Question 1: Estimation of intrinsic value of Home Depot’s stock as of Feb 1, 2001 To simplify the question, let’s Supppose ROE of Home Depot Inc would be constant during the following years as 20%:
By doing this we assume: the Market risk premium during 2001 would be 6.4%. Acctually, according to the lecturer, the risk premium during year 1998-2008 should be within the range of 4% to 8%. Therefore the assumption of 6.5% seems probable.
Abnormal earnings=Net Income – Shareholders’ Equity at the beginning of the year*Re=(20%-12.76%)BVE0=1086.3M BVE0=15004M
So the intrinsic value of Home Depot’s stock of Feb 1, 2001 is 23379.4 millions Question 2: Assumptions regarding Home Depot’s future growth rate, ROE, and cost of equity support for Home Depot’s observed stock price of $48.20 on Feb 1, 2001: ✓ Investors perceive investment opportunities in terms of a probability distribution defined by expected return and risk. ✓ Investors’ expected utility is an increasing function of return and a decreasing function of risk (risk-aversion) ✓ Investors are rational
✓ There would not be any significant capital structure change in the future. ✓ Home Depot company can maintain its competitive advantage and thereby earning a stable profit ✓ The risk premium in the future would be similar to the rate during 1998-2008 ✓ Introduction of Home Depot’s Service Performance Improvement (SPI) program since 2000 and is planned to implement in every store by the year-end 2001, which simultaneously increased sales productivity and customer satisfaction and is expected to bring out benefits in future such as: lower operating cost and higher sales revenue. Its commitment to rollout best practices is appreciated in investors’ view. ✓ Its growth initiatives in terms of customer groups, product...