Chapter: Stock Valuation

Case: The Swiss Wealth Corp.

The Swiss Wealth Corp. (SWC) is in the last stage of its growth phase. While the variability in the companys earnings has decreased significantly, its revenue growth rates, though still impressive, are beginning to slow down. As the company is turning into a cash cow, the question arises of what to do with the free cash flow it generates. Since an increasing portion of this cash cannot be reinvested at rates higher than the companys cost of capital, a necessary condition to increase firm value, the management has decided to pay an annual dividend for the first time in the companys history, starting next year with CHF 1.60.

Having noticed the dividend announcement in the local business newspaper, you wonder if buying shares of SWC would be a lucrative idea. After all, you are a total return investor, that is, you favor a mix of capital gains and dividend income.

From your investment experience, you known that it often takes a few years before a newly dividend paying company establishes a somewhat constant dividend policy. Based on your analysis of the dividend paying behavior of companies that in the past were in a financial position similar to SWC, you estimate the next dividends to be CHF 2.10, CHF 2.50, and CHF 2.85 for years two, three, and four, respectively. For the years to follow, you anticipate an annual dividend growth rate that reflects the industry average of 4 percent. Upon the dividend announcement, SWC shares went up by almost 1.25 percent and are currently trading at CHF 46.85. Given a yield of 3.25 percent on Swiss government bonds, you have calculated the markets required risk premium for SWCs industry rivals to be 550 basis points (5.5 percent) on average.

1.

When relying on valuation models such as the DDM, it is important to understand how sensitive the models share price estimate is to changes in the input variables. Determine the percentage change in the share price estimate for P5 of CHF 61.52 to an increase in the required rate of return by 100 bp to 9.75 percent, a decrease in the dividend growth rate by 100 bp to 3 percent, a decrease in DPO by 100 bp to 19 percent, and a decrease in EPS growth by 100 bp to 3 percent. Compute the resulting changes in the share price in isolation, i.e., change one variable at a time. (explain your results as well)