Common Stock Valuation: The Variable Growth Model
It seems the whole world is going wireless. On the shuttle bus from SFO airport to my hotel downtown, I couldn't help but overhear an attorney discuss his legal strategy. First he called his office on his cell phone to see if a settlement offer had been reached. Then he pulled out his Palm Pilot to log the next sequence of motions to be filed.
Not wanting to seem nosey, I busied myself by tracking the latest stock performance within my portfolio via PocketBroker, a hand-held wireless investment service through Charles Schwab. With my RIM (Research in Motion) 950, I can access my account, download the latest quotes and even execute trades all while being driven on Highway 101. With my TradeStation 2000 technical analysis based automated software package, I was able to
identify several sell signals and lock in a hefty profit all before arriving at my hotel. The shuttle driver used his antenna to obtain my credit card approval and I was off to my meeting.
If you think only business people use wireless technology to this extent, think again. On board the USS McFaul, one of the Navy's newest vessels, crew members are now able to move freely throughout the ship while sending vital information back and forth over their wireless Palm handheld devices. Note only does the mobility directly translate into greater efficiency, but the need to keep extensive paper records and hold clipboards is a way of the past.
The Wake Forest University School of Medicine uses wireless handheld devices not only to track patient records, but update them as well. Updated records are automatically sent back to the central computer via the system's intranet. Aether Systems, Inc., is the firm responsible for many of these advancements. Their commitment to increasing mobility, productivity, and efficiency has allowed them to grow at an exponential rate.
Your task is to determine, using the discounted cash flow method, whether or not Aether is fairly, over-, or under-valued. To complicate matters, since the firm only came into existence in 1998 and because they are growth oriented, they have yet to pay a dividend and do not plan to do so in the short to intermediate run.
Instead, Aether will only begin to pay a dividend 10 years from now. The expected annualized dividend at the end of year 10 will be $2.50 per share. This dividend is expected to grow at a rate of 9% over the next 5 years and will then taper off to a steady 4%, a rate at which it is assumed to grow forever. Answer the following questions using a discount rate of 13%.
Questions
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aw_gitman_pmf_10|Case Studies in Finance|Case 17: Aether Systems
1.
Calculate the dividends over the first growth stage.2.
Using the Gordon Growth Model, calculate the value of all remaining dividends at time 15.3.
Calculate the present value (at time 0) of ALL future dividends.4.
Assuming Aether was currently trading at $10 per share, what would be your long-term recommendation for this stock: buy, sell, or hold?Copyright © 1995-2003 by Addison Wesley A division of Pearson Education Legal Disclaimer
aw_gitman_pmf_10|Case Studies in Finance|Case 18: NetJ.com
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Case 18: NetJ.com
The Behavioral Component of Pricing Common Stocks
A few years ago when the stock market was reaching new highs every day, investors were pouring more and more money into the capital markets. This free flow of funds encouraged small firms to go public before they were ready. More directly, many of these firms had limited track records, and in several cases, no track record at all. Still, with such a hot IPO market, these premature public offerings had been extremely successful; the majority of these firms had no problem fully subscribing their shares.
The market capitalization of NetJ.com was over $22.9 million. Yet in their SEC statement it read, "The company is not currently engaged in any substantial business activity and has no plans to engage in any such activity in the foreseeable future." How is it that a firm with no business operations had come to command such a market capitalization? NetJ.com began under the name NetBanx.com. The mission of this firm was to perform bad debt collections for doctors. Finding this to be a not so profitable venture, the firm shifted gears. Recognizing that the IPO process is a lengthy and expensive one, they saw value in the fact that they were already a publicly held corporation. As such, they could identify private companies who
wished to go public, but didn't want to put the necessary time and effort into the process. The game plan was to merge with the other firm and have that be their line of business.
This practice of making it up as you go along seemed not only to be a necessary course of action, but an attractive one as well. The trick appears to be keeping yourself "new."
NetJ.com is certainly keeping itself open to possibilities. As stated in their SEC statement,
"The company does not intend to restrict its search (for a partner) to any particular business or industry…high tech, natural resources, manufacturing, R&D, communications,
transportations, insurance, brokerage, finance, and all medical related industries." That pretty much covers it.
With "extremely limited assets" and "no source of revenue," one wonders how long NetJ.com can continue to command a stock price above zero before investors stop believing in
possibilities and start demanding performance.
Questions
1.
How is it that a company with little to no track record can successfully go public?2.
How can a firm with no revenue have a positive stock price?http://wps.aw.com/aw_gitman_pmf_10/0,6047,347201-,00.html (1 of 2) [11/27/2002 12:21:04 AM]
aw_gitman_pmf_10|Case Studies in Finance|Case 18: NetJ.com
3.
Why would a privately held firm generating significant profits consider merging with a publicly held firm who seems to be without direction and who is operating at a loss?4.
How long can a corporation with no revenue and no immediate plans to generate revenue expect to have their stock price supported by the market?Copyright © 1995-2003 by Addison Wesley A division of Pearson Education Legal Disclaimer
aw_gitman_pmf_10|Case Studies in Finance|Case 19: OTCBB
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Case 19: OTCBB
The Trading of Stocks in the OTCBB Market
Having just made senior partner in his Hawaii based architectural firm, Matt Gilbertson sought to invest a substantial portion of his new, much higher salary in speculative grade stock.
Normally in the habit of deleting mass e-mail, Matt's attention was drawn to the subject line:
"Bulletin Board Trading Now Available," that was sent by Datek Online. Datek is an online trading company where investors pay $9.99 per transaction and can trade up to 5,000 shares of a single stock. This emerging trend of do-it-yourself investing (at a much lower commission cost) was attractive to Matt. However, since Matt did not know what a Bulletin Board Stock was, he carefully read the e-mail to learn more about them.
Bulletin Board stocks are recommended for investors at the high end of the risk-return
spectrum. There are several sources of risk associated with these securities. OTCBB stocks are not required to meet minimum listing and reporting requirements as are stocks listed on organized exchanges, such as the New York Stock Exchange (NYSE) or the American Stock Exchange (ASE or AMEX). This means that investors will find it more difficult to find publicly available information and news that affects the value of the firm. Moreover, since national exchanges have stringent listing requirements, OTCBB stocks tend to be less stable companies with short track records, possibly facing regulatory actions or maybe even bankruptcy.
Another concern with OTCBB stocks is that because of low volume or liquidity, they have dramatically higher bid-ask spreads and are subject to partial order executions and in some cases unfilled orders. Finally, automation, which so many investors have become
accustomed to in recent years, is not available in the OTCBB. For all these reasons, OTCBB stock investing opportunities are being presented by Datek with a warning label that investors should do their homework, not only about the firm itself, but on this risky marketplace as well.
Questions
1.
With the added risk associated with OTCBB stocks, why are investors so attracted to them?2.
If we assume the added risk of the OTCBB stocks is not sufficiently compensated for by higher rates of return, should Datek continue to offer these stocks for sale to their customers?3.
Should stocks be allowed to be available for sale if they do not have to disclose information and have no reporting requirements?http://wps.aw.com/aw_gitman_pmf_10/0,6047,347202-,00.html (1 of 2) [11/27/2002 12:21:07 AM]
aw_gitman_pmf_10|Case Studies in Finance|Case 19: OTCBB
4.
Should an investor in Matt's position decide to invest in OTCBB stocks?Copyright © 1995-2003 by Addison Wesley A division of Pearson Education Legal Disclaimer
aw_gitman_pmf_10|Case Studies in Finance|Case 20: Pittston
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Case Studies in Finance
Case 20: Pittston
Tracking Stocks
With the Initial Public Offering (IPO) market doing so well a few years ago, tracking stocks were popping up everywhere. A tracking stock is a separately traded common stock that only reflects the well being of a particular division. The parent company still completely owns and operates the division. But, the parent has its own stock price that trades independent of the tracking stock's division. Tapping into the then hot IPO market, tracking stocks, particularly those in the technology sector, were able to generate significant proceeds when offered as a separate trading opportunity. With the overall market performing so well for so long, there seemed to be no drawback to this relatively new way to raise extra capital.
The question many investors started to ask was, "What will happen if tracking stocks start to act more as an anchor rather than a sail?" Pittston Co., announced it would revert back to its non-tracking stock structure because its coal division was dragging down its other, more healthy divisions. This brings up many interesting conflict of interest concerns for investors.
While the two stocks are managed by the same Board of Directors, the stockholders are not necessarily the same. In fact, they will likely be quite different. For which set of shareholders should the board seek to maximize value? Both the tracking stock and the parent stock are tapping into the same pool of resources. If the tracking division begins to flag or seems to be an unsuccessful venture, the natural managerial decision might be to divest or at least cut back on investment. However, this would cause the tracking stockholders to complain because their stock would go down in value. The question then becomes, is the job of management to maximize the value of the two stocks concurrently?
Executive compensation becomes an issue as well. Consider what might happen if the board owned a different amount or percentage of shares in the parent company when compared to the tracking stock. Might there be an incentive to place the interests of one set of
stockholders above those of the other?
The stock market cannot remain bullish forever. And when it corrects, there is likely to be a tremendous backlash surrounding tracking stocks. Are tracking stocks the wave of the future or are they a law suit waiting to happen?
Questions
1.
Why would the price of a firm before tracking stocks are introduced be different from the combined price of the parent and the tracking stock once the new structure is in place?http://wps.aw.com/aw_gitman_pmf_10/0,6047,347203-,00.html (1 of 2) [11/27/2002 12:21:10 AM]
aw_gitman_pmf_10|Case Studies in Finance|Case 20: Pittston
2.
Why are there so many tracking stocks in the technology sector as opposed to other sectors?3.
Why is it necessary for the market to become bearish before the potential problems associated with tracking stocks get noticed?4.
For which set of shareholders should the board seek to maximize value?5.
How could executive compensation be structured to discourage favoritism of either the parent stock or the tracking stock?Copyright © 1995-2003 by Addison Wesley A division of Pearson Education Legal Disclaimer
aw_gitman_pmf_10|Case Studies in Finance|Case 21: Vanguard
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Case 21: Vanguard
Mutual Funds and Taxes
Most everyone is aware that mutual funds are an ideal investment vehicle for the small investor. Mutual funds allow for the benefits of a diversified portfolio yet require only a small amount of funds to be invested. Moreover, for those who wish to avoid market timing
strategies and the time consuming process of analyzing individual stocks, index investing in broad market indexes is a favorable alternative. What most people do not know, however, is that even a buy and hold objective pursued through an index mutual fund is not without serious potential tax consequences.
Billy and Sherri Simpson invest regularly in Vanguard's Extended Market Fund, a mid-cap, buy and hold index mutual fund roughly tracking the Wilshire 4500. To date, Billy and Sherri have never withdrawn money from the fund. Instead, they periodically make deposits
whenever they have enough to do so. Even though the Simpsons have never sold their mutual fund shares, they noticed on their FORM 1099-DIV, that they were listed as earning
$1,266.90 in capital gains (Box 2a).
Thinking there had been a mistake, Billy called Vanguard's 1-800 number and asked for clarification. The Vanguard representative explained that when common stock is owned directly, there are two ways to realize returns: (1) payment of dividends by the company, and (2) capital gains (or losses) when the individual sells their shares. However, with mutual funds, there are three ways to realize a return. The first two are the same as if the stock was owned directly. The third is a capital gain that occurs when the fund itself sells shares in the portfolio. It was this third reason that had caused the Simpsons to realize the capital gain even though they themselves had never redeemed any mutual fund shares.
The next year when the Simpsons received their FORM 1099-Div, they noticed that the capital gains number in Box 2a had jumped up to $4,208.71 even though they did not contribute any more money that year. Knowing that the index fund had a buy and hold
strategy, the Simpsons were very surprised that so much turnover could have been caused within a single year's time.
After again calling Vanguard, they learned that due to the stock market's run up in that year, the mid-cap stocks that the fund held were now large cap stocks. To keep to the objective of holding mid-cap stocks, Vanguard said they sold off the firms that had become large cap stocks and used the proceeds to buy smaller firms. This turnover generated realized capital gains that had to be spread out over the mutual fund investment base on a pro rata basis.
The next year, the stock market bottomed out. Vanguard's Extended Market fund lost over
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aw_gitman_pmf_10|Case Studies in Finance|Case 21: Vanguard
40% of its value. Sherri joked that the good news was that at least they didn't have to pay high capital gains this year. However, at the end of January when they received their FORM 1099-DIV, they saw the highest number yet in Box 2a. The Total Capital Gain Distributions were reported to $7,444.72, even though the Simpsons had never withdrawn money from the account.
Not surprisingly, Sherri called Vanguard for an answer. The Vanguard representative explained that investors panicked when the stock market dropped. They sold off so many shares that the cash the fund keeps on hand to handle "normal" transactions had run out. In order to meet investor demand to withdraw funds, Vanguard had to sell off shares to raise the necessary funds. Many of the shares sold were originally purchased many decades ago. As such, they had a very low cost basis for tax accounting purposes.
Extremely upset by the turn about of events that had transpired, Billy and Sherri Simpson seriously contemplated the way they would invest in the future.
Questions
1.
Do you think Vanguard's objective to maintain a mid-cap index is more important than the tax burden it causes their clients?2.
Explain how investor behavior can be extremely detrimental to a mutual fund owner who will truly follow a buy and hold strategy through good times and bad.3.
Will there be certain economic conditions/times when this investor behavior will be worse than others?4.
Why should current mutual fund shareholders pay for the taxes caused by stocks that were purchased many decades before they became an investor? That is, why not recalculate the cost basis of a stock to more fairly assign tax liabilities to investors?5.
How might you change the way you would invest if you were the Simpsons?Copyright © 1995-2003 by Addison Wesley A division of Pearson Education Legal Disclaimer
aw_gitman_pmf_10|Case Studies in Finance|Case 22: Florida Power & Light
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