The Estimated Rate of Return on Equity
The volume of dividends being paid out by a number of Australian listed companies has substantially grown in the last decade, more so after the advent of the 2008 financial crisis. The most notable entities that have been able to achieve the desired margin of growth include capital resource companies and banks. Such increases have been realized together with a modest increase in the level of earnings per share. However, dividend-paying companies have been able to pay these payouts in a relatively smooth approach due to their reluctance to pay particularly reduced payment rates. The increase that has been realized in the last couple of years could be attributed to an increase in shareholders preferred rate of return on investment and the perception of institutional managers that there is a scarcity of viable stocks to invest in. the following discussion and analysis will provide some modest support to both of the above hypothesis.
Introduction
Before delving into the issue of dividend analysis, it is important for an investor to begin by understanding the real definition of a dividend, especially in the financial circles. Essentially, dividends can be defined as financial cash benefits that a company advances to its shareholders after a predetermined period of time usually 1 year. Dividends represent an alternative for realizing a return on capital on the side of the shareholders instead of it being used in for other activities such as retention to improve the working capital, funding future investments, strengthening the company’s liquidity position and maintaining an adequate balance sheet. For instance, in the last year, the average declared divided for listed companies in Australia is $ 100 billion. This is equivalent to 85% of the underlying earnings for these companies in the realized in a steady growth rate since July 2008. This represents at least 5% of the total market capitalization by the end of the year ending 1st June 2018.
Telstra Corporation – telecommunications utility (Australia)
The rationale for using the model
- The Company has had a stable growth considering its area of operation. It is also regulated in such a manner that allows its profits to grow exponentially at incredible rates.
- The company has a beta of 0.75, a level that has been stable for the last decade
- The company has also had a stable leverage
- Telstra also pays out a dividend that is approximately equal to the FCFE
Background information
The growth model that will be used for this analysis will be the Gordon Model where the rate of return will be assessed for each of the three selected stocks (Shaoping, 2008, p 978). The main question to consider here is; Does the share price of the selected companies reflect the real worth of the respective stocks? The following analysis takes into consideration the future cash flows or respective companies to calculate the intrinsic value of their stocks by discounting their value today. This will be done using the Gordon model of calculating the intrinsic value of a stock (Damoran, 2013, p 344). The analysis using the Gordon model will follow a two-stage approach where the first stage will be focused on estimating company cash flows for each company. The second stage will involve estimation of the companies’ share price growth in a for a stable growth rate.
Financial estimates
Average annual FCFE = $480,000,000
Average annual divided $461,000,000
Total dividend payout by FCFE = 96%
Earnings per share base year = 2.95
Dividend payout ratio 69%
Dividend per share base year = 2.04
Expected growth rate = 5%
Con Ed beta = 75%
Solution:
Cost of Equity = 0.06 + 0.75 × 5.5% = 10.13%
Value of equity = 2.04 × 1.05 = $41.80
(0.1013 – 0.05)
The expected growth therefore is estimated as:
The stock was trading at 2.73 at the end of the last financial .Solving for the expected growth rate
$2.73 = 2.04 (1+g)
(0.1013-g)
g= (0.1013 × 2.73-2.04)/ (2.72+2.04) = 4.77%
This means that the growth rate for earnings from dividends has to be 4.77% per annum so as to justify the share price of 2.73.
Common wealth Bank of Australia – Finance
The rationale for using the Gordon model
- Being a company that is operating in the Banking industry, is faced with a moderately competitive environment. The company is bound to experience relatively greater than normal growth. The model allows financial analysts to apply a growth rate that allows expansion.
- The model uses dividends as estimating free cash flows in such a market can be a difficult task.
- The financial leverage for most firms in the Australian economy is highly unlikely to experience changes in the long-term.
Financial estimates information
Earnings per share as at June 2018 = 2.70
Dividend payout ratio as at June 2018 = 0.81
Dividend per share $2.31
Expected Growth Rate in Earnings and Dividends = 6.50%
Stock Beta = 1.12
Solution
Cost of equity = 6% + 1.12 × 5.5% = 12.16%
Value of equity 71.73 × 1.81/ (0.1216-0.81) = $188.07
The beta is considerably high for a firm with a stable growth. This represents a case of additional risk usually encountered by firms in the financial service provision industry out of self-exposure mainly during expansion initiatives.
BHP Billiton – Materials
Earnings per share as at June 2018 = $1.39
Dividend payout ratio as at June 2018 = 63%
Dividend per share = 1.5618
Expected Growth Rate in Earnings and Dividends = 6.3%
Stock Beta 1.18
Solution
Cost of Equity = 6% +1.18 × 5.5% = 12.49 %
Value of Equity = 34 × 1.063/ (0.1249-0.063) = 583.7
Notes:
The current scenario reflects that lack of capacity of the firm to buy back its stocks. This measure is well above the market average. In addition, the risk premium may be on a downward trend which is reflective of a higher level of cash flows in alternative investments such as pension funds, the willingness of the market participants to go with the flow among other paradigm shifts (Botosan & Plumlee, 2005, p 22).
- E) Issues Related to Gordon’s Growth Mode
The Gordon model of growth estimation is one of the most popular and widely applied growth estimation models for valuing equity. Nonetheless, like any other approach, it has several issues related to calculations and assumptions.
Precision
Essentially, the Gordo model is extremely sensitive to the changes in data inputs and variables that are used in its calculation (Nwude & Egunwu, 2013, p 171). For example, where there is a slight change in the constant growth rate or the rate of return on investment, a bigger change will be observed in the resulting terminal value and eventually the value of the stock. This, therefore, makes it imperative that all inputs and variables be assessed and applied in the right manner and for value for the analysis to be accurate. However, the dilemma is that it is impossible for investors and some finance department officers to estimate these variables accurately with a 100% degree of precision. This makes it impossible to get the correct value of a stock. The Gordon model is therefore susceptible to the effects of the principle of “Garbage in Garbage out” problem. A slight mistake in the declaration of the variables and value of inputs means that the resultant figure will be fundamentally off the mark.
Non-linear growth patterns
The Gordon model assumes that the company in question has a stable growth rate. The effect is that the dividends of the company appear to be linear. This should not be the case. In practice, previous research and survey activities have concluded that the growth rate for dividends is usually not linear. The main reason for this kind of conclusion is that the growth rate is affected by the company’s business cycle and the current level of the company in its business cycle. For instance, a company in the early stages of its inception may realize a lower growth rate in the early days. The level of growth rate in the infant stage is expected to change over time as the company gets a hold of the company and as the perceptions of customers and other stakeholders change due to changes in performance (Guay et al, 2011, p 130. In addition, where a firm has been performing better and them suffers a dip in performance, the dividend growth rate is bound to decrease or to increase in a decreasing manner. The level of growth rate is also affected by other financial securities policies such as a share split.
Simplicity
While the Gordon model may work well, being simple and easy to understand, it may also be a source of cost of equity estimation problems. There are some experts and scholars who believe that the approach is too simple for application in a complex world. The main takeaway here is that the stock market environment is a fiercely dynamic one and it beats logic how a single and heavily simplified formula can be able to explain the status of the market. In addition, for the approach to be successful there must be an assumption that a companies dividends will continue to grow at an increasing rate. This assumption does not always hold water and in a case where there is a considerable deviation in the estimation, it can have serious effects on the calculations. It is important to note that while some companies are capable of maintaining a fairly constant dividend price, others find it challenging to maintain a fixed level of dividend payouts (Eston and Sommers 2007 p. 983). It even leads to some companies ceasing to pay any dividends in entirety. In addition, the model can only work with stocks that a5re actually paying dividends. For instance, there are smaller companies with great growth potential but end up ploughing back their earnings each year. The model does not allow an investor to calculate the would be the rate of return on such stocks. The issue with simplicity is that a particular stock may appear undervalued on the face of it while it would have been correctly valued and provide investors with a good option for investment while earning the company extra capital.
Alternative methods of measuring the cost of Equity
- The Fama-French Model
The model identifies a number of issues that can not be explained by other approaches such as CAPM and the Gordon model. These include issues that are related to going beyond the considerations of systematic risks that have been found to affect the rate of return on equity. The model does this by incorporating additional variables to the normal formula used in CAPM. These are the size and the value of the company’s stock. The size represents the historical premiums that investors have been receiving in the past especially on investments in the so-called smaller companies (Hail and Leuz, 2006, 485). The assessment of the size is done in reference to the total market value of the firm’s securities. A positive SMB means that smaller stocks by market capitalization have been able to outperform higher securities by market capitalization over a given period of time. The “High minus Low” on the other hand reflects the value premium received by an investor on stocks that have been returned to be invested in high-value companies. Where this value is positive, it means that the high-value stocks have been able to out-perform “low book-to-market stocks”. By including these variables, the analysis is able to get more information as they have a higher explanatory power including be able to eliminate the “marginal impact of a wide range of cost of equity estimation problems.
- The dividend growth model
This model calculates the estimates by taking into consideration the relationship between future payment flow from an investment and the market value of the concerned security. It assumes that the current market price of an investment must be equal to the present future value of a share. The market value is equal to the prevailing share price. The estimation is done by dividing the future value for a dividend by the prevailing market cost of capital and then subtracting the growth rate from the result. This approach can also be rearranged to solve for the cost of capital (Elton, 2011 p. 260). Nonetheless, as simple as the model is it is associated with a number of challenges related to implementation. These include;
The model can be considered as a short-term model of cost estimation for an investor currently looking for an investment stock. It is therefore not suitable for a market that is prone to regular changes in growth rate. In addition, it is also difficult to estimate the expectations of stock market participants in the long-run. In essence, it does not consider the difference in the between data that is in the public domain and the changes in such data due to changes in market activities. Further, the model assumes a constant rate of growth which is unrealistic in an open and competitive market. It can be more helpful in a regulated market than a market that is regulated by the rules of demand and supply. Where a market is regulated by the laws of demand and supply, there is a high possibility of fundamental errors occurring during the estimation process. Finally, the number of companies in Australia that have substantially regulated stocks is very small.
Can these identified methods be better than Gordon’s model?
Capital is a scarce commodity that affects all sectors. All companies must compete for the available capital investments and be able to manage them effectively to ensure that the investor realizes a positive return. It is therefore important to remain vigilant in the valuation and assessment of viable options for investment. The method of assessment matters the most. There are several approaches to estimating the cost of capital but Gordon’s Model Is more superior. The dynamics in each of the selected sectors makes it improper to use other models. The Gordon’s model is favourable as it provides an in-depth statistical analysis and allows for a graphical representation of the results.
References
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Damodaran, A., 2013. Equity risk premiums (ERP): Determinants, estimation and implications—The 2012 edition. In Managing and Measuring Risk: Emerging Global Standards and Regulations After the Financial Crisis (pp. 343-455).
Easton, P.D. and Sommers, G.A., 2007. Effect of analysts’ optimism on estimates of the expected rate of return implied by earnings forecasts. Journal of Accounting Research, 45(5), pp.983-1015.
Elton, E. J. (2011). Expected return, realized a return, and asset pricing tests. In Investments And Portfolio Performance (pp. 257-278).
Guay, W., Kothari, S.P. and Shu, S., 2011. Properties of implied cost of capital using analysts’ forecasts. Australian Journal of Management, 36(2), pp.125-149.
Hail, L. and Leuz, C., 2006. International differences in the cost of equity capital: Do legal institutions and securities regulation matter?. Journal of accounting research, 44(3), pp.485-531.
Nwude, E.C. and Egungwu, C.I., 2013. Is CAPM A Good Predictor Of Stock Return In The Nigerian Commercial Services, Hotel And Tourism Stocks?. Developing Country Studies, 3(11), pp.171-181.
Shaoping, C.H., 2008. Positivist analysis on the effect of monetary policy on stock price behaviours. In Proceedings of 2008 conference on the regional economy and sustainable development. ISBN (pp. 978-0).