ï»¿ESTIMATION OF GROWTH RATES
The value of a firm is ultimately determined not by current cash flows but by expected future cash flows. The estimation of growth rates in earnings and cash flows is therefore central to doing a reasonable valuation. Growth rates can be obtained in many ways: they can be based upon past growth; drawn from estimates made by other analysts who follow the firm; or related to the firm's fundamentals. Since each of these approaches yields some valuable information, it makes sense to blend them to arrive at one composite growth rate to use in the valuation. This chapter examines different approaches to estimating future growth, and discusses the determinants of ...view middle of the document...
Estimate the geometric average growth rate in earnings from 1987 to 1993.
B. Estimate the arithmetic average growth rate in earnings from 1987 to 1993, using a correction for the negative earnings.
C. Estimate the growth rate in earnings, using the linear regression model.
Question 4 - Earnings Growth and ROE
Johnson and Johnson, a leading manufacturer of healthcare products, had a return on equity in 1992 of 31.4%, and paid out 36% of its earnings as dividends. It earned a net income of $1,625 million on a book value of equity of $5,171 million. As a consequence of healthcare reform, it is expected that the return on equity will drop to 25% in 1993 and that the dividend payout ratio will remain unchanged.
A. Estimate the growth rate in earnings based upon 1992 numbers.
B. Estimate the growth rate in 1993, when the ROE drops from 31.4% to 25%.
C. Estimate the growth rate after 1993, assuming that 1993 numbers can be sustained.
Question 5 - Earnings Growth, Leverage, and Risk
Eastman Kodak was, in the view of many observers, in serious need of restructuring in 1994. In 1993, the firm reported the following:
Net Income = $1,080 million
Interest Expense = $ 550 million
The firm also had the following estimates of debt and equity in the balance sheet:
Equity (Book Value) = $6,000 million
Debt (Book Value) = $6,880 million
The firm also paid out total dividends of $660 million in 1993. The stock was trading at $63, and there were 330 million shares outstanding. (It faced a corporate tax rate of 40%.) Eastman Kodak had a beta of 1.10.
Analysts believe that Kodak could take the following restructuring actions to improve its financial strength:
Ã¯ It could sell its chemical division, which has a total book value of assets of $2,500 million and has only $100 million in earnings before interest and taxes.
Ã¯ It could use the cash to pay down debt and improve its bond rating (leading to a decline in the interest rate to 7%).
Ã¯ It could reduce the dividend payout ratio to 50% and reinvest more back into the business.
A. What is the expected growth rate in earnings, assuming that 1993 numbers remain unchanged?
B. What is the expected growth rate in earnings, if the restructuring plan described above is put into effect? ...