FIN 330 Module 3 Valuation Assignment Example

Valuing the Company's Notes and Common Stock

[Student Name]

Southern New Hampshire University

FIN 330: Corporate Finance

Module Three Assignment

[Instructor Name]

[Date]

The organization, setting and figures below are a composite written as a model document. No real employer, client, colleague or patient is described.

Valuing the Company's Notes and Common Stock

Introduction

The company's securities are the starting point for estimating its cost of capital in Project One, so their values must be understood first. This paper values the 5.25 percent senior notes the company issued in 2022 and its common stock. For the notes, it calculates the price at today's market yield and shows how the price would move if rates changed. For the stock, it sets the return shareholders require using the CAPM, applies two dividend discount models and a peer multiple, and interprets the gap between those estimates and the market price.

The Notes

The company has $210 million of notes with a 5.25 percent coupon, paid semiannually, maturing in October 2032, six years from now. Comparable BBB-rated industrial notes currently yield about 6.1 percent. The price is the present value of twelve semiannual coupons of $26.25 per $1,000 of face value plus the $1,000 repaid at maturity, all discounted at 3.05 percent per period. Discounted, the twelve coupons are worth about $260.51 and the final principal about $697.31, for a price of $957.82. Because investors can earn 6.1 percent on similar bonds, they will pay less than face value for a bond paying 5.25 percent; the discount makes up the difference. The current yield, the annual coupon of $52.50 divided by the price, is 5.48 percent, and the remaining return comes from the price rising toward $1,000 as maturity approaches.

Rate Sensitivity

Bond prices move opposite to yields. If yields on similar notes rose to 7 percent, the price would fall to $915.45, a drop of 4.4 percent. If they fell to 5 percent, the price would rise to $1,012.82, slightly above par. The notes' six-year maturity makes them moderately sensitive; a longer bond would move more. This matters for the company because its cost of new debt follows market yields, not the coupon it set four years ago.

Note price at different yields (per $1,000)

Required Return on Equity

The capital asset pricing model sets a stock's required return as a riskless yield plus the stock's beta multiplied by the extra return investors demand for owning the market. Taking 4.3 percent from the 10-year Treasury, a beta of 1.18 measured over five years against the S&P 500 and an equity premium of 5.5 percent, the required return comes to 10.79 percent, of which 6.49 points compensate for risk. Fama and French (2004) caution that the CAPM's empirical record is mixed, so this figure is an estimate with a margin of error, not a precise number.

Constant-Growth Model

The company paid $1.20 a share in dividends over the past year and has raised its dividend about 5 percent a year for a decade. Gordon (1959) showed that if dividends grow at a constant rate below the required return, a share is worth the coming dividend over the spread between required return and growth. Next year's dividend is $1.26, so the value is $1.26 ÷ (0.1079 minus 0.05) = $21.76. Using the sustainable growth rate instead, return on equity of 14.4 percent times the 41 percent of earnings retained, or 5.9 percent, raises the estimate to about $26.

Two-Stage Model

If the propane transition lifts growth to 9 percent for five years before it settles at 4 percent, the dividend reaches about $1.85 in year five. Discounting the five dividends plus a year-five estimate of all later dividends, $1.85 × 1.04 ÷ (0.1079 minus 0.04), gives a value of about $22.66. Even with faster near-term growth, the dividend models fall well short of $40.

Peer Multiple

Three peers trade at a median price to earnings ratio of 18.5. Applied to the company's earnings of $2.04 a share, that gives $37.74, close to the market price. The multiple reflects what investors pay for similar companies, while the dividend models reflect only the cash paid out under stated assumptions. Multiples have their own weakness: they assume the peers are fairly priced and comparable. One peer sells mostly to large restaurant chains and has steadier sales, which may justify a higher multiple than this company deserves, so $37.74 is best treated as an upper reference point rather than a precise value.

Stock value estimates

Duration

Duration summarizes how sensitive a bond's price is to yield changes. The notes' Macaulay duration is about 5.2 years, and their modified duration, which divides that by one plus the periodic yield, is about 5.0. That predicts a price change of roughly 5 percent for each one-point change in yield, close to the actual 4.4 percent fall and 5.7 percent rise in the table; the difference reflects convexity, the curve in the price-yield relationship. For the company's treasurer, duration offers a quick way to judge how much the notes' market value, and the cost of refinancing them, would move if rates shifted.

Interpreting the Gap

Solving the constant-growth model for the rate that justifies $40 gives about 7.6 percent a year, forever. Damodaran (2012) notes that dividend models tend to undervalue companies whose value depends on reinvestment and growth opportunities rather than current payouts. Three explanations fit. Investors may expect the shift to propane refrigerant to give the company several years of strong replacement demand and higher returns on new investment. The required return may be lower than 10.79 percent if beta overstates the company's risk. Or the stock may simply be priced optimistically. The first explanation connects directly to the propane line: the market appears to be pricing in profitable growth that the company has not yet committed to.

Conclusion

The notes are worth $957.82 per $1,000 at today's 6.1 percent yield, and new borrowing would cost about that yield, not the 5.25 percent coupon. The stock's $40 price is well above what dividends alone support and close to what peers' multiples imply, which suggests investors expect growth from new investment. If management does not deliver it, the price is at risk.

References

Damodaran, A. (2012). Investment valuation: Tools and techniques for determining the value of any asset (3rd ed.). Wiley.

Fama, E. F., & French, K. R. (2004). The capital asset pricing model: Theory and evidence. Journal of Economic Perspectives, 18(3), 25-46. https://doi.org/10.1257/0895330042162430

Gordon, M. J. (1959). Dividends, earnings, and stock prices. The Review of Economics and Statistics, 41(2), 99-105. https://doi.org/10.2307/1927792