Your supervisor sees your potential as a future analyst for a large brokerage firm. (You haven't told her you want to work for her firm after graduating. But that's okay; everything will be in due time.) Thus, she gave you an assignment to help her analyze the Adidas (ADDDF) stock. Your supervisor recommends determining prices based on the dividend-discount model and discounted free cash flow valuation methods. Adidas has debt, but for this analysis, your supervisor asked you to assume it doesn't have any. Assume that Adidas's risk premium is 5%, so add that to the yield on long-term Treasuries to get Adidas's cost of capital. You are ready for the challenge but also are a little concerned because your supervisor told you that these two methods can result in widely differing estimates when applied to real data. You are really hoping that the two methods will lead to similar conclusions.

Your supervisor recommended you look for the data through the following sources: Look up yields on long-term treasuries by searching for "Treasury Yields."  On Morningstar.com, enter the symbol for Adidas (ADDDF). The current stock price is on the main page for ADDDF.  Next, click the "Dividends" tab (you might have to scroll right), which lists the current annual dividend per share amount. Next, click the "Financials" tab.  You can export five years of income, balance sheet and cash flow statements into an Excel file. The most recent total number of shares outstanding can be found on the Income Statement. Next, go to Yahoo! Finance, enter the symbol for Adidas, click the  "Analysis" tab and find the revenue forecasts under "Revenue Estimates." From the revenue forecasts, compute the revenue growth rates using the last full year of revenue.  Morningstar does not report earnings before interest and taxes (EBIT).  In general, you can calculate EBIT from the Income Statement by adding Interest Expense to Pretax Income, but since you assume ADDDF has no debt, you can use Pretax Income for EBIT.

1. Using ADDDF's latest financial statements, calculate the five-year historical average for the following ratios:

• Return on Equity, that is, Net Income/Total Stockholder's Equity
• Dividend Payout Rate, that is, Dividend Paid/Net Income
• Earnings Before Interest and Taxes (EBIT)/Sales
• Net Property Plant and Equipment/Sales
• Net Working Capital (excluding cash)/Sales

2. Look up the latest revenue growth forecasts for the next five years. For missing years, linearly interpolate the growth rate between years using a long-run growth rate of 2.5% for year six and beyond (Interpolation Hint - if the growth rate is 8.0% in year 1 but 2.5% in year 6, a linearly interpolated decreasing growth rate down to 2.5% would be 8.0%, 6.9%, 5.8%, 4.7%, 3.6%, 2.5%). Use these forecasts to forecast future sales based on the most recent year's total revenue growing at the forecasted growth rates for the first five years. Use the long-run revenue growth rate for year six.

3. Next, forecast EBIT for the next six years by assuming that the EBIT/Sales ratio remains constant and equal to its five-year historical average.

4. Finally, forecast net income and earnings per share from EBIT using the current U.S. tax rate of 21%.

5. Your supervisor told you about the limitations of the dividend discount model. Given the limitations, she doesn't think it would be useful for you to use the model to infer the current value of ADDDF. Instead, she recommended using the model and the current stock price to infer the market-implied dividend growth rate.

• Begin by calculating the dividend yield, the ratio of the current dividend (annualized) to the price.
• Infer the implied annual dividend growth rate using the equationWhere: P₀ = stock price at the end of year 0, Div₁ = dividends paid in year 1, r_E = equity cost of capital, and g = expected dividend growth rate
• Next, calculate the implied dividend growth rate using the equation below by assuming future payout rates and returns to new investment equal the historical five-year average payout rate and average return on equity.

 

• What accounts for the difference between the implied dividend growth rate estimates? How might share repurchases affect these two estimates? How does the difference inform you (and your boss) about the limitations of the dividend discount model?

6. Next, calculate the implied stock value based on the discounted free cash flow method:

• Under the assumption that the ratios in part 1 remain constant, use the average ratios computed to forecast Net Investment (change in Sales × Property Plant and Equipment (PPE) to Sales ratio) and Increases in Net Working Capital (NWC) (change in sales × NWC to Sales ratio) for the next six years.
• Forecast free cash flow for the next six years using the equation:
  Where: EBIT = Earning Before Interest and Taxes and τ_C = corporate tax rate.
• Estimate the terminal enterprise value in year five using the free cash flow in year six, the assumed long-run revenue growth rate and the equation:

Where: V_N = enterprise value in year N, g_FCF = expected free cash flow growth rate, r_wacc = weighted average cost of capital, and FCF_N = free cash flow in year N.

• Determine the firm's enterprise value as the present value of the free cash flows.
• Determine the stock price using the equation:

Where: P₀ = stock price at the end of year 0 and V₀ = enterprise value in year 0.

7. Compare the stock to the actual stock price. What recommendations can you make (if any) regarding whether clients should buy or sell Adidas stock based on your price estimates? Specifically, address the assumptions implicit in the model and those you made in preparing your analysis.