Computing Long-Term Constant Growth Rates for Dividends

1. The three companies that have been selected for the underlying task are as highlighted below.

• BHP Billiton – Mining company
• Woolworths Limited – Retail company
• Commonwealth Bank (CBA) – Banking or financial company.

The dividend history of the stocks of the above mentioned companies for the last years beginning from July 1, 2008 and ending on June 30, 2018 is indicated as follows.

1. Since the interim dividends are paid in the middle of the year, hence the annualised dividends can be calculated by adding the interim dividend, final dividend along with the underlying interest for six months on the interim dividend. For convenience sake, it has been assumed that the interim dividend for all the above companies is paid exactly in the middle of their financial years. Further, the risk free interest for computation of interest has been given as 2.64% p.a. The annualised dividends for the three selected companies during the given 10 year period are provided as follows.

Relevant Formula

Annual dividend = Final Dividend + Interim Dividend*1.0132

The multiplication factor of 1.0132 has been derived by taking into consideration the semi-annual interest rate of 1.32%.

1. The objective is to highlight the dividend for the next year taking into consideration a suitable proxy constant growth rate of dividend for the three companies based on the data computed in part (b). The annual growth rate of dividends for the three companies over the given period has been highlighted as follows.

CWB – The proxy dividend growth rate for this would be the average annual growth rate of dividend during the period from 2008-2018. This is because this represents a complete business for the company since in the aftermath of 2008, there was a significant impact on the Australian banking industry which since then has improved and is now in a stable phase (Damodaran, 2015). Further, the annual average dividend growth rate has come out as 1.33% which seems quite suitable.

Hence, next year dividend = 4.34*1.0133 = $ 4.39

BHP Billiton- For the company, there has been a high variation in the annual dividend growth rate. This is primarily because during the period, there were some years (2013-2014) when the commodities prices plummeted owing to which the dividends also suffered. However, in the recent times (2015 onwards), there has been recovery in the prices which has led to improvement in the dividends being paid (Lasher, 2017). Owing to this huge fluctuation, the average is 8.72% which cannot be taken as the long term constant growth rate. Instead the average growth rate of the period from 2010-2012 has been considered which yields a constant dividend growth rate of 1.67% p.a.

Hence, next year dividend = 2.37*1.0167 = $ 2.41

Woolworths – In relation to Woolworths also, there is high variation in the dividend growth rate which is reflective of the challenging times that business has faced in the recent times coupled with portfolio restructuring. As a result, for deriving the long term constant growth rate of the company, it makes sense to exclude these periods of turbulence and recovery which is primarily visible from 2012 onwards (Arnold, 2015). Hence, the period from 2010-2011 has been taken for computing the average annual dividend growth rate. It has come out as 1.1%.

Hence, next year dividend = 0.54*1.011 = $0.54

1. The objective is to compute the expected rate of return on equity by considering the Gordon model. In accordance with Gordon model,

Current stock price = Next Year Dividend/(Cost of Equity – Constant dividend growth rate)

Commonwealth Bank

Closing price as on June 30, 2018 = $ 72.87

Perpetual dividend growth rate = 1.33%

Next year dividend = $ 4.39

Using the Gordon Model to Derive Cost of Equity

Hence, 72.87 = 4.39/(k-0.0133)

Solving the above, we get k = 7.36% p.a.

It is imperative that the underlying rate of return desired by the investors should be proportional to the underlying risk associated with the business. With regards to banking, it is a stable industry which is based on financial services. Also, CBA is one of the four big banks in Australia which tends to lower the overall risk. However, there is intense competition between the large banks for customers owing to saturation of total customer base (Petty et. al., 2015). Considering the above dynamics of this industry, the above rate of return seems taking into consideration that risk free rate is 2.64% p.a.

BHP Billiton

Closing price as on June 30, 2018 = $ 33.91

Perpetual dividend growth rate = 1.67%

Next year dividend = $ 2.41

Hence, 33.91 = 2.41/(k-0.0167)

Solving the above, we get k = 8.79% p.a.

It is apparent that mining is a cyclical industry since the underlying profitability is essentially dependent on the commodity prices. As a result, the stock price would remain volatile owing to the fluctuations in the commodity prices. Clearly, such a business is riskier than the stable bank business discussed above. Also, there is high dependence on China which has been realised in the stock price fall and profit fall during 2014-2015. It is estimated that more than 30% of the sales of the company are derived from Chinese customers (BHP, 2016).

The risk is mitigated to some extent since the company is one of the largest in the mining space and therefore has deep financial pockets which allow it to survive any downturn in the commodity prices.  Hence, considering the above factors, the cost of equity seems to be fair for the given company.

Woolworths

Closing price as on June 30, 2018 = $ 30.52

Perpetual dividend growth rate = 1.1%

Next year dividend = $ 0.54

Hence, 30.52 = 0.54/(k-0.011)

Solving the above, we get k = 2.82% p.a.

The company is based in the retail segment in Australia and about 55% of the business is derived from supermarkets. The company has market share in excess of 35% in the Australian supermarket space. Besides, the company has a diversified portfolio of other retail based businesses. However, in the recent times, the supermarket industry is facing a still competition leading to price wars. Woolworths in the recent times has lost market share to discount retailers that are penetrating the market. The price based intense competition is still continuing in the industry which makes it a risky investment particularly due to the shrinking margins witnessed in the recent times (Woolworths, 2017).

Issues with Gordon Model Methodology

As a result, the given rate on equity investment which has been computed is clearly on the lower side. Any investor to assume this risk of investing in this space would expect a return of no less than 8% pa.

1. One of the most common methods of determining cost of equity is the Gordon model which considers the current stock price along with expected future dividends to provide an estimation of the cost of equity. Despite the underlying popularity, there are key methodological issues in relation to the use of Gordon’ model and two of the most relevant problems are indicated as follows.

• The first issue relates to the usage of this method is that it requires an estimation of the future dividends. This can be reliable done only for companies which tend to have a consistent history of paying dividends. This allows prediction of future dividends with some precision. In case of firms which are during their growth phase, this model falls short since either such firms do not pay dividends owing to their capital needs or have an uncertain character associated with the same. In case of such firm, the Gordon model is not an appropriate choice and alternatives may be better (Parrino and Kidwell, 2014).
• One of the assumptions associated with Gordon’s model is that the dividend growth rate would be constant. However, it is unrealistic to expect a long term average dividend growth ate to sustain in the long run as the underlying industry typically changes and hence forces the firm to innovate which would tend to impact the dividend paid and also disallow estimation of reliable dividend growth rate estimate. Therefore, it is quite possible that this input used in the model can be biased and more dependent on the recent performance (Brealey, Myers and Allen, 2014).

Thus, in wake of the methodological issues highlighted in the Gordon Model, it is essential that reliable alternative methods for providing cost of equity estimated need to be highlighted. This is imperative since the equity cost plays a pivotal role in conduct various analysis especially related to capital budgeting and decisions related to making investment which is in the interest of shareholders. A potential alternative arises in the form of the CAPM approach or Capital Asset Pricing Model which has also been quite popular over the years amongst academicians and practitioners alike (Arnold, 2015).

A key idea which forms the basis of this model is that investors need to be given incentive by way of higher returns so as to lure them to invest in equity and thereby assume higher risk in comparison to debt. As a result, it can be logically deduced that the cost of equity would be greater than cost of debt. Besides, the CAPM also considers the time value of money principle which is highlighted in the equation of the model captured below (Northington, 2015).

The above equation clearly highlights that the equation’s first component is the risk free rate which is aimed at ensuring that the investors tend to obtain the risk free rate of return which is aimed at accounting for the underlying opportunity cost of funds. The equation’s second component is concerned with rewarding the investor for assuming higher risk that has been assumed by making an equity based investment (Damodaran, 2015). 

The risk of the investment with regards to the stock index is captured through the use of beta multiplied by the risk premium which is computed by highlighting the incremental returns that investors derive though investments in equity market in comparison to the risk free asset.  The computation of cost of equity is further used for computation of WACC of companies and projects thereby playing a crucial role in the decisions related to capital budgeting (Parrino and Kidwell, 2014).

Despite the extensive usage of CAPM technique, there are pivotal problems with CAPM usage also that need to be highlighted.  The first aspect relates to determining beta which for unlisted firm might be an issue since it is usually done by earmarking a firm which has a similar business model and underlying risk.  But this process requires that suitable adjustments ought to be made in order to account for the capital structure differences and other key differences which can alter the underlying risk (Lasher, 2017).

Alternative Methods for Computing Cost of Equity

Besides, it does consider the unsystematic risk which investors tend to have portfolios that are not fully diversified. The computation is typically performed in the perspective of a well-diversified portfolio which is not the case for firms making investment decisions that would have assets concentrated in their line of business. Thus, in this respect, suitable adjustments have to be made for highlighting the unsystematic risk which is only rarely done (Petty et. al., 2015).

But when comparing the CAPM with the Gordon model, it would be fair to conclude that the former is the more superior of the two. This has been derived on the basis of the reasons listed below (Damodaran, 2015).

• The CAPM inputs tend to rely in the present or past for which data tends to exist. It does not require any input that requires estimation of future in a reliable manner and thus tends to be more accurate.
• CAPM can measure the cost of equity for growing companies and other companies which do not have any dividend payout. This is not possible in case of Gordon model.
• For unlisted companies, CAPM is a more suitable choice when compared to Gordon model. This is because while it is possible to estimate the beta of an unlisted company by finding a suitable comparison, it is not possible to estimate the future dividend of an unlisted company even if it has a comparable listed peer.

Yet another approach that can be used for cost of equity is the risk premium approach. In this method, a risk premium is added to the debt cost for determining the cost of equity. This is done in order to compensate the investor assuming incremental risk assumed by making equity investment.  This approach advocates that the underlying risk premium tends to remain constant since the factors determining the equity cost and debt cost tend to be same only and therefore any change in any macro or micro variable would bring about same change in cost of equity and cost of debt (Brealey, Myers and Allen, 2014).

A big concern regarding this method is that it is only used for estimation in the companies that tend to have debt which is trading in the financial market and hence can provide a suitable base rate for levying the risk premium.  Besides, the underlying about risk premium remaining the same over the years also does not have any empirical backing and thus is dubious. However, despite the limited application of this approach one key advantage that this method offers is the underlying simplicity of method and implementation. This makes this approach better in case of Gordon’s model. It might be possible that Gordon’s model has a wider sphere of application but estimation of future dividends with accuracy and reliability remains a concern (Petty et. al., 2015).

Based on the above discussion, it would be fair to conclude that the Gordon model tends to suffer from serious methodological issues particularly in relation to estimation of future dividends. The unreliability of this estimate can potentially lead to incorrect prediction of the cost of equity which may hamper decision making especially in relation to new investments. Two alternatives which have been proposed for the Gordon model are CAPM and risk premium approach. Both these methods tend to have shortcomings with regards to usage under particular circumstances but still these are considered to be superior than Gordon method owing to the higher reliability of the former. As a result, the suitable choice regarding these tools should be made by keeping in references the underlying circumstances.  

References

Arnold, G. (2015) Corporate Financial Management. 3^rd ed. Sydney: Financial Times Management.  

BHP Billiton (2016), Annual Report 2016, BHP Billiton Website, 

Brealey, R. A., Myers, S. C., & Allen, F. (2014) Principles of corporate finance, 2nd ed. New York: McGraw-Hill Inc.

Damodaran, A. (2015). Applied corporate finance: A user’s manual 3rd ed. New York: Wiley, John & Sons.

Lasher, W. R., (2017) Practical Financial Management 5th ed. London: South- Western College Publisher.

Northington, S. (2015) Finance, 4^th ed. New York: Ferguson

Parrino, R. and Kidwell, D. (2014) Fundamentals of Corporate Finance, 3rd ed. London: Wiley Publications

Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M., & Nguyen, H. (2015). Financial Management, Principles and Applications, 6^th ed..  NSW: Pearson Education, French Forest Australia

Woolworths (2017) Annual Report 2017.