II. Assignment two (THA#4, page 191) Valuation of Colgate Palmolive (I) Ltd.

Stock using Dividend Growth Model : CAPM calculation is also attached. We are ignoring CAPM, based upon weekly 5 years prices in comparison to S&P CNX NIFTY, as there, market risk premium is coming negative. So, S&P CNX NIFTY may not truly represent a market portfolio. (In case you have found it out, why dont you adjust the Expected Rate of Return on Market to a More Realistic number???? That would be more rational I guess and would solve the problem you are facing. In case I am estimating about the Indian markets.....I see that rf as offered by T bills is around 7%pa and the bonds and other debt instruments provide a rate of return of up to 12% pa. Therefore I would expect for the market index rate of return to be at least 15% or more before I would think of investing in the market index.This implies that as per my expectations the market risk premium should at least be 8% per annum. If you agree with this logic you would think of revising your estimates accordingly (but that you should do only after finding the CAPM estimates and arguing for the reasons of revising it). You may also use a similar logic and argument for revising your estimated CAPM r either on the daily or the weekly basis. On the weekly basis the 8% pa market risk premium would become (1+0.08)^(1/52)-1 (you can do similar calculation for the daily revised market risk premium). Therefore the Market rate of return can also be revised to a weekly basis by (1+0.15)^(1/52)-1 or a daily basis.

So, taking CAPM calculation, based upon daily prices for year 2012, where market portfolio is S&P CNX NIFTY , we are getting expected annual return as 11.05%. (but even in case of daily returns your market risk premium seems to be negative....so how does it make a difference???)

Data on Colgate Palmolive financial parameters from websites are as under :-

2007-08 2008-09 2009-10 2010-11 2011-12

Net Profit (Cr) 231.71 290.22 423.26 402.58 446.47

Dividend Payout (Cr) 227.64 238.13 317.83 348.87 395.13

RE 4.07 52.09 105.43 53.71 51.34 Avg

Retention Ratio 0.01756506 0.17948453 0.24909039 0.13341448 0.11499093 0.13890908

Outstanding Shares (Cr) 13.5993 13.5993 13.5993 13.5993 13.5993

Dividend/ Share (Rs.) 16.739097 17.51046 23.371056 25.653526 29.055172

2007-08 2008-09 2009-10 2010-11 2011-12

Net Profit (Cr) 231.71 290.22 423.26 402.58 446.47

Net Worth 162.21 216.3 326.11 384.05 435.39 Avg

ROE 1.4285 1.3417 1.2979 1.0482 1.0254 1.2284

Traded price on 31st March closing Dividend Yield 342.84 411.86 0.051074729 628.06 0.056745146 792.43 0.040845662 1101.48 0.036665916 0.046332863

Dividend Growth Rate 0.0460815 0.3346911 0.0976623 0.1325995 0.1839

A) We take g = 0.1839 as per hurdle rate of growth in dividend for last four years. Then R is assumed to be as per CAPM, then R < g, and so it gets absurd. You may take the assumption as above. But I would prefer to estimate g which is based on the expected rate of return from equity reinvestment (it assumes that if you retain earnings, the retained earnings becomes equity investment on which equity investors would require similar return which they have been expecting on the actual equity i.e. CAPM estimated rate of return for assuming the systematic risk in the company). Therefore taking the average retention rate as the input and CAPM expected r (which you have estimated from the daily returns and have annualized) I may estimate g as g = 0.13890908 x 0.1105 = 0.01534945334 or aprox 1.54% now using this I can calculate the Year 1 dividend on the time from the dividend of Year 2011-12 (assuming 2011-12 to be year zero on the time line) as D1 = 29.055172*1.0154 = 29.5026216488. Now using the DDM with growth formula V0 = D1/(r-g) we can calculate V0 = 29.5026216488/(0.1105-0.0154) = 310.22735698002103049421661409043 B) We take g = 0.1839 and calculate R = Dividend Yield + g = 0.046 +0.1839 = 0.2299. So, Expected Stock Price = Div1/(R-g) = 29.05 X (1+0.1839) / 0.046 = 747.65 ( quite low from current price of Rs. 1340) C) If we calculate g = Retention Ratio x ROE (CAPM) = 0.1389 X .1105 = 0.0153 So, R = 0.046+0.0153 = 0.0613 In this case, expected stock price = Div1/(R-g) = 29.05 X (1+0.0153) / 0.046 = Rs. 641 ( quite low from current price of Rs. 1340) D) If we calculate g with ROE as per financial reports of last years, where ROE has been above 1, average for last five years = 1.2284 So, g = 0.1389 X 1.2284 = 0.1706 R = Div1/P0 + g = 29.05 / 792.43 + 0.1706 = 0.0366 + 0.1706

Formatted: Subscript Formatted: Subscript Formatted: Subscript Formatted: Subscript

In this case, expected stock price = Div1/(R-g) = 29.05 X (1+0.1706) / 0.0366 = Rs. 929 ( still quite low from current price of Rs. 1340)

I am really getting confused as what kind of calculation to be used and basically I am finding it very difficult to relate to practical the theory read from book or in classes. Also, which CAPM to be used ? That is also a tough decision ? What is the practicality of these theory ? Kindly help out . You identified it right. There seems to be a lot of confusion and a closer looks into the theory is the way out. First of all please understand that is a subject of logic and not an outcome of computation. So have a reason as to which one would follow logically, rather than trying to somehow match it to the current prices. If your logic is correct for choosing the path of valuation which cannot be improved upon, it can have two reasons, Either the security is mispriced in the short run in the market (which happens at all times for short intervals of times), Or you dont know something which the market does....which is quite possible....given that you have not looked at the potential reasons of the current prices beyond the historical relationship of the stock with the market and the historical rate of growth which you expect to hold in future (what if your assumptions are based on limited information about past only ignoring the present and the future which may be quite different from the past???)...........in such cases you would need to incorporate those current information about the present and the future into your expectations about the relationship of the security with the market (which the investors may see as changing) and about its impact on the growth in future (which the investors may see as different from the past). And therefore in light of such additional information you would adjust your figures of Cost of Capital (CAPM) and/or Growth rate (g) which is what happens when we do valuation in practice. This is a subject matter of a specialized area in finance called Valuation which is also discussed as part of the Investment Course. Please note that apart from the DDM with growth model, there are a lot of other models as well which we use for valuation. At this time our purpose of studying DDM with growth is only to understand the logic behind and to learn about its calculation. This area requires you to think in a dynamic way...be informed at all times about all that can affect your estimates......and incorporate the impact of such information in the valuation and estimation models either by revising your estimates directly or by developing new models to do so. Hope it helps.