Useful Notes for the Report # 2 Assignment
Due: Friday, March 26, 2021
These notes summarizes what was said in our last class session:
- The dividend growth model:
You will need to estimate both the cost of equity (rs) and the g.
For the rs estimate using the SML formula: use 11 or 12% for Rm and 4% for Rf.
Your next big job is to estimate g, which is usually estimated using growth in EPS.
For that, you either estimate it by extrapolating from your firm’s historical growth in earnings record, using sustainable growth formula, or find this estimate from any of the many Investment Advisory Services.
- The cash flow model:
For an estimate of Free Cash Flow, you can “earnings after tax plus depreciation”.
In this model you will need your weighted average cost of capital (WACC).
If your firm has no debt, then this will be the same as the cost of equity capital estimated above.
If your firm has debt, then estimate the weighted average yield to maturity of your outstanding debt, multiply it by (1-tax rate) and obtain your overall cost of capital by calculating your weighted average cost of capital using the proportion of each component in the total capital used.
Alternatively, you should be able to find your company’s “cost of capital” from several of the investment advisory services as well.
- The P/E model:
As described in detail in class and shown in the handout provided in class, you will need two very important estimates to apply this model:
- A very good estimate for the industry average in which your firm belongs. If you decided to use major competitors for a comparison, you must have a minimum of three other competitors to obtain a reasonable average P/E.
- An estimate of your firm’s earning per share for next year. This can be obtained through:
- Extrapolating EPS for the most reasonable and representative historical time period.
- Multiplying your estimated growth rate g estimated earlier to current EPS.
- Using what the firm is actually estimating for next year EPS (the company’s own guidance).
- Using the average EPS estimates for “next year” provided by the many available Investment advisory services.