Stock Valuation Using CGM and DDM

Stock Valuation Using CGM and DDM
AD731: Corporate -1 of 15- Chee / BU MET
Description and Guidance for this assignment
Let’s apply what we have learned thus far in the classroom to stock valuation using Dividend Discount Model
(DDM). Does the approach (“rubber”) meets the market (“road”)? This assignment has TWO parts:
Part [1] Do a Constant Growth Model CGM valuation of your chosen stock.
1. Select a stock of your choice (one that pays dividends). DO NOT use Proctor & Gamble; it is used in this guidance.
2. Download your stock’s dividend payout history.
3. Tabulate your stock’s annual dividend payout and its growth rate.
4. Estimate the stock’s discount rate ks to use on the CGM.
5. Estimate the constant dividend growth rate gc to use on the CGM.
6. Implement stock valuation using CGM with a range of ks and gc.
Guidance on this part
o The guidance document is lengthy but don’t worry. It is not difficult; it is cookbook-like. If you follow
the instructions and do this part correctly, “you should get around 80 points”.
o Follow instructions below, Step #0 to Step #6 .
o PS: you do not need to do Step #7. These are comments and learning outcomes provided by the
instructor with regard to the equity valuation and the stock market in general. As you will find out
during this part of the assignment, this is where “the rubber DOES NOT meet the road”.
o You probably want to use Excel to do this part.
o Originate our post with your Excel along with any additional assumptions on this process.
o PS: check with your facilitator the timing of this posting in order to get near/full credit for this part.
Part [2] Improving your stock valuation beyond CGM.
You will realize that in general, CGM is an inappropriate, unreliable, or inaccurate method for stock valuation. This
is probably the case for your chosen stock. So, after you originate-post Part [1], later in the week, you may followup
with subsequent posting(s) in this Part [2]. Some guidance on this part:
a. Was your CGM valuation (V0) on your chosen stock “close enough” in value to its currently traded stock
price (P0)?
b. PS: If your calculated V0 is not very good, this is OK and typical — you won’t get points deducted when it is
not close to P0. In fact, this is very common and normal — it illustrates the general difficulty in stock
valuation, especially using CGM.
c. In this case, comment about some of the difficulties and issues you encountered using CGM on your
chosen stock.
d. Perhaps explain why there is a big/significant difference in valuation of your stock to its market price. Hint:
what does the company of your chosen stock make/sell in the market? Products, services? Competitors?
Bad economic/market conditions? Yes, there a many very good/valid reasons your calculated V0 is
different from P0.
e. Finally, can you improve upon your stock valuation using CGM? Hint: perhaps you can use the more
sophisticated multi-stage Dividend discount Model DDM. If you do so, you might want to implement it
using another Excel. If you do this, post this other Excel later in the assignment week.
f. Also, you should view your classmates’ originating post and comment discuss, and add to the discussion
topic.
g. Part [2] accounts for the remaining points in the entire assignment.
Grading policy for this assignment
Any further questions, check in with your facilitator. Grading of this assignment is exclusively done by your
facilitator with regard to promptness/timing of originating post and amount of follow-up participation in the
assignment.
Week 4 Weekly Discussion WD4
Stock Valuation Using CGM and DDM
AD731: Corporate -2 of 15- Chee / BU MET
Step #0 Assumptions used in this assignment.
? You may use/assume the following [based on 11/24/2020]. No need to change it if you do it a week or two
after this date; the numbers should be about the same and won’t impact your calculations:
? Risk-free Rate, also notated as kRF, RFR = 0.10% [U.S. 1-year T-Bill].
? Market Risk Premium MRP = kM – kRF = 4.00% [how did we get this “magic” number?].
? Therefore, Required Rate of Return of the Market kM = RFR + MRP = 4.10%.
Step #1 Pick a stock with a dividend history.
You will be doing a stock valuation using Constant Growth Model CGM. In order to make this assignment work,
your proposed stock must meet the following requirements:
a) It must be U.S. publicly traded only because its long-run historical stock prices are easily available and
downloadable from most (free) financial websites.
b) Stock must have been listed since 01/02/2000; we need data from this date till 11/25/2020.
c) Your selected stock must have a dividend history since year 2000, whether quarterly or annually over these
years. This is an obvious requirement since CGM and DDM only works if it has sufficient dividend history.
d) Note that it is OK for more than one student to pick the same stock. And I will assume that each student is
doing his/her own (individual) work on the same selected stock. It is also likely that different students using
the same stock can end up with different answers based on the other estimates used by the student.
e) This Project is not graded on how close your calculated CGM answer(s) is from the corresponding market
traded price of the stock.
f) PS: if you do not wish to use U.S. domestic stocks, you are allowed to propose your own stocks from another
country. Then that proposed stock are “domestic” with respect to that country. For example, a Chinese stock,
a European stock, a Latin American stock, etc. BUT you must still
? Meet the data requirements as spelled out in above steps [b] thru [c],
? You need to find out that country’s Risk-free Rate (RFR), i.e. its 1-year T-Bill rate.
? And you need to estimate that country’s Market Risk Premium. PS: it may not be 4.00%.
g) PS: if you decide on U.S. stocks, you do not have to limit your choice of U.S stocks to the pre-screened list
in [k].
? Choose something you are interested in or you plan to follow …
? … and might have a future interest in investing in that stock, or even employment prospect.
? However, whichever stock you choose to use, you must still meet those requirements [a] thru [c].
k) Suggestions on how to screen for your stock
If you already are an experienced investor, you could use any of the free or commercially available stock
screener apps to help you; most of them comes with your online stock trading account. However, if you do
not have this resource, it is not an issue. In fact, one of the goals of this course is to teach you to build and
look for stock information manually; it is part of the learning process.
To save you time, the following is a list <see next page> of some pre-screened S&P500 stocks which might
meet the above requirements [b], [c] at the time of assignment. They are organized by sectors [and listed in
order of sector weight] as defined by the Global Industry Classification Standards (GICS), a system developed
by Morgan Stanley Capital International (MSCI) and Standard & Poor’s (S&P):
Week 4 Weekly Discussion WD4
Stock Valuation Using CGM and DDM
AD731: Corporate -3 of 15- Chee / BU MET
This list of pre-screened stocks should have the dividend history requirements [b] and [c].
? Pick one stock from any of the 11 sectors [vertical column] based on your interest.
SELECT FROM THIS LIST OF PRE-SCREENED STOCKS. PS: stocks marked with a * have a
dividend payout history since 2000 or earlier.
Stock candidates listed in order by index weight within sector:
Health Comm Real
Discr Staples Energy Financials Care Industrl Materials Tech Utilities Services Estate
HD* KO* XOM* JPM* JNJ* HON* ECL* MSFT* DUK* CMCSA* PLD*
MCD* PEP* CVX* WFC* MRK* MMM* APD* INTC* D* DIS* EQR*
LOW* WMT* COP* AXP* PFE* UPS* NEM* TXN* SO* VZ* ARE*
TGT* KMB* SLB* USB* ABT* WM* VMC* ADP* SRE*
CCL* WBA* HES* PNC* AMGN FDX* MLM* XEL*
HSY* HAL* SCHW* LLY* LUV* IP* ED*
MRO* CVS* GD* IFF*
<11/24/2020>
Sourced from Yahoo!
DO NOT select and use the following stocks in your portfolio. Because:
– insufficient data over the required observed period,
– negative returns or average of annual HPY > 16%.
– no dividend payouts or insufficient dividend history.
AMZN #1 PM #5 PSX #3 BRK-B #1 UNH* #3 BA* #1 LIN #1 AAPL #2 NEE* #1 FB #1 AMT #1
NKE* #4 MO* #6 MPC #5 BAC #3 MDT* #5 UNP* #3 DD #3 V* #3 EXC* #5 GOOG #2 CCI #2
SBUX #5 MDLZ* #7 EOG #7 C #5 TMO #8 UTX* SHW* #5 MA #4 AEP* #6GOOGL #3 SPG* #4
BKNG #7 COST #8 KMI #8 CME #8 ABBV #9 LMT* #5 PPG #8 CSCO #6 PEG* #9 CHTR #4 EQIX #5
TJX #8 CL* #9 OXY #9 CB #9 DHR* #11 GE* #8 DOW #6 ADBE #7 WEC* #11 T* #6 PSA* #6
GM #10 EL #11 VLO #10 GS* #10 BMY* #12 CAT* #9 BLL* #9 CRM #8 ES* #12 ATVI #7 WELL #7
DG #11 SYY* #13 OKE* #11 SPGI #12 GILD #14 NOC* #10 LYB #10 IBM* #9 PPL* #18 NFLX #8 AVB* #9
ROST* #12 GIS* #14 WMB #12 ICE #13 CELG #15 RTN* #11 NUE* #15 ORCL #10 TWTR #11 SBAC #10
YUM* #13 STZ #15 PXD #13 MS* #14 BDX* #17 CSX* #12 CE #17 PYPL #12 EA #12 DLR #11
F* #14 ADM* #18 FANG #17 BLK #15 ANTM #19 DE* #13 FCX #18 ACN #13 TTWO #15 VTR*#12
MAR* #15 MNST #19 CXO #18 MMC*#16 ISRG #20 NSC* #14 CF #20 NVDA #14 CBS #16 BXP* #16
EBAY #17 KR #21 DVN* #22 AIG #17 CI* #21 CMI* #29 FMC #21AVGO #15 CTL #17 WY* #15
VFC* #18 CLX* #22 APA #25 AON #18 BAX #25 EMN* #23QCOM* #16 FOXA* #18 O #13
DLTR #19 KHC #24 COG* #28 BK* #24 VRTX #26 MOS* #26 INTU #19 DISCK #19 ESS* #14
BBY #30 SJM* #27 MET* #26 BIIB #28 airlines SEE #30 MU #21 DISH #20 HCP* #17
MGM #33 MCK* #33 DAL #24 ADI #22 VIAB #21 CBRE #19
REGN #34 UAL #39 CTSH #26 TRIP #26 HST* #20
AAL #54 VNO* #26
IRM #28
Sectors
Consumer
Week 4 Weekly Discussion WD4
Stock Valuation Using CGM and DDM
AD731: Corporate -4 of 15- Chee / BU MET
Step #2 Download your selected stock’s periodic dividend payouts since 1/2/2000.
a) Use the date range 1/2/2000 to 11/25/2020.
b) Typical place to download data from is Yahoo! , www.finance.yahoo.com. If you have other more
convenient/familiar sources to download from, that is also OK; all you really need is historical dividend data
for your chosen stock.
The following screen shots might look a little different from the one you will be using. Please note the
following:
? Irrelevant info, tabs and pop-up ads have been de-cluttered from the screen shot.
? Also, websites frequently change/refresh the appearance of their web pages from time to time to
include additional web features and advertisement placements.
? In any case, they are similar enough to what you will be actually seeing.
(i) At the top or top-right home page, in the Quote Lookup search box, enter your selected stock’s ticker
symbol, for example “PG” for Proctor and Gamble. Or type in the full name of the company.
(i)
(ii)
(i)
Week 4 Weekly Discussion WD4
Stock Valuation Using CGM and DDM
AD731: Corporate -5 of 15- Chee / BU MET
(ii) Click on the Historical Data tab:
(iii) In the Time Period box, use the ? pull-down list to specify date range, for example 1/2/2000 to
11/25/2020.
(iv) In the Show box, use the ? pull-down list to select the Dividends Only item.
(v) Ignore the Frequency box. This is only applicable if you are downloading stock prices (daily, weekly,
monthly); perhaps you will need to do this in other future courses/assignments. But for this
assignment, you are not using this.
(vi) Then click the Apply button to retrieve the dividend data according to the earlier settings. Below it
you will see dividend data for the remaining part of your browser’s scrolling screen.
(vii) Finally click the Download to download the stock’s dividend data. Please note the following:
? The data will be downloaded onto your system in “CVS tab delimited” format. You should be
able to open it using Excel …
? … YOU SHOULD THEN do a File > Save As and save the data as an Excel file type so that you
can use the full features of Excel to do additional functions, e.g. averages, etc.
? When you open the downloaded dividends’ Excel file, the dividend is NOT necessarily arrange
in any date order …
? … IMPORTANT: make sure you sort the data in chronological order (from oldest to most
recent date. PS: you do this by highlighting the date and dividends columns of data and then
using Excel’s Data > Sort > Sort by > Date to sort them in chronological order. See next
section’s illustrated data, column [A].
(ii)
(iii) (iv) (vi)
(v)
(vii)
(viii)
Week 4 Weekly Discussion WD4
Stock Valuation Using CGM and DDM
AD731: Corporate -6 of 15- Chee / BU MET
Step #3 Tabulate the stock’s annual dividend payout and its annual dividend growth rates
a) From previous step, we have sorted the downloaded periodic dividend data, in chronological order, see
column [A]:
[A] [B] [C] [D] [E]
Quarterly Annual dividend
Date Dividends Year Dividends growth
01/19/2000 0.1600 2000 $0.6700 –
04/18/2000 0.1600 2001 $0.7300 8.96%
07/19/2000 0.1750 2002 $1.1350 55.48%
10/18/2000 0.1750 2003 $0.8650 -23.79%
01/17/2001 0.1750 2004 $0.9775 13.01%
04/18/2001 0.1750 2005 $1.0900 11.51%
07/18/2001 0.1900 2006 $1.2100 11.01%
10/17/2001 0.1900 2007 $1.3600 12.40%
01/16/2002 0.1900 2008 $1.5500 13.97%
04/17/2002 0.1900 2009 $1.7200 10.97%
06/03/2002 0.3450 2010 $1.8860 9.65% [F] … is there a predictable growth pattern?
07/17/2002 0.2050 2011 $2.0570 9.07%
10/16/2002 0.2050 2012 $2.2110 7.49%
01/22/2003 0.2050 2013 $2.3680 7.10%
04/15/2003 0.2050 2014 $2.5340 7.01%
07/16/2003 0.2275 2015 $2.6330 3.91%
10/22/2003 0.2275 2016 $2.6730 1.52%
01/21/2004 0.2275 2017 $2.7400 2.51%
04/21/2004 0.2500 2018 $2.8410 3.69%
07/21/2004 0.2500 2019 $2.9550 4.01%
10/20/2004 0.2500 2020 $3.1190 5.55%
01/19/2005 0.2500 [G] Average = 8.75% [H] ????????????????????????????????????????????????
04/20/2005 0.2800
07/20/2005 0.2800
:
b) For most stocks (e.g. JP Morgan; Proctor & Gamble, Exxon-Mobil; etc.), at least North American stocks,
dividends if paid out, occur on a quarterly basis. See illustrated data, column [B] — dividends (sometimes to 4
decimal places) were paid out regularly per quarter in the months of January, April, July, and October. PS:
during exceptional year(s) of company profits, the company can pay out an “extra” dividend, sometimes call
an “extra-ordinary dividend”, as in the case of 06/03/2002 above.
c) Create a column by year, see column [C].
d) For convenience (although less accurate in valuation of the stock), aggregate these quarterly dividends over
each entire year (e.g. Q1 Jan, Q2 April, Q3 July, Q4 October), see column [D]. For example, during the year
2000, the total dividend paid out were $0.1600 + $0.1600 + $0.1750 + $0.1750 = $0.6700. Thus, we will be
doing Constant Growth Model CGM valuation over annual periods of years.
e) Calculate the historical annual dividend growth rate from one year to the next. This is the percentage change
of dividend from one year to the next. For example, from Year 2000 to Year 2001, the dividend growth rate is
(0.73 – 0.67) ÷ 0.67 = 8.96%. Do this for subsequent years’ dividend growth rate. See column [E].
f) See item [F]. Take a visual look at the dividend growth rate from one year to the next. This is where classroom
CGM method runs into market reality — can you spot a consistent trend in dividend growth rate from one
year to the next? Yeah, it is not that simple actually.
Week 4 Weekly Discussion WD4
Stock Valuation Using CGM and DDM
AD731: Corporate -7 of 15- Chee / BU MET
g) In any case, we need to project the constant dividend growth rate gc for the next and future years of this
stock. “One way” to do this is take the average of the annual dividend growth rates of the stock over the
number of years of observation. See item [G].
h) See item [H] with regard to this calculated average annual dividend growth rate. Is this average the gc? Some
comments on this issue:
o Some stocks (e.g. Consolidated Edison) have extremely predictable annual dividend growth rates.
Spotting such a consistent trend is easy: e.g. growth rate declined slowly and steadily in subsequent
years indicating a maturity within the industry and a slowdown (to a constant rate) of earnings growth.
o In other instances, a company’s earnings are more volatile, leading to corresponding large ups and
downs in dividend payouts from one period to the next (e.g. Exxon-Mobil and the above).
o This is quite common with stocks which are more vulnerable and highly correlated to economic and
business cycles — this is one issue and challenge with using Constant Growth Model CGM — the stock
you are doing CGM valuation “has yet to reach a predictable or consistent dividend payout policy”.
o Yet, in this part of the assignment, we are forcing the issue by doing a CGM valuation on the stock.
i) In any case, hold on to that calculated average annual dividend growth rate [8.75%]. In a later step, we will
probably “adjust down” the average to a lower number and the use a range of constant dividend growth
rates gc to “bracket” the uncertainty in CGM valuation of this stock.
Step #4 Estimate the discount rate ks to use on the CGM
a) In DDM, we value the stock by using a discount rate to do a “net present value of all dividends”. In the case of
an assumed constant dividend growth rate gc , i.e. the CGM valuation of the stock simplifies to:
??(?????) =
??
?? ? ??
=
??(1 + ??)
?? ? ??
b) Since we are doing a current (today) CGM valuation of the stock, the most “recent dividend” D0 is the above
dividend at Year 2020, i.e. $3.1190.
c) And we “sort of” have an estimate of gc from previous Step #3 [g] and [i]. This gives us an estimate of D1.
What remains is an estimate of the equity required rate of return (ks) of this stock. For the moment, based on
what we have learned in this course, there are TWO ways to estimate ks:
d) Method 1 to estimate ks: use Capital Asset Pricing Model CAPM.
(i) See previous preen shot item (viii), in Yahoo! , click on the tab. Find the stock’s
reported Beta under the Stock Price History section. For example, this stock’s Beta is 0.40, “derived
using monthly returns from the past 5 years”.
(ii) Then apply the CAPM formula to get the CAPM-suggested ks. For example, using the assumptions for
kRF and kM at the beginning of this document,
ks = kRF ???s(kM – kRF)
= 0.10% + 0.40(4.10% – 0.10%)
ks = 1.70% [CAPM method]
Week 4 Weekly Discussion WD4
Stock Valuation Using CGM and DDM
AD731: Corporate -8 of 15- Chee / BU MET
PS: this estimated ks “looks too low”, which is why we sometimes need other methods like Method 2
below.
e) Method 2 to estimate ks: use “Own-Bond-Yield-Plus-Judgemental-Risk-Premium OBYPJRP”.
We have done this before in a previous assignment. If this company also issue bonds, go find its Yield to
Maturity YTM. The instructions from previous assignment is repeated at the end of this document as
“Appendix????????????????????????????????????????
(i) From that Appendix, we estimated this stock’s bond yield at kd = 2.76% [YTM].
(ii) Using this OBYJPRP method,
ks = kd + Judgmental Risk Premium
= 2.76% + 4.00%
ks = 6.76% [OBYPJRP method]
PS: The point is not to spend too much time to be accurate about it because in most of our analysis,
we will be using a range of ballpark ks to do equity valuation and analysis on it. See next step’s CGM.
f) Now, back to the previous two steps, (d) and (e), why do we use a number of methods to estimate ks? This
question I posed highlights the prevailing issue of Investment and financial market analysis, and in this
assignment, equity valuation in particular:
(i) “There are no ???? ??????????????????????? For example, Newton’s F = ma on Earth and Einstein’s e =
mc2 in the known parts of the universe …
(ii) … “In , there are only models and theories”. So, the CAPM, the Beta, the SML we learned
about in the classroom does not govern/guarantee the behavior of a stock price in the financial
market.
(iii) And we see this issue in in Method 2 by just adding a ????????????? Risk Premium to the
company’s bond’s kd (YTM). Wow, that is really professional! Is it 3% or 4% or 5%? This is exactly what
we are doing in the classroom and sometimes in the workplace.
(iv) See also item (g) below; more wishy-washy techniques in . PS: and we pay you $120K annual
salary to do this in the workplace …
g) Which ks should we use? In this document’s example, we have a ks = 1.70% [CAPM method] and a ks = 6.76%
[OBYPJRP method]. Further guidelines on how to arrive at a final ks
(i) If the estimated ks from all the methods are “close enough” in value to each other, for example 6.00%,
6.75%, 7.15%, etc., then “take the average of all the estimated ks”.
(ii) If some of the estimated ks is either “too low” or “too high”, ignore these “outlier” values and settle
on the remaining “reasonable” estimated ks.
(iii) When in doubt, it is also ok to be conservative and “take the higher, reasonable ks and not do averages
of ks”. Why, this is the general rule of conservative Accounting, , Management, and even
Engineering, “?????????????? ????? ??????? (revenues, cost savings, investment rates, et al),
?????????????????????????? (costs, expenses, borrowing rates, TVM discount rates, et al)”.
h) So, in this document’s example, ks = 1.70% [CAPM method] is “too low” and rejected, while the other is
accepted. We will settle on an estimated ks = 6.76% [OBYPJRP method] .
Week 4 Weekly Discussion WD4
Stock Valuation Using CGM and DDM
AD731: Corporate -9 of 15- Chee / BU MET
Step #5 Estimate the constant dividend growth rate gc to use on the CGM
a) In order for CGM to work, one of the conditions of the valuation is gc must be less than ks; see denominator
of the CGM formula.
b) Furthermore, as described Step #3, (f) through (i), the average of the annual dividend growth rate for a
company that is still growing (in revenues and earnings) tends to be a high rate; sometimes even higher than
its ks; i.e. this won’t work.
c) What this implies is that the company’s business/market/industry “has yet to mature and settle down”,
because it is still growing to a consistent/stable, more predictable pattern of revenues and earnings and
thereby has yet to stabilize to a consistent constant dividend payout rate in the form of gc.
d) In this part of the assignment, “we are forcing CGM valuation” on the stock that has yet to reach this gc …
e) … one way to do this is to set a gc by “?????????????? the average of the annual dividend growth rates to a
lower rate”.
f) Using the previous estimated values:
(i) From Step #4 (h), we have ks = 6.76% [OBYPJRP method]
(ii) From Step #3 (i), we have average annual dividend growth rate = 8.75%
g) How should we set gc? The conservative approach is to lower-adjust the average annual dividend growth rate
???????????????????????????. Some guidelines:
(i) If your stock is in the U.S., the long-run annual GDP growth rate is 2.50%. In China, it is at least 6.00%.
In the Eurozone (Germany, France, Italy, Spain, et al), it is 1.50%.
(ii) Check which industry your stock is in. Is it in Energy, Financial, Healthcare, Industrial, Technology,
Utilities, etc.? For example, in the U.S.
o The Technology sector grows at a much higher rate than the country’s annual GDP growth rate.
So, it could be “up to 6% or 10%”.
o The Healthcare sector also grows at a rate higher than GDP growth rate, about “4% or 5%”.
o On the other hand, the Energy and Utilities sectors are below average, “may be 1% or 2%”.
o PS: if you don’t know the long-run growth rate of that sector, just use the country’s annual GDP
rate.
(iii) Guideline (ii) also applies relatively to other countries within the respective sectors. In the case of
China, we are dealing with correspondingly “higher growth rates”. Conversely, in Europe, lower rates.
(iv) Finally, lower-adjust the stock’s gc to less than ks and closer to the long-run growth rate with that of
the stock’s sector.
h) In this document’s example, we could use a gc of 4.00% (the stock in this example is in the Staples sector).
PS: The point is not to spend too much time to be accurate about it because in most of our analysis, we
will be using a range of ballpark gc to do equity valuation and analysis on it. See next step’s CGM.
Thus, we can settle on a range of dividend gc from 0.00% [most conservative no growth] … to 4.00% … to
5.00% [more optimistic] .
Week 4 Weekly Discussion WD4
Stock Valuation Using CGM and DDM
AD731: Corporate -10 of 15- Chee / BU MET
Step #6 Implement stock valuation using CGM with a range of ks and gc
a) From the previous steps, we can now use CGM to calculate the stock’s price using a range of ks (± 0.25% and
± 0.50%) and a range of constant dividend growth rates gc [gc1, gc2, gc3, gc4, gc5].
o PS: since in the following example we are using six columns of different gc, starting at gc = 0% …
o … we will have one-fifth increments of gc up till the maximum range of 5.00%.
b) The following is an example of a two-dimensional matrix of CGM valuation (highlighted in yellow) using these
ranges of estimated gc and ks:
Notation: Dividends
inputs D0 $3.1190 $3.1190 $3.1190 $3.1190 $3.1190 $3.1190
D1 $3.1190 $3.1502 $3.1814 $3.2126 $3.2438 $3.2750
gc0 gc1 gc2 gc3 gc4 gc5
0.00% 1.00% 2.00% 3.00% 4.00% 5.00%
k1 6.26% $49.82 $59.89 $74.68 $98.55 $143.53 $259.92
k2 6.51% $47.91 $57.17 $70.54 $91.53 $129.23 $216.88
ks 6.76% $46.14 $54.69 $66.84 $85.44 $117.53 $186.08
k4 7.01% $44.49 $52.42 $63.50 $80.11 $107.77 $162.93
k5 7.26% $42.96 $50.32 $60.48 $75.41 $99.50 $144.91
actual stock price:
assumed dividend growth rates gc
DDM Valuation V0
assumed
discount
rate ks
P0 = $138.31
<11/24/2020>
e c k g
V D
?
? 1
0
c) As seen above, CGM (same for multi-stage DDM) valuation is extremely sensitive to the assumptions in gc
and ks. In the above valuation matrix, it can vary by as much as a 100% or even more. One should ask the
questions:
o “How useful is this CGM model?”
o And “how good must your estimates (projections) be in order for the valuation to have any accurate
and useful meaning?
d) PS: the above highlighted cells’ $117.53 ~ $186.08 valuation V0 is closest to the closing market price P0 of
this stock [$138.31, 11/24/2020]. It would seem that market expectations of this stock with regard to its
historical dividend payout, the project dividend payout [via gc] and the market required rate of return of the
stock ks has been “fairly”, or rather sensibly priced into the current valuation of this stock. Hence, this stock
trades around this valuation in the stock market.
e) In fact, based on the current market traded stock price, if it is “trading at fair valuation”, then “working
backwards” from this price, the “market-implied future dividend growth rate, according to DDM is 4.00% or
5.00%”.
Week 4 Weekly Discussion WD4
Stock Valuation Using CGM and DDM
AD731: Corporate -11 of 15- Chee / BU MET
Step #7 Learning Outcome of Part1 of this assignment (nothing to calculate here)
1) This part of the assignment illustrate a very common activity in investment analysis and financial market
analysis, “I??????????????????????????????????????????????????”
2) If an analyst or trader believes that it is under/over -valued, then s/he will “long/short that security”.
3) This is the role of a financial market; it is a forum for “price discovery”. If the market is efficient (all relevant
information available to market participants), then it will be factored into the price of the security correctly
and fairly.
4) BUT the market, in particular the stock market, exhibits extreme deviation from market efficiency for at least
the following reasons:
a. Stock markets are extremely complicated.
b. Stock markets have very diverse participants = each group can have very different trading/investing
objectives.
c. Participants can have very different activity horizon or holding period — day trading, short-term,
longer-term, buy-and-hold (till death), etc.
d. Stock markets are sometimes used as an “arena for speculation, i.e. like a casino”. It was the case of
the stock market in the United States eighty years ago. PS: it is somewhat speculative in the Chinese
stock market at times, part of it due to “lack of alternative avenues of investments”. In the past, and
it still is to a certain degree, it was/is either the real estate or the stock market. Where else can an
investor put his/her money to work?
e. Stock markets can also have a significant group of “inexperienced” investors. Their behavior can
distort and/or magnify market momentums, e.g. longer/higher bull markets, lower/extended bear
markets …
f. … even “professionals” can exhibit such psychological traits. In fact, Behavioral is a new area
in Investment Science. Alan Greenspan, a famous former Chairman of the U.S. Federal Reserve
(1987~2006, central bank), coined the phrase “Irrational Exuberance” (= extreme overvaluation?)
during a speech at the American Enterprise Institute (12/5/1996) – he was referring to the fact that
the S&P500 was up 23% during that year. PS: this term was later amplified by Nobel Prize winner
Robert Shiller (2000, professor of Economics, Yale University) in describing an asset bubble.
g. The market certainly will have “mood swings the other way”, the companion Irrational Despair,
leading to extended market depression.
h. Finally, there is no escaping the fact that the financial market is really really uncertain and
complicated. So, stock prices do react quickly (volatility) to any new bit of good/bad news. PS: we
have very good models to predict hurricanes but we still have yet to do the same for financial markets;
it is this complex.
5) A final word from our beloved Warren Buffett, “Price P0 is what you pay, Value V0 is what you get”. Your
job is to identify the differences and trade/invest accordingly.
P0 ???0
This is the justification for paying you at least US$150,000 if you are a good investment analyst.
End of Part [1]
~ Chee, 11/24/2020
Week 4 Weekly Discussion WD4
Stock Valuation Using CGM and DDM
AD731: Corporate -12 of 15- Chee / BU MET
Appendix: [2A] Using Moody’s to find bond info
a. Go to https://www.moodys.com.
b. Use the following search bar, to enter your stock’s ticker symbol. If this is the first time you are using this
website, Register using an email address of your choice:
c. Proceed to enter the search using your stock’s tick symbol, for example “PG” for Proctor and Gamble:
d. You should see a lot of credit-related information, for example:
PS: items with a “lock” icon next to it means access to info on that is a paid service – so, I lied, not all Moody’s
data is free; the free ones are public domain data and info they willingly give you.
Week 4 Weekly Discussion WD4
Stock Valuation Using CGM and DDM
AD731: Corporate -13 of 15- Chee / BU MET
The section we are interested in is the “Long Term Rating” section. PS: don’t worry an “old”
date — for example, PG has been rated an Aa3 since 19 April 2018 and had remained so till
today.
e. PS: if you click on the “Ratings” tab, you will also see a history of PG’s credit ratings:
? On 19 Oct 2001, PG was downgraded from Aa2 to Aa3 …
? … and since that date, there had been a number of “rating affirmation”, i.e. periodic review of credit
rating, to confirm that its credit rating had stayed at Aa3 since.
? In addition, PG is currently “not on watch” for potential near-future downgrade.
Week 4 Weekly Discussion WD4
Stock Valuation Using CGM and DDM
AD731: Corporate -14 of 15- Chee / BU MET
? The following is also useful in find more about this company’s bond:
? Underneath the company name, the bond issue will have an LEI number. For example, in the above,
we have “LEI 25721BTTBCCZW6AU4141”.
i. An LEI number is a “Legal Entity Identifier”. It is a unique number assigned on a global basis by
participating government, institutions, agencies, and companies on all sorts of financial
transactions and documents.
ii. Think of it as a unique Internet address or the more familiar North American CUSIP number.
iii. In any case, take the LEI number of the company’s bond issue, go to an Internet search engine
[Google Chrome, Firefox, etc.], and paste this LEI number in the search box …
iv. … you should be able to see a number of search results from various websites and financial
portals. In particular, a common one would be Cbonds cbonds.com:
v. Thus, feel free to “chase” whichever search results you get from its LEI.
f. Now, how do you translate PG’s Aa3 credit rating to its current market yield?
g. You need to look up the current market’s benchmark yields, for example, the Aaa and the Baa, which are
tracked by the Federal Reserve on a daily basis.
h. Go to the following URLs https://fred.stlouisfed.org/series/AAA and https://fred.stlouisfed.org/series/BAA
and read off the current yield for these two corporate credit ratings. For example, 2.43% for a AAA credit
rating:
Week 4 Weekly Discussion WD4
Stock Valuation Using CGM and DDM
AD731: Corporate -15 of 15- Chee / BU MET
and 4.13% for a BAA credit rating:
i. Using these two known credit ratings and their respective yields and also keeping in mind that there are “finer
shades” of credit rating within some grades, linearly interpolate PG’s Aa3 credit rating. For example:
Ratings Yields Moody’s Seasoned Corporate Bond Yield
0 Aaa 2.35% https://fred.stlouisfed.org/series/AAA
1 Aa1 2.49% linearly interpolated
2 Aa2 2.62% linearly interpolated
3 Aa3 2.76% linearly interpolated
4 A1 2.90% linearly interpolated
5 A2 3.03% linearly interpolated
6 A3 3.17% linearly interpolated
7 Baa1 3.30% linearly interpolated
8 Baa2 3.44% https://fred.stlouisfed.org/series/BAA
Baa3
Ba1
Ba2
Ba3
j. Some explanation on how we interpolate the above yields:
? There are 8 grades of credit ratings from Aaa [= 2.35%] to Baa [= 3.44%].
? PG’s Aa3 credit rating is 3 grades lower than Aaa.
? Therefore Aa3 is linearly interpolated as Aaa + 3 × (Baa2 – Aaa) ÷ 8
= 2.35% + 3 × (3.44% – 2.35%) ÷ 8
= 2.76%