Two-Stage Dividend Discount Model

Assignment 2 –

Coca-Cola (KO) is the world’s largest producer of soft-drink concentrates, syrups, and juices.  Its soft-drink brands include Coke, Diet Coke, Cherry Coke, Sprite, Tab, Nestea, and Barq’s.  The firm sells about 59% of its concentrates and syrups to company-owned and independent bottlers in the United States and abroad, who distribute them to end users.  Coca-Cola also makes fruit juices sold under names like Minute Maid. 

Follow the Two-Stage DDM method presented in class (including the Two-Stage DDM spreadsheet).  If you need a further review, remember that you studied the Two-Stage DDM in your F371 text.

Answer the following question.  You MUST show all of your calculation in the questions below is order to receive credit for any numerical answers.  All five questions are worth 20 points each (5 x 20 = 100 points).

Two-Stage Dividend Discount Model

Q1.  The First Step in using the Two-Stage DDM is to estimate an annual expected first-stage growth rate in dividends during stage 1, g1, AND the number of years, n, that you expect the g1 level of growth to persist.  Two (2) popular methods for estimating g1 that were discussed in class are:

B. (Method 2): Use the formula provide in the AAII article “Methods for Valuing a Stock” for estimating the sustainable growth rate in EACH of the past five years then take a simple average of these five annual sustainable growth estimates in order to arrive at a second estimate for g1.  The assumption in this method is essentially that the historical average sustainable growth rate, which is essentially the expected sustainable growth rate in net income for a given level of ROE and a given retention ratio, is a good estimate for g1 (the growth rate in dividends).  The sustainable growth rate formula assumes the capital structure remains constant and no new common stock is issued.

Sustainable growth rate = ROE x retention ratio

Write a short paragraph (just three sentences) that COMPARES and CONTRASTS your two estimates for g1.  Are the similar?  Are they extremely different?  Give your thoughts on why there are similarities or differences.

You can also provide a subjective adjustment to the average value estimates of g1 above based on any other information you feel is relevant (new products, increased competition, DuPont analysis, etc.).   

C. SELECT the one (1) single estimate from Q1A and Q1B above that YOU believe is the most appropriate value of g1 for valuing KO using the Two-Stage DDM.  Further, LIST the number of years, n, you expect g1 to persist.  Provide a short paragraph ( just three sentences) that EXPLAINS your reasoning for selecting these values of g1 AND n.

*IMPORTANT:  A Key Learning Point here is that any estimate of the future growth in dividends will generally NEVER equal the actual growth that results after time passes.  All financial valuation estimates are subject to forecast error, which is also referred to as estimation risk.

Q4.  Using KO’s current annual dividend (most recent quarterly dividend x 4) as D(0) in the Two-Stage DDM, LIST your value (price per share) estimate for KO using the Two-Stage DDM (provide a screen shot of your Two-Stage DDM spreadsheet).

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