To test the assumption of a discount rate of 7% as given in the outline of the case, we calculated the required rate of return for the Wal-Mart stock using CAPM . Using rWalMart = Rf + βWalMart [E(RM) – RF], we find the required rate of return to be 7.01% and in line with the information given in the case outline.
Perpetual dividend growth model:
The standard method of calculating a stock price using the perpetual dividend growth model is done by assessing a company’s dividend one year into the future adding the future expected growth rate. The formula is written as: P0 = D1/(Ke − g), where Ke is the investor required return, D1 is next year’s dividend and g is the expected growth rate of the dividend. The standard method can however be rearranged if the company analyzed is consider in “steady state”. A steady state implies that the annual return on equity equals the cost of equity capital providing the rational that the dividend payout ratio is the sole determinant of the dividend growth.
It requires some complexity to determine if a company has reached steady state. To investigate and analyze if Wal-Mart is in steady state, we would employ the following definition: Steady state value = free cash flow / discount rate . After careful consideration we have reached the conclusion that we find it fair and realistic to label Wal-Mart as such. This is further underlined by the maturity and stable performance of the company, which is illustrated in the stable revenue growth (exhibit 1), stable financial market stock data and relative stable dividend distribution (exhibit 3). Further, we are comfortable using the simplified steady state formula given the foreseeable forecasting period as we are only forecasting the stock price a few years in the future and not conduction long-term multiyear forecasting where the underlying assumptions of the model and the competitive landscape can dramatically change. We find evidence that the forecast period is essential in the selection of method in the INSEAD article “Selecting an accounting-based Valuation Model” of May 2011. If we were to forecast long-term price levels, we would opt for the conventional formula of P0 = D1/(Ke-g).
Given the steady state nature of Wal-Mart we use the adjusted dividend growth model of: P0 = (E1 × p)/ (Ke − g), where g = (1-p)*Ke and where E1 is the earnings 1 year into the future and p is the payout ratio or the percentage of earnings paid in dividends. Using this method, P0 = (E1 × p)/ (Ke – ((1-p)* Ke)), we estimate the stock price to be $58.56 . For reference and to provide validation to our estimates, we have in addition estimated the stock price using the conventional dividend discount model of P0= (D1/(Ke-g). Using the conventional model we estimate the stock price to be $59.78.
We conclude that the estimated price of the stock is higher than the current market price of $53.48 , which means we believe there is unrealized intrinsic value, hence the stock is undervalued and should we be analyzing the stock on this basis only, our recommendation would therefore be buy.
Forecasted Dividend for the next 3 years plus future sale of the stock:
Instead of valuing the stock with infinite dividend approach, we use a set number of years (3) plus we included the value of selling the stock after the set number of years. The selling of the stock is represented in the model as a terminal value. The terminal value is the value of the company’s expected cash-flow beyond the forecast period. We estimate the terminal value by using the perpetuity method mentioned above and be employing the formula of Terminal Value (TV) = FCFt+1 / WACC . We used the approximation that WACC equals the required rate of return as found using CAPM (7.01%, appendix 1). This also corresponds with the given discount rate of 7%. As we are asked to find to price by forecasting dividends for the next three...