Stock analysis of General Electric Corporation.
The dividend discount model (DDM) is the simplest method of valuing equity. The expected dividends play a big role in determining the value of a stock. Some analyst prefers using other methods to calculate the price of stock while others use the DDM which is important in estimating the stock’s value. When investors purchase stocks they expect a) Cash flow from dividends of the current stock. b) Cash flow from dividends of the expected price eventually at the end of the period. The future dividends determine the expected price of dividends whereas the real value of a given stock is the PV of dividends infinitely.
To value a company based on the discounted totals of all its expected future dividends is a method known as Gordon growth developed by Myron Gordon of Toronto University whose work was originally published in 1938. The formula was P = D1/ r – g. Where P is the current stock price, g is the steady growth rate infinitely expected for dividends. The r is the constant equity cost of the company. Later John Burr developed the theoretical part of the derivation in 1938 under the title “Theory of investment value”. (Gordon, u1959).
They can also generate the stock value so that the sum of the dividend yield or income together with its growth i.e. gains in capital equals the required investors total returns. Consider the growth rate in dividends as an alternative to the earnings growth and also as regards the stock price and gains in capital. Consider the cost of the company’s equity capital as an alternative for the total returns required by the investor.1). Income + Capital gain =Total Return. 2). Dividend yield + Growth = Cost of Equity. D/P +g = r or D/ r – g = P or D/P = r – g. In short the Growth cannot be more than the cost of all equity. (Gordon, 1959).When the growth is likely to exceed the equity cost during the short run then the two stage DDM method is used.
The discounted free cash flow method includes the cash flow balance left over after settling all financial responsibilities including the debts and also covering or paying the capital expenditures and the working capital obligations. It also analyses the reasons and causes of differences among the dividends and the Equity’s free cash flows and provides the discounted FCFE (Free Cash Flow to Equity) for valuation. Free Cash Flow to Equity (FCFE) = Net income – (capital – Depreciation) – (Change in Non – cash Working Capital) + (New Debt Issued – Debt Repayments). This balance on cash flow is the dividends available to be paid.
If the net expenditures on capital and the working capital differences are covered financially using a fixed or permanent mix of debt and the equity. If theta (d) is the net expenditure on capital and the changes in working capital is financed through debt then, Cash Flows to Equity related to Capital Expenditure requirements = – (Capital Expenditures – Depreciation)( 1 – d) and Equity Cash Flows related with WC demands = – ( change in WC) ( 1- d).
The current market price of General Electric Corporation is 23.9. The current dividend amount is 3.21 %. The number of shares of stock outstanding is 567671 with a market capitalization of 246.13 billion dollars. The P/E ratio 17.55, EPS of 1.35 and dividend of 0.19. The date ex of dividend was 21st/February 2013.
Payout ratio is the percentage payout of dividends for each year owned. Payout ratio is the percentage earnings to dividends. The payout ratio of General Electric Corporation is 3.21% * 23.9 = 0.07672. = 7.67 %
5 c) Determine the stock value based on the dividend – discount model.
P = D1/ r – g. P = 0.07672/0.0321 + 5.2 = 0.01466.
- 7. Compare the stock prices from the two methods to the actual stock price. What recommendations can you make as to whether clients should buy or sell GE stock based on your price estimates?
The current dividend price of General Electric Corporation is 23.69. The FCFE price is 14.558. The price estimates are lower and have the potential to rise rapidly. I would recommend that more stock should be bought as its value may increase in future making the purchase profitable.
- Explain to your boss why the estimates from the two valuation methods differ. Specifically, address the assumptions implicit in the models themselves as well as those you made in preparing your analysis. Why do these estimates differ from the actual stock price of GE?
The growth model by Gordon is suited for companies growing uniformly with the country’s economy. The company’s payout of dividend has to be consistent with the assumptions of stability. This model will particularly under value the stock if the company regularly pays out fewer dividends than it can afford and prefers to save cash in the process. For this model to apply effectively, the following assumptions have been made.
- The company is in a regular and stable business and the market is regulated to restrict new businesses.
- The company’s leverage is stable.
- The dividends paid are relatively equal to FCFE (Free Cash Flow to Equity)
- The annual FCFE average between 2008 – 2011 = 15.73
- Dividends payout ratio 7.67 %
In conclusion both methods can be used but each has its own restrictions and assumptions. The best in prevailing conditions should be applied.
Gordon, M. (1962). The Investment, Financing, and Valuation of the Corporation. Homewood: D. Irwin.
Khan, M. (1993). Theory & Problems in Financial Management. Boston: McGraw Hill
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