Question #86
Reading: Reading 20 Discounted Dividend Valuation
PDF File: Reading 20 Discounted Dividend Valuation.pdf
Page: 33
Status: Unattempted
Correct Answer: A
Question
If an asset was fairly priced from an investor's point of view, the holding period return (HPR) would be:
Answer Choices:
A. lower than the required return
B. the same as the required return
C. equal to the alpha returns. Flyaweight Foods is a vertically integrated producer and distributor of low-calorie food products operating on a consumer club model. They have enjoyed rapid growth in the southwest United States during their 5-year history and are planning rapid expansion throughout the rest of the country. To fund their expansion, they are soliciting investments from a variety of venture capital groups. One of the groups considering a bid for Flyaweight is Angelcap Investors, a private equity fund run by Harry Moskowitz. Angelcap is interested in acquiring a 10% interest in Flyaweight. Moskowitz' partner, Bill Sharpless, runs the group doing due diligence on Flyaweight. He provides Moskowitz with financial data on the firm: Table 1: Flyaweight Foods Historical Data (Dollars per share) FY1 FY2 FY3 FY4 FY5 Sales per share 4.25 5.60 6.40 7.35 8.05 EPS 1.20 1.85 2.30 2.79 3.10 Dividends 0 0 0.10 0.20 0.35 Free Cash Flow –2.50 –2.10 –1.85 –1.60 –1.25 They ask Merle Muller, an analyst at the firm, to calculate an appropriate required return on Flyaweight. Muller collects the following market consensus information: Table 2: Current Market Conditions (Consensus estimates) Expected 5-year EPS growth 8.0% Expected 1-year Dividend yield 2.2% Current Treasury yield (10-year note) 4.8% Food industry beta (specialty segment) 0.95
Explanation
A fairly priced asset would be one that has an expected HPR just equal to the investor's
required return.
(Module 20.1, LOS 20.a)
Flyaweight Foods is a vertically integrated producer and distributor of low-calorie food
products operating on a consumer club model. They have enjoyed rapid growth in the
southwest United States during their 5-year history and are planning rapid expansion
throughout the rest of the country. To fund their expansion, they are soliciting investments
from a variety of venture capital groups.
One of the groups considering a bid for Flyaweight is Angelcap Investors, a private equity
fund run by Harry Moskowitz. Angelcap is interested in acquiring a 10% interest in
Flyaweight. Moskowitz' partner, Bill Sharpless, runs the group doing due diligence on
Flyaweight. He provides Moskowitz with financial data on the firm:
Table 1: Flyaweight Foods Historical Data (Dollars per share)
FY1
FY2
FY3
FY4
FY5
Sales per share
4.25
5.60
6.40
7.35
8.05
EPS
1.20
1.85
2.30
2.79
3.10
Dividends
0
0
0.10
0.20
0.35
Free Cash Flow
–2.50
–2.10
–1.85
–1.60
–1.25
They ask Merle Muller, an analyst at the firm, to calculate an appropriate required return on
Flyaweight. Muller collects the following market consensus information:
Table 2: Current Market Conditions (Consensus estimates)
Expected 5-year EPS growth
8.0%
Expected 1-year Dividend yield
2.2%
Current Treasury yield (10-year note)
4.8%
Food industry beta (specialty segment)
0.95
Sharpless argues in favor of using the Gordon Growth Model (GGM). "We know what the
company growth rate is, we know what the dividend is, and we can decide what our required
rate of return is. The GGM will give us the most accurate valuation because it uses the inputs
we can measure most accurately." Moskowitz points out, "An H-model would be more
appropriate because it assumes a linear slowdown in growth to a constant rate in
perpetuity."
While Sharpless and Moskowitz debate the appropriate valuation approach, Muller prepares
forecasts for Flyaweight.
Table 3: Forecast Values for Flyaweight
Forecast
Average total liabilities per share
$14.40
Average owners' equity per share
$12.70
Profit margin
29%
Sales per share
$10.70
Dividend payout ratio
10%