Estimating Inputs for the DCF Approach (2)
by MaestroEquation 6-6 produces a constant growth rate, but when we use it we are, by implication, making four important assumptions: (1)We expect the payout rate, and thus the retention rate, to remain constant; (2) we expect the return on equity on new investment to remain constant; (3) the firm is not expected to issue new common stock, or, if it does, we expect this new stock to be sold at a price equal to its book value; and (4) future projects are expected to have the same degree of risk as the firm’s existing assets. NCC has had an average return on equity of about 14.5 percent over the past 15 years. The ROE has been relatively steady, but even so it has ranged from a low of 11.0 percent to a high of 17.6 percent. Analysts’ Forecasts A third technique calls for using security analysts’ forecasts. Analysts publish growth rate estimates for most of the larger publicly owned companies. For example, Value Line provides such forecasts on 1,700 companies, and all of the larger brokerage houses provide similar forecasts. Further, several companies compile analysts’ forecasts on a regular basis and provide summary information such as the median and range of forecasts on widely followed companies. These growth rate summaries, such as the ones compiled by Zack’s or by Thomson Financial Network, can be found on the Internet.
However, these forecasts often involve nonconstant growth. For example, some analysts were forecasting that NCC would have a 10.4 percent annual growth rate in earnings and dividends over the next five years, but a growth rate beyond that of 6.5 percent. This nonconstant growth forecast can be used to develop a proxy constant growth rate. Computer simulations indicate that dividends beyond Year 50 contribute very little to the value of any stock—the present value of dividends beyond Year 50 is virtually zero, so for practical purposes, we can ignore anything beyond 50 years. If we consider only a 50-year horizon, we can develop a weighted average growth rate and use it as a constant growth rate for cost of capital purposes. In the NCC case, we assumed a growth rate of 10.4 percent for 5 years followed by a growth rate of 6.5 percent for 45 years. We weight the short-term growth by 5/50 10% and the long-term growth by 45/50 90%. This produces an average growth rate of 0.10(10.4%) 0.90(6.5%) 6.9%.
Rather than convert nonconstant growth estimates into an approximate average growth rate, it is possible to use the nonconstant growth estimates to directly estimate the required return on common stock. See the Web Extension to this chapter for an explanation of this approach; all calculations are in the file Ch 06 Tool Kit.xls.
Taken From : Credit Repair by Attorneys Robin Leonard and Deanne Loonin
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