Equity Valuation $2$

Having done a great job trading Prandium Industries $($EV$1$ Case Simulation$),$ you have been

promoted to start applying the hedge fund's more complex valuation model to a different stock,

BoxCars $($BOXX$).$

This company is currently experiencing growth so the EV$1$ valuation model for which EPS and

dividends remain constant forever is not applicable. Instead, your fund believes that the

appropriate valuation model to use for BOXX is the Gordon dividend growth model.

The Gordon growth model states that the value of a firm's equity shares is equal to the expected

value of the firm's future cash flows $($in the form of dividends$),$ discounted by an appropriate equity

discount rate less the growth rate of dividends.

During the next trading year your responsibility is to trade BOXX using the fund's model. The

following table shows last year's earnings per share, as well as analyst estimates for the next four

quarters.

$"A"$ refers to actual and $"E"$ to estimated values.

BOXX has a corporate policy to pay out $60\%$ of its earnings as dividends each quarter. In addition,

your hedge fund analyst has told you that the appropriate discount rate to use is the current market

risk$-$free rate plus an equity risk premium for BOXX of $11\%.$ Throughout the trading case, you will

be able to observe the real$-$time risk free rate which is labeled RF$.$

The company will release actual earnings per share at the end of each quarter and analysts will

update their estimated earnings per share intermittently throughout the year.

In this trading simulation, you can purchase or sell shares of BoxCars $($BOXX$).$ The stock price at the

end of the trading case reflects the Gordon growth model, based on that year$$s dividends, the

growth of dividends relative to the previous year, and the equity discount rate:

Where r $=$ RF$($yearend$)+11\%$ and g $=($ This year's dividend $\frac{?}{?}$ Last year's dividends$)-1$

The case represents $1$ year of calendar time which is simulated over $8$ minutes of trading time.

There is a position limit of net long or short $100,000$ shares, and a trading fee of $1$ cent per share.

Discussion Questions and Follow Up:

$(1)$ Assuming that analyst estimates are the most accurate predictor available for future

earnings, what should the starting price per share be for BOXX?

$(2)$ Build an Excel valuation model with the earnings $($dividends$)$ as inputs and link the current

risk$-$free rate to your model by dragging and dropping the LAST value for RF $($in the RIT

Client$)$ into your excel sheet.

$(3)$ Given no other information about what drives RF$,$ or any forecasts, why is using the realtime RF the best predictor of what the ending value of RF will be$?$

$(4)$ What are the pitfalls of the Gordon growth model, and for which types of stocks would it be

best suited