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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