INTEGRATED CASE Ping An Insurance (Group) Company of China Ltd. Stock Valuation a.

Describe briefly the legal rights and privileges of common stockholders. Common stockholders are owners of the corporation. And as owners, they are entitled to some legal rights and privileges. These are: Right to Share in profit it is the right to receive dividends equally on a per-share basis. Right to sell common stockholders have the privilege to sell their shares of the to others Claim on assets in the event of liquidation, these stockholders may receive the residual amount assets after all obligation are fulfilled, especially those pertaining to creditors and preferred stockholders. Preemptive right this is the right to purchase newly issued ordinary shares on a pro rata basis. Voting right this is the right to cast a vote during meetings, most especially the annual general meeting. In case stockholders are unable to attend, they can issue a document, known as proxy, which gives a person the authority to vote in behalf of a certain stockholder. b. The following questions are: 1. Write out a formula that can be used to value any stock, regardless of its dividend pattern.

2. What is a constant growth stock? How are constant growth stocks valued? Constant growth stock is a stock whose dividends are expected to grow at a constant rate. This means that the best estimate of future growth rates is some constant number although it is not really expected that growth is the same every year. And since many companies expect their dividends to grow at a constant rate, these stocks are valued at constant growth using the

Constant Growth Model, otherwise known as the Gordon Model. To find the value of the constant growth stocks using the Gordon Model, it is essential to use this equation:

With this regular dividend pattern, the general stock valuation model can be simplified to the following very important equation:

The equation above is the Gordon Model for valuing stocks with constant growth rate. Shown here are the following: D 0, which is the dividends received during the present year; D1 is the expected dividends to be received 1 year from now; rs is the required rate of return that is computed using the SML equation discussed in Chapter 7; and g is the growth rate.

3. What are the implications if a company forecasts a constant g that exceeds its r s? Will many stocks have expected g > rs in the short run (that is, for the next few years)? In the long run (that is, forever)? Since the Gordon model equation is a mathematical formula, it has certain requisite and that is g should not exceed rs. And if the former exceeds the latter, the calculation using the model would result to a negative answer which is, in fact, nonsensical since stock prices cannot have negative values. Stocks may have periods of supernormal growth, where g > rs, in the short run. Thus, stocks can have this extreme growth in the foreseeable future but it cannot be sustained indefinitely. Accordingly, g is less than rs in the long run.

c. Assume that Bau Bau Agency has a beta coefficient of 1.2, that the risk-free rate (the yield on Tbonds) is 7%, and that the required rate of return on the market is 12%. What is Bau Bau Agencys required rate of return? In calculating Bau Bau Agencys required rate of return, we must use the SML equation:

Substituting the given data above, the required rate of return of Bau Bau Agency would be:

d. Assume that Bau Bau Agency is a constant growth company whose last dividend (D0, which was paid yesterday) was $2.00 and whose dividend is expected to grow indefinitely at a 6% rate. 1. What is the firms expected dividend stream over the next 3 years? Since it is assumed that Bau Bau Agency has a constant growth stock, we can calculate the expected dividends for the next three years by using this formula:

Using the formula the above, this is the firms expected dividend stream over the next 3 years as expressed in this timeline:

6%

6%

2 6% $ 2.247

$ 2.000

$ 2.120

$ 2.382

2. What is its current stock price? Using the Gordon model, the current stock price is: 6 6

3. What is the stocks expected value 1 year from now? If we assume that the expected dividends one year from now, which $2.12, will be paid next year, the stocks expected value would be: 6 6

4. What are the expected dividend yield, capital gains yield, and total return during the first year?

9 9 9 7 6

e. Now assume that the stock is currently selling at $30.29. What is its expected rate of return? By rearranging the Gordon Model to another form, we can derive this equation: The equation above will be used in finding the expected rate of return assuming that Bau Bau Agencys stock is currently selling at $ 30.29. Therefore: 6

f.

What would the stock price be if its dividends were expected to have zero growth? If the dividends were not expected to grow at all, then the dividend stream would be perpetuity. And because of that, we use the zero growth model represented by this equation Therefore, the value of a zero growth stock would be:

g.

Now assume that Bau Bau Agency is expected to experience nonconstant growth of 30% for the next 3 years, then to return to its long-run constant growth rate of 6%. What is the stocks value under these conditions? What are its expected dividend and capital gains yields in Year 1? Year 4? Using the assumptions above, we can say that Bau Bau Agencys stock is a supernormal growth stock since the growth rate is 30% for the 3 succeeding years followed by a 6% percent constant growth rate. Thus, we use the Supernormal Growth Model. The formula for this model is: Although this equation will provide the stocks value under the supernormal condition, we have decided to present our solution, for the purpose of better understanding, in a timeline we set up below:

30%

30%

30%

6%

$ 2.000 2.301 2.647 3.045 46.108 54.101

$ 2.600

$ 3.380

$ 4.394

$ 4.657

4 94
3

4 657 6 66 5 9

The timeline above is just a deconstruction of the Supernormal growth model equation. Here we could see that the value of a supernormal growth stock is just the sum of the present value of the dividends in a supernormal growth period and all expected dividends of the constant growth that follows (horizon value). With the dividend flows for D1, D2, D3, and the horizon value shown on the time line, we discount each value back to Year 0, and the sum of these four PVs is the value of the stock today. Therefore, the stocks value, under the conditions stated above, is $ 54.10.

And because we have the current stock value, we can now solve for the dividend yield and the capital gains yield for Year 1. Therefore:

6 54 48
As for Year 4, the dividend yield is 7% while the capital gains yield is 6% because after Year 3, the dividends are expected to grow at a constant rate. h. Suppose Bau Bau Agency is expected to experience zero growth during the first 3 years and then to resume its steady-state growth of 6% in the fourth year. What would its value be then? What would its expected dividend and capital gains yields be in Year 1? In Year 4? We use the timeline again to better illustrate and present the process in finding the stocks value under a condition where in dividends are not expected to grow for 3 years followed by a constant growth of 6%.
0 0% 1 0% 2 0% 3 6% 4

$ 2.000 1.77 1.57 1.39 20.99 25.72

$ 2.000

$ 2.000

$ 2.000
3

$ 2.120

6 9

The process in solving for the stocks value under the assumptions above is the same as the one we used on the previous assumption (g). Therefore the stocks value is $ 25.72.

Then, the dividend yield and capital gains yield for Year 1 would be:

57 78
Again, in Year 4 Bau Bau Agencys stock becomes a constant growth stock; hence g = capital gains yield = 6.0% and dividend yield = 7.0%.

i.

Finally, assume that Bau Bau Agencys earnings and dividends are expected to decline at a constant rate of 6% per year, that is, g = 6%. Why would anyone be willing to buy such a stock, and at what price should it sell? What would be its dividend and capital gains yields in each year?

Since we assume that Bau Bau Agencys earnings and dividends are expected to decline at a constant rate of 6%, g would be negative; hence, it g is - 6%. The common belief on a declining growth stock is that buyers are not willing to buy such stock. However, this is not always true. Below is the dividend stream over the next 3 years when g = - 6%:

-6%

-6%

2 -6% $ 1.767

$ 2.000

$ 1.880

$ 1.661

The timeline above clearly shows that the stock is still earning dividends even though the growth is declining. Thus, the stock value is still greater than zero. And if we look at this on a long run basis, the stock value may exceed its stock price in the market. Hence, it is still a good investment since it can provide some good return in the future.

We have stated above that the stock still earns dividends and its value is still greater than zero. So if we solve using the Gordon Model (since declining growth rate is constant), the stock value would be:

88 6

88 9

So, the stock should sell at $ 9.89. This value is needed to find the dividend yield. Therefore:

88 9 89
And as for the capital gains yield, its value is equal to g since dividends are expected to decline at a constant rate; hence:

The dividend yield and the capital gains yield for Year 1 would be the dividend yield and the capital gains yield for the succeeding years since, as stated above, the dividends are expected to decline at a constant rate. Note that the dividend yield is very high. This is to offset the expected capital losses due to its capital gains yield being negative.

j.

Suppose Bau Bau Agency embarked on an aggressive expansion that requires additional capital. Management decided to finance the expansion by borrowing $40 million and by halting dividend payments to increase retained earnings. Its WACC is now 10%, and the projected free cash flows for the next 3 years are -$5 million, $10 million, and $20 million. After Year 3, free cash flow is projected to grow at a constant 6%. What is Bon Temps total value? If it has 10 million shares of stock and $40 million of total debt, what is the price per share?

Since Bau Bau Agency embarked on an aggressive expansion, we need to determine the ability of the company to generate cash flows for the purpose of knowing if the company has sufficient funds to support capital expenditures and operating activities (since it is risky to expand at this intensity) while maintaining a positive free cash flow for its investors. Thus, we need to use the corporate valuation model in solving for the companys total value.

So in computing the total value of Bau Bau Agency, we will present our solution in this timeline:
0 WACC = 10% 1 2 3 4

g= 6%

$ -5 million - 4.545 8.264 15.026 398.197 416.942

$ 10 million

$ 20 million
3

$ 21.2 million

5 3 6 3 5

The firms total value is the sum of the present value of all free cash flows. So in solving for the present value of each FCF we need to discount them back to Year 0. We add all the present value of the cash flows. Hence, the companys total value is $ 416.94 million. This value, however, is not the total value of the companys common stocks. It is still inclusive of debts and preferred stocks. And since Bau Bau has $ 40 million of debt and preferred stocks combined, we need to subtract this from the companys total value. Therefore:

4 6 94

Accordingly, the price per share would be: 76 94

i.

Suppose Bau Bau Agency decided to issue preferred stock that would pay an annual dividend of $5.00, and the issue price was $50.00 per share. What would the expected return be on this stock? Would the expected rate of return be the same if the preferred was a perpetual issue or if it had a 20-year maturity?

If Bau Bau Agency decided to issue preferred stock, stockholders would receive regular and fixed dividend payments, which, in this case is $5.00. And since it is assumed that the issue is perpetuity, we will use this equation:

However, this is not the case, the stock price and the dividend is given above. The unknown value is the required rate of return. So by reconstructing the equation above we will derive another form of the equation where r P is equal to dividends divided by the stock price. Hence we get:

5 5
If the preferred stock has a 20-year maturity its value would be calculated using the formula in finding the PV of an ordinary annuity. Thus: 5( )

The $ 42.57 is the present value of the preferred stock if its maturity is 20 years. This means the remaining $ 7.43 (50 42.57) is the present value of the horizon value if it is held forever. Thus, the expected rate of return of the perpetual issued stock is the same as that of a preferred stock with a maturity of 20 years since it is both are preferred and it receives fixed amount of payment.

INTEGRATED CASE On STOCK VALUATION

Submitted by: Allado, Nile Alric Barbas, Raiza Grace Gan, Lynzel BABA2A

Submitted to: Dr. Felix D. Cena Professor

November 29, 2013