Equity Valuation with Changing Growth and Multiples
You are valuing a mature industrial company that pays a dividend of $2.00 per share. The company has a return on equity (ROE) of 12% and a retention ratio of 40%. The required rate of return on equity is 10%. The company is expected to maintain this dividend policy and ROE for the next three years, after which its ROE is expected to decline to 8% and its retention ratio to 30%, indefinitely. The current stock price is $45. The company has 10 million shares outstanding and debt of $50 million. Its EBITDA is $30 million, and the industry average EV/EBITDA multiple is 8. The company's tax rate is 25%.
1. Using a two-stage dividend discount model, estimate the intrinsic value of the stock and compare it to the market price. Show your calculations.
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First, calculate the growth rate in the first stage: g1 = ROE * retention ratio = 0.12 * 0.40 = 0.048 or 4.8%. The dividend in year 1 is D1 = D0 * (1+g1) = 2.00 * 1.048 = $2.096. Year 2 dividend = 2.096 * 1.048 = $2.1966. Year 3 dividend = 2.1966 * 1.048 = $2.3020. In the second stage, the growth rate g2 = 0.08 * 0.30 = 0.024 or 2.4%. The dividend in year 4 is D4 = D3 * (1+g2) = 2.3020 * 1.024 = $2.3572. The terminal value at the end of year 3 is V3 = D4 / (r - g2) = 2.3572 / (0.10 - 0.024) = 2.3572 / 0.076 = $31.0158. Now discount the dividends and terminal value to present: PV of D1 = 2.096 / 1.10 = $1.9055. PV of D2 = 2.1966 / 1.21 = $1.8154. PV of D3 = 2.3020 / 1.331 = $1.7295. PV of V3 = 31.0158 / 1.331 = $23.3025. Total intrinsic value = 1.9055 + 1.8154 + 1.7295 + 23.3025 = $28.7529. The market price is $45, so the stock appears overvalued by about $16.25 per share. However, this model assumes the dividend policy and ROE are the only drivers. The analyst should also consider the EV/EBITDA multiple. The company's EBITDA is $30 million, so EV at 8x is $240 million. Equity value = EV - debt = 240 - 50 = $190 million. Per share = $19.00. This is even lower than the DDM value, suggesting overvaluation. But the industry multiple may not be appropriate for this company. The discrepancy between DDM and multiples highlights the need for sensitivity analysis.
2. Critique the use of the industry average EV/EBITDA multiple for this company and discuss what adjustments might be necessary.
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The industry average EV/EBITDA multiple of 8 may not be appropriate for this company because it does not account for differences in growth, risk, or capital structure. The company is mature, with a declining ROE and retention ratio, which suggests lower growth prospects than the industry average. A lower multiple might be justified. Additionally, the company's debt level affects EV but not EBITDA; the multiple should be applied to a comparable capital structure. The company's tax rate is 25%, but EBITDA is pre-tax, so the multiple is not affected by tax. However, the company's capital expenditures and working capital needs may differ from the industry, which would affect free cash flow and thus the appropriate multiple. The analyst should adjust the multiple for differences in expected growth, profitability (ROE), and risk. One approach is to use a regression of multiples against fundamentals, or to use a peer group with similar characteristics. The company's ROE of 12% declining to 8% is below the industry average perhaps. Also, the EV/EBITDA multiple ignores the value of non-operating assets and liabilities. The company has no mentioned non-operating assets. The analyst should also consider that the DDM value was $28.75, while the multiple gives $19.00. The difference is large, indicating that either the DDM assumptions are too optimistic or the multiple is too low. A sensitivity analysis on the growth rate and required return would show a range of values. The analyst should also consider using a free cash flow to firm (FCFF) model, which would incorporate the company's debt and tax shield explicitly. The CFO's skepticism about the DDM might be due to its sensitivity to inputs. The best approach is to use multiple valuation methods and triangulate.