or as projected unit volume multiplied by unit variable costs. By contrast, increases in fixed costs are not directly related to revenue; rather, they are related to future investment in property, plant, and equipment (PP&E) and to total capacity growth.
ROCE
focusing on pretax operating profit, is return on capital employed (ROCE), which is essentially ROIC before tax defined as operating profit divided by capital employed (debt and equity capital). As a pretax measure, ROCE can be useful in several contexts, such as peer comparisons of companies in countries with different tax structures, because comparison of underlying profitability would not be biased in favor of companies benefitting from low tax rate regimes.
The two-stage dividend discount model
Assumes different growth rates in Stage 1 and Stage 2 V0=n∑t=1 D0(1+gS)t(1+r)t + D0(1+gS)n(1+gL)(1+r)n(r−gL) where gS is the expected dividend growth rate in the first period and gL is the expected growth rate in the second period. The terminal stock value, Vn, is sometimes found with the Gordon growth model or with some other method, such as applying a P/E multiplier to forecasted EPS as of the terminal date.
GGM Formula Again?
Assuming that P=V, GGM estimate of a stock's expected rate of return: r=D0(1+g)P0+g=D1P0+g Given an estimate of the next-period dividend and the stock's required rate of return, GGM can be used to estimate the dividend growth rate implied by the current market price (making a constant growth rate assumption).
COGS as Large Cost
Because cost of goods sold is relatively a large cost, a small error in this item can have a material impact on the forecasted operating profit. Thus, analysts should consider whether an analysis of these costs (e.g., by segment, by product category, or by volume and price components), when such an analysis is possible, can improve forecasting accuracy. For example, some companies face fluctuating input costs that can be passed on to customers only with a time lag. Particularly for companies that have low gross margins, sudden shocks in input costs can affect operating profit significantly. A good example is the sensitivity of airlines' profits to unhedged changes in jet fuel costs. In these cases, a breakdown of both costs and sales into volume and price components is essential for developing short term forecasts, even if analysts use the overall relationship between sales and input cost for developing longer-term forecasts.
PRAT Model!
By combining Equations 22 and 25, it shows that the dividend growth rate is equal to the retention rate multiplied by ROE: This expansion of the sustainable growth expression has been called the PRAT model (Higgins 2007). Growth is a function of profit margin (P), retention rate (R), asset turnover (A), and financial leverage (T). The profit margin and asset turnover determine ROA. The other two factors, the retention rate and financial leverage, reflect the company's financial policies. So, the growth rate in dividends can be viewed as determined by the company's ROA and financial policies. Analysts may use Equation 26 to forecast a company's dividend growth rate in the mature growth phase. R&T Reflect Financial Polices, while P and A determine ROA
Growth phase.
For many companies, growth falls into phases. In the growth phase, a company enjoys an abnormally high growth rate in earnings per share, called supernormal growth. In the transition phase, earnings growth slows. In the mature phase, the company reaches an equilibrium in which such factors as earnings growth and the return on equity stabilize at levels that can be sustained long term. Analysts often apply multistage DCF models to value the stock of a company with multistage growth prospects. Enjoys rapidly expanding markets, high profit margins, and an abnormally high growth rate in earnings per share (supernormal growth). Have negative free cash flow to equity because the company invests heavily in expanding operations. Given high prospective returns on equity, the dividend payout ratios of growth-phase companies are often low or even zero.
IRR of a DDM
In addition to valuing equities, the IRR of a DDM, assuming assets are correctly priced in the marketplace, has been used to estimate required returns. For simpler models (such as the one-period model, GGM, and the H-model), well-known formulas may be used to calculate these rates of return. For many dividend streams, however, the rate of return must be found by trial and error, producing a discount rate that equates the PV of the forecasted dividend stream to the current market price For multistage models and spreadsheet models, finding a single equation for the rate of return can be more difficult. The process generally used is similar to that of finding the IRR for a series of varying cash flows. Using a computer or trial and error, the analyst must find the rate of return such that the present value of future expected dividends equals the current stock price. The first stage of a multistage DDM frequently incorporates analysts' individual earnings and dividend forecasts for the next two to five years (sometimes longer). The final stage is often modeled using the Gordon growth model based on an assumption of the company's long-run sustainable growth rate. In the case of the H-model, the transition to the mature growth phase happens smoothly during the first stage.
Economies of Scale Evidence
Operating margins that are positively correlated with sales provide evidence of economies of scale in an industry.
Valuation Formulas
The DDM with a single holding period gives stock alue as V0= D1/ (1+r)^1 + +P1 / (1+r)^1 =(D1+P1)/(1+r)^1 where D1 is the expected dividend at time 1 and V0 is the stock's (expected) value at time 0. Assuming that V0 is equal to today's market price, P0, the expected holding-period return is r=((D1+P1) /P0) −1 = D1/P0 + (P1−P0)/ P0
GGM Model
The Gordon growth model assumes that dividends grow at a constant rate g forever, so that Dt = Dt-1(1 + g). The dividend stream in the Gordon growth model has a value of V0=D0(1+g)r−g,orV0=D1r−g where r>g
H-Model
The H-model assumes that the dividend growth rate declines linearly from a high supernormal rate to the normal growth rate during Stage 1, and then grows at a constant normal growth rate thereafter: V0=D0(1+gL)r−gL+D0H(gS−gL)r−gL=D0(1+gL)+D0H(gS−gL)r−gL The first term on the right-hand side of Equation 20 is the present value of the company's dividend stream if it were to grow at gL forever. The second term is an approximation of the extra value (assuming gS > gL) accruing to the stock because of its supernormal growth for Years 1 through 2H (see Fuller and Hsia 1984, for technical details).23 Logically, the longer the supernormal growth period (i.e., the larger the value of H, which is one-half the length of the supernormal growth period) and the larger the extra growth rate in the supernormal growth period (measured by gS minus gL), the higher the share value, all else equal. The H-model is an approximation model that estimates the valuation that would result from discounting all of the future dividends individually. In many circumstances, this approximation is very close. For a long extraordinary growth period (a high H) or for a large difference in growth rates (the difference between gS and gL), however, the analyst might abandon the approximation model for the more exact model.
Free cash flow to equity
The cash flow available to a company's common shareholders after all operating expenses, interest, and principal payments have been made, and necessary investments in working and fixed capital have been made. FCFE also represents cash flow that can be redeployed outside the company without affecting the company's capital investments. A controlling equity interest can effect such redeployment. As a result, free cash flow valuation is appropriate for investors who want to take a control perspective.
Free cash flow to the firm
The cash flow available to the company's suppliers of capital after all operating expenses (including taxes) have been paid and necessary investments in working and fixed capital have been made.
COGS Mfg
The cost of goods sold (COGS) is typically the single largest cost for manufacturing and merchandising companies. Because COGS has a direct link with sales, forecasting this item as a percentage of sales is usually a good approach. If a company is losing market share in a market in which the emergence of new substitute products are also putting the overall sector under pricing pressure, gross margins are likely to decline.
NTM and TTM P/E Breakdown
The leading price-to-earnings ratio (P0/E1) and the trailing price-to-earnings ratio (P0/E0) can be expressed in terms of the Gordon growth model as, respectively, P0E1=D1/E1r−g=1−br−g and P0E0=D0(1+g)/E0r−g=(1−b)(1+g)r−g The above expressions give a stock's justified price-to-earnings ratio based on forecasts of fundamentals (given that the Gordon growth model is appropriate). The first term, 1/r, is the value of the P/E for a no-growth company. The second term is the component of the P/E value that relates to growth opportunities. value of growth and the value of assets in place generally have different risk characteristics
3-Stage Models
There are two basic three-stage models. In one version, the growth rate in the middle stage is constant. In the second version, the growth rate declines linearly in Stage 2 and becomes constant and normal in Stage 3. In the first stage, analysts may forecast earnings and dividends individually for a certain number of years. The model also makes estimates of the required rate of return and the lengths of the three stages, assigning higher growth companies shorter growth periods (i.e., first stages) and longer transition periods, and slower growth companies longer growth periods and shorter transition periods.
the horizon selected often depends on
the horizon selected often depends on the perceived predictability (sometimes called the visibility) of the company's earnings.