wk 4 - Estimating Growth and Terminal Value_2011s2

Ii look at the current earnings growth rate and the

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ii) Look at the current earnings growth rate and the excess return on capital (equity) above the cost of capital (equity). The time taken to reach stable growth is likely to be longer if the current growth rate is high and the excess return is large. We tend to observe strong earnings growth in succession. Look at ORG track record of earnings growth over the past decade under Grant King’s leadership. The driver of earnings growth is a firm’s ability to earn a larger return on capital (equity) than the cost of capital (equity). The longer a firm can sustain the excess return, the longer it will take the firm to reach stable growth. Look at COH impressive ROC & ROE over the past decade. iii) Look at the magnitude and sustainability of competitive advantages. The longer a firm can hold off competition due to regulatory and other entry barriers such as economies of scale, the longer it will take to reach stable growth. Compare Telstra now to when it went public in 1997.
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FINS3641 SAV Week 4: Estimating Growth and Terminal Value 19 2. Identify the characteristics of stable growth firms in order to estimate the inputs required by the terminal value i) Stable growth firms tend to have average risk 2/3 of US firms have betas between 0.8 and 1.2. Prudent to expect the betas of stable growth firms to fall in this range Those in riskier businesses are given a larger beta than those in less risky businesses Beta will affect the cost of equity and ultimately the cost of capital applied to the stable growth firms ii) Stable growth firms tend to have higher leverage Size and earnings stability allow stable growth firms a larger capacity to borrow and use more debts Leverage is ultimately the decision of the management team Prudent to use the industry average debt ratio and cost of debt While the debt ratio will affect the FCFE via interest expense, the cost of equity via bottom-up beta and ultimately the cost of capital, the cost of debt will affect the cost of capital applied to the stable growth firms
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FINS3641 SAV Week 4: Estimating Growth and Terminal Value 20 iii) Stable growth firms tend to have lower reinvestment rate Stable growth does not imply that there is no reinvestment needs For DDM valuation model which assumes that the reinvestment is sourced solely from retained earnings, we know Growth rate in EPS = retention ratio × ROE ׵ retention ratio = stable growth rate ÷ ROE Assume that ABN Amro will be in stable growth in 5 years at which point its return on equity will be closer to the average for European banks of 15%, and that it will grow at a nominal rate of 5%. Stable growth retention ratio = 0.05/0.15 = 33.33% Stable Growth Payout Ratio = 1 - 0.05/0.15 = 66.67% For FCFE valuation model which focus on net income growth Growth rate in net income = equity reinvestment rate × ROE ׵ equity reinvestment rate = stable growth rate ÷ ROE For FCFF valuation model which focus on operating income growth Growth rate in operating income = capital reinvestment rate × ROC ׵ capital reinvestment rate = stable growth rate ÷ ROC
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