Please answer the following questions (show calculations where necessary) and su
ID: 2791212 • Letter: P
Question
Please answer the following questions (show calculations where necessary) and submit for grading:
1. In what circumstances would you choose to use a dividend discount model rather than a free cash flow model to value a firm? Why?
2. Johnson & Johnson has a ROE of 19% and a plowback ratio of 50%. If the coming year's earnings are expected to be $2 per share, at what price will the stock sell? The market capitalization rate is 12%.
What price do you expect Johnson & Johnson shares to sell for in three years?
3. Choose two firms of interest from fiance.yahoo.com, finance.google.com, or money.msn.com and download their financial statements. For each firm:
a. Write the ROE, the number of shares outstanding, the dividends per share, and the net income.
b. Compute the sustainable growth rate (g = b * ROE), where b equals the plowback ratio.
c. Calculate the total amount of dividends paid (dividends * number of shares outstanding), the dividend payout ratio (total dividends paid/net income), and the plowback ratio (1 - dividend payout ratio).
d. What does this information reveal about the ROE for the firms you selected?
Be sure to include the link for the financial statements that you select.
Explanation / Answer
1. Since Divdend Discount models use the dividends paid by the firm to estimate stock prices, DDM is highly suitable for firms that pay regular dividends i.e. mature firms. On the other hand, the rapidly growing companies dont pay dividends and are not expected to pay dividends in the near future. These firms are best valued by free cash flow models.
2. G = ROE * Plowback Ratio = 19 x 0.5 = 9.5%
D1 = 2 x (1 – 0.5) = 1
P0 = D1/(Capitalization Rate - Growth Rate) = 1/(0.12 – 0.095) = 1/0.025 = $40
3. Firms: Walmart & CostCo
Links: https://finance.yahoo.com/quote/WMT/
https://finance.yahoo.com/quote/COST?p=COST
a. Walmart:
ROE = 17%
Shares Outstanding = 2.99B
Dividend/Share = 2.02/share
Net Income = 12.73B
CostCo:
ROE = 23.19%
Shares Outstanding = 436.99M
Dividend/Share = 1.90/share
Net Income = 2.68B
b. Plowback Ratio for Walmart = (12.73B - 2.02*2.99B)/12.73B = 52.56%
G(Walmart) = 17 x 0.5256 = 8.93%
Plowback Ratio for CostCo= (2.68B - 1.90*436.99M)/2.68B = 69.02%
G(CostCo) = 23.19 x 0.6902= 16%
c. Walmart:
Dividends Paid = 2.02*2.99B = 6.0398B
Dividend Payout Ratio = 6.0398B/12.73B = 47.45%
Plowback Ratio = 1 - 0.4745 = 52.55%
CostCo:
Dividends Paid = 1.90*436.99M = 830.281M
Dividend Payout Ratio = 830.281M/2680M = 30.98%
Plowback Ratio = 1 - 0.3098 = 69.02%