Tuesday, November 6, 2012

Honda Analysis

15.






















In the first scenario where the PV of CF is 39.71, let’s make note that ROE is greater than cost of equity. If this relationship holds, we can assert that any change in the growth rate, all else the same, will increase the PV of CF. This is the profitable growth that investors look for.

In the second scenario, we have lowered the ROE where it is less than the cost of equity. Therefore, this translates into growth that is not profitable. This is why the PV of CF has decreased. If such a situation were to persist, then one of the ways to increase intrinsic value is to increase the dividend payout ratio.

In the third scenario, we have manipulated beta upwards and this has increased the cost of equity such that it is equal to ROE. In comparison to the first scenario where ROE>cost of equity, the intrinsic value has fallen.

In the last scenario we have indirectly manipulated the cost of equity such that ROE is slightly greater than cost of equity. In comparison to the third scenario, the intrinsic value has increased because of the relationship between these two variables. 


16.
In this example we are using the discounted cash flow method to determine the intrinsic value of a company and its stock. As we will see below, the primary change in the intrinsic values will be derived from the fact that the cost of equity and WACC are changing. The results are outlined in Exhibit B.  

If we assume the P/E multiple to be 16 in 2012, we derive intrinsic values of $37.61 for FCFF and $38.55 for FCFE (Exhibit A).  When compared to the benchmark, the intrinsic values are higher because investors are willing to pay more for each dollar of income than in 2011. The assumptions for this example are outlined in Exhibit A. 

When the unlevered beta is increased from 0.79 to 0.8 (scenario 2), the cost of equity and consequently the WACC increases. This intrinsic value is reduced as a result because investors demand a higher premium

Notably, in scenario 3, the market risk premium has increased by a full percentage point. This has served to increase the cost of equity from 11.7% to 12.6%. This also increases the WACC and as a result the cash flows are discounted by a higher figure and lower intrinsic values ensue.

The dividend discount model in comparison to the DCF model is more simplistic given the less number of variables required. However it can be argued the DCF model is more complete given its wholistic approach.



Exhibit A

Exhibit B

- Akhil P

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