Gordon Growth Model for Equity Valuation

Assumptions in the model:

1. The firms dividends will grow abruptly in the first five years then at a constant rate thereafter. 2. The firms capital structure is known and constant.

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The Model:
The Gordon Growth Equity Valuation Model Company Name HERI de ELIJAH Sdn. Bhd. (Name)

First Period Dividend (D0) Growth rate for the first 5 years (g1-5) Growth rate after 5 years (gp) Required Rate of return (Ks)

$ 1.50 20% 5% 25%

(In currency) (In percentage) (In percentage) (In percentage)

Time Dividend Terminal Value Total Cash Flow Present Value

1 $ 1.80

2 $ 2.16

3 $ 2.59

4 $ 3.11

5 $ 3.73 $ 19.60

(Years) (In currency) (In currency) (In currency) (In currency)

$ 1.80 $ 1.44

$ 2.16 $ 1.38

$ 2.59 $ 1.33

$ 3.11 $ 1.27

$ 23.33 $ 7.64

Equity value Estimated Share Price

$ 13.07 $ 19.60

(In currency)

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Outputs of the model:

Estimated dividend in Year 6 Estimated Share Price (P) $ 3.92 $ 19.60

Market valuation model using free cash flows of the firm for equity valuation

Assumptions in the model:

1. The firms free cash flow would form a level of perpetuity beginning in year 5 (2015). 2. The firms capital structure is known and constant. 3. The industrys cost of capital is constant at 12%. 4. The chargeable tax rate is 35%

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The model:
FREE CASH FLOW CORPORATE VALUATION MODEL Company Name: Inputs: Sales for 2010 (Year 0 sales) Sales growth rate from year 1 - 4 Operating profit margin ratio Net working capital to sales ratio Fixed assets to sales ratio Tax rate Cost of capital Number of outstanding shares Current liabilities Market Value for Preference shares (Par value $ 1) Years Time Sales Operating Income (EBIT) LESS: Tax Net operating profits after tax (NOPAT) $ 300,000.00 10% 20% 12% 19% 35% 12% 20,000 $ 4,000.00 $ 9,900.00 2010 0 $ 300,000.00 2011 1 $ 330,000.00 $ 66,000.00 $ (23,100.00) $ 42,900.00 2012 2 $ 363,000.00 $ 72,600.00 $ (25,410.00) $ 47,190.00 2013 3 $ 399,300.00 $ 79,860.00 $ (27,951.00) $ 51,909.00 2014 4 $ 439,230.00 $ 87,846.00 $ (30,746.10) $ 57,099.90 2015 5 $ 439,230.00 $ 87,846.00 $ (30,746.10) $ 57,099.90 Page 4 of 15 Heri de Elijah Sdn. Bhd.

Less Investments: Investment in Net Working Capital Capital Expenditures Free Cash Flow (FCFs) Terminal Value Total Cash flows Present Value of FCFs Company's Intrinsic Value Total Present Values Less: Current liabilities of the firm Market value of preference shares Intrinsic Value Shares Outstanding Estimated Share price $ (4,000.00) $ (9,900.00) $ 405,323.96 20,000.00 $ 20.27 $ 419,223.96 $ 33,600.00 $ 30,000.00 $ 36,960.00 $ 29,464.29 $ 40,656.00 $ 28,938.14 $ (3,600.00) $ (5,700.00) $ 33,600.00 $ (3,960.00) $ (6,270.00) $ 36,960.00 $ (4,356.00) $ (6,897.00) $ 40,656.00 $ (4,791.60) $ (7,586.70) $ 44,721.60 $ 475,832.50 $ 520,554.10 $ 330,821.54 $ 57,099.90

Outputs of the model:

Estimated Share Price $ 20.27

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Portfolio Consisting of Assets from Procter & Gamble and Unilever

Introduction
The two assets that are selected to illustrate this model where Procter and Gamble (P&G) and Unilever. These two companies are the leading producers in consumer goods in the world. P&G ranks the first while Unilever is second after P&G took the peak in 2005 after acquiring Gillette Company. Therefore these companies are from the same industry which makes the task of comparing and analyzing its assets less cumbersome as the nature of the markets and economy would affect both of them in the same severity. In this model 40% of the investment is given to Unilever while the remaining 60% is allocated in Procter and Gamble. The data are obtained from yahoo finance website and filtered from January 2006 to June 2011.

Assets Returns
Using the data in appendix C the following statistical values were obtained for both Procter and Gamble and Unilever. Asset Returns Unilever Mean (Average) Return Variance Standard Deviation Covariance Correlation Coefficient 0.82% 0.00429 6.55% 0.001603 0.513151 Procter & Gamble 0.36% 0.00227 4.77%

Mean (Average) Return: The average return measures the return that an investor is likely to obtain by investing in each stock. The higher the average returns the better the stock in terms of return. Despite Unilever having higher share prices as compared to P&G; P&G has higher average return than Unilever. The figures Page 6 of 15

obtained above show that investing in P&G is likely to provide the investors with higher rate of return as compared to investing in Unilever since the return from P&G is more than two times than that of Unilever.

Variance and standard deviation: The variance and standard deviation figures measure the level of riskiness of each asset. The higher the value the riskier the investment it is. From the figures obtained it can be concluded that P&G is a riskier investment as compared to Unilever. Both the variance and standard deviation measures are higher in P&G assets as compared to those in Unilever. This result supports the theory which states that the higher the risk the higher the rate of return also. Citation. Therefore despite P&G shares being very attractive in terms of the expected return but also it can make the risk averse investors not to invest as a result of its riskiness.

Correlation coefficient: Sengupta C, 2010 defines the correlation coefficient value is a statistic that measures the degree to which two sets of data vary together. Looking at the correlation coefficient between P&G and Unilever which is 0.51315 it suggest that the two assets are positively correlated to each other. Moreover, the figure 0.51315 suggests that the strength of the correlation is just moderately strong. The correlation is positive moderately correlation because the two stocks come from the same industry. As seen earlier both P&G and Unilever are worldwide consumer goods producers. This suggests that their exposure to risk and levels of return is likely to be very similar in the sense that if the economy or the general conditions does not favor the demand for consumer goods in the market, both P&G and Unilever will be affected because they all produce consumer goods. On the other hand if the market is going to favor the supply of consumer goods, the benefits are likely to be shared by both P&G and Unilever. This is an indication that the share prices movement for the two assets will go in the same direction at most times. When the share price of P&G goes up so will the share price of Unilever as well.

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Covariance: Financial-dictionary defines covariance as a measure of the degree by which the returns on two risky assets move in tandem. A positive covariance means that the assets returns move together while a negative covariance means the assets returns move inversely to each other. Looking at the covariance between P&G and Unilever which is 0.001603 it suggests that the two assets are moving in the same direction to each other in the sense that when the prices of P&G increases so does the prices of Unilever. This again is the result of having 2 assets in a portfolio whereby both assets are from the same industry. This suggests that this is not a good portfolio since the portfolio holder is not able to diversify the portfolios diversifiable risk by holding a portfolio with a positive covariance. Therefore, using the covariance measurement one should make sure that in the portfolio held the covariance is negative; which is a sign that the investor is able to minimize the diversifiable risks to a possible minimum.

Portfolio Returns
Portfolio Returns Using assets Returns Expected Portfolio Return Portfolio Standard Deviation 0.55% 4.77% Using Portfolio Return 0.55% 4.77%

Expected Portfolio Return: The expected portfolio return is the return that an investor is likely to obtain when he decides to invest in different assets at a certain weight for each. When 40% of the funds are invested in P&G while 60% in Unilever, the Expected portfolio return will be equal to around 0.55%. This return is significantly lower than the mean return from P&G asset itself but it is also quite high if compared to Unilevers average return. Nonetheless, the portfolio expected return will be of different value if the weights distributed to each stock were different.

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Standard Deviation of Portfolio: The portfolio standard deviation is the level of riskiness that an investor is likely to face when he decides to invest in different assets at a certain given weight for each asset. When an investor decides to invest 40% of his funds in P&G and the remaining in Unilever the standard deviation will be 4.77%. This level of riskiness is very low as compared to that of P&G which was 6.55%; but it is the same level of riskiness as that of Unilever. This implies that when an investor decides to invest in two different assets his risk will definitely reduce. Again these findings support the idea of holding a portfolio rather than holding one stock only. The portfolio theory suggests that by holding a portfolio an investor is entitled to an average return of the component stocks but a lower than average risk level. As seen from the scenario; by investing in a portfolio consisting of assets from both Unilever and P&G the expected return is lowered to only 0.55% but the level of risk is also lowered to 4.77%. Therefore one will enjoy an average amount of return at a lower risk level when he decides to hold a portfolio instead of holding only one stock. Conversely, if the correlation coefficient between P&G and Unilever was negative the impact of the portfolio would have been more profitable. If the correlation was negative the average return would decrease to just average but the standard deviation (which measures the risk level) would reduce to a figure way below any of the stocks level of risk. Therefore, the best idea of investing in a portfolio is to ensure that the two portfolios are from two different industries (such as one from banking and another one from consumer goods) which ensure that the correlation between the two sides is negative or positively weak and the level of risk will reduce tremendously once the portfolio theory is applied. Investing in a portfolio with a high positive correlation will just ensure that the investor gains an average return at a slightly lower level of risk.

Construction of an Efficient Frontier

The efficient frontier was constructed by altering the proportion of funds that was invested in the two portfolios. By changing the weight of Procter and Gamble, which automatically changes that of Unilever by (1 weight of P&G), the efficient frontier below was obtained using the new portfolio standard deviation and the portfolio expected return.

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Efficient Frontier
0.90%
Wp = 1.0 Wu = 0.0

Portfolio Expected Return

0.80% 0.70% 0.60%

B

0.50% 0.40% 0.30% 4.00%

Wp = 0.0 Wu = 1.0

4.50%

5.00%

5.50%

6.00%

6.50%

7.00%

Portfolio standard Deviation

The efficient frontier above shows the trend of both the level of risk and return at different levels of weights investments in the portfolio. The frontier shows that by increasing investment in Procter and Gambles assets and reducing that in Unilever will lead to a decrease in the level of portfolio risk at first while the returns will be growing up; however in the future the level of portfolio risk will start going up while still maintaining an increase in the expected portfolio return level. The efficient frontier helps to describe what combination of assets several people will consider taking into consideration their perception towards risk. An investor who is a risk averse person will consider investing at point A in the efficient frontier whereby the portfolio will have 20% of funds in Procter and Gamble while the remaining 80% in Unilever. At this combination the investor will bear the lowest possible risk level of 4.63% while accepting an average return of only 0.46%. Since the person is very risk conscious he will be happy investing at this point since it allows him to incur a very low amount and rate of risk. Conversely, if an investor is an average risk taker he will invest at point B. An average risk taker is an investor who can bear a higher risk only if it promises a higher return. Investing at point B means having 40% of the funds in Procter and Gamble whilst the remaining 60% in Unilevers assets. At point B, an investor will incur a risk level of 4.77% which is exactly the same as if he only invested in Unilever only but the return will be higher as compared to the later scenario. If an investor puts all Page 10 of 15

his funds in Unilever he will gain a return of 0.36% but at point B the expected return is 0.55%. Therefore as an average risk taker since there is a higher return at point B but the same risk level, he will definitely consider investing 40% in P&G. On the other hand if an investor is a high risk taker he will consider investing at any point after point B in the efficient frontier. At this region the amount invested in Procter and Gamble will be higher as compared to that invested in Unilever. After point B the level of riskiness of the portfolio increases at an increasing rate and so does the expected rate of return. Therefore an investor who is quite a risk taker will consider investing his portfolio at this region bearing in mind that the expected return on the portfolio will be higher also.

Estimation of Beta and Intercept

By comparing P&Gs return and Unilevers return against the SP 500 return, the scatter diagrams below were drawn to portray the relationship between the two stocks returns with that of the market. On the scatter diagrams seen below the trend lines are drawn in the form of Y = a + bX, whereby by a is the intercept and b is the beta of the stock. Brigham, E., Houston J, (2010) defines beta as a metric that shows the extent to which a given stocks returns move up and down with the stock market. Beat thus measures market risk. The slope of the lines drawn on each of the scatter diagrams is the beta for each stock. The higher beta value or the steeper the slope of the trend line the riskier the stock is since a stocks beta reflects its contribution to the riskiness of a portfolio. Therefore, because a stocks beta coefficient determines how stock affects the riskiness of a diversified portfolio, beta is the relevant measure of a stocks risk. On the other hand, the intercept measures the alpha coefficient of the investment. Financialdictionary elaborates alpha as the mathematical estimate of the return on the security when the market return as a whole is zero. Furthermore, the alpha value measures the performance of the portfolio after adjusting for risk. Therefore, it has been cited out by several researchers and authors that the alpha coefficient is normally zero in an efficient market; however when the value is less than zero it signifies that investment has earned too little for its risks whilst when the value is positive it means the investment has a higher return than the investment risk.

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PnG Return vs SP 500, 2006 - 2011

12.00% 8.00% 4.00% 0.00% -4.00% -4.00% -8.00% -12.00% -16.00% -20.00% Y = 0.484X - 0.0036 R = 0.393

-24.00%

-14.00%

6.00%

16.00%

26.00%

Unilever Return vs SP 500, 2006 - 2011

15.00% 10.00% 5.00% 0.00% 0.00% -5.00% -10.00% -15.00% -20.00% Y = 0.587X - 0.0017 R = 0.307

-15.00%

-10.00%

-5.00%

5.00%

10.00%

15.00%

From the figures above the following estimates were obtained: Estimated Beta (b) for Procter and Gamble = 0.484 Intercept (a) for Procter and Gamble = - 0.0036% Estimated Beta (b) for Unilever = 0.587 Intercept (a) for Unilever = - 0.0017%

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Based on the findings from the two scatter diagrams earlier it can be seen that the changes of Procter and Gambles stock is less dependent on the market movement as compared to the stocks of Unilever. Therefore Unilevers stock will be regarded to be riskier as compared that of Procter and Gamble since the beta value of Unilevers stock of 0.587 is larger as compared to that of P&G which is only 0.484. If the market return falls by lets say 10% due several economic factors such as inflation, the return of Unilever will fall by 5.87% whilst the return of Procter and Gamble will fall by only 4.84%; which means the fall of Unilevers return will be higher as compared to P&Gs returns fall. On the other hand if there is a rise in the market return during the boom period, Unilevers return will rise by 5.87% while that of P&G will rise by only 4.84%. This indicates that Unilevers stock is more volatile as compared to P&Gs hence Unilever will be riskier. Conversely the intercepts for both stocks indicate that the performance of the stock has been poor to date. The intercept for P&G is -0.0036 while that of Unilever is -0.0017 which are all less than zero which suggests a poor performance of the stocks. In other words the investment in both P&G and Unilever is very risky whilst their returns are not sufficient to compensate the investor for the risk assumed. In conclusion, despite the good levels of expected returns that can be seen from each stock and together in a portfolio, the risk position for each stock is very much in excess hence making the stocks unattractive to risk-averse investors.

Moving averages & Technical analysis

References
http://financial-dictionary.thefreedictionary.com/Covariance http://financial-dictionary.thefreedictionary.com/Alpha http://stockcharts.com/school/doku.php?id=chart_school:technical_indicators:moving_averages

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Brigham, E., Houston J, (2003), Fundamentals of Financial Management, 10th Edition, Thompson South Western, United States of America Brigham, E., Houston J, (2010), Essentials of Financial Management, 2nd Edition, Cengage Learning Asia Pte Ltd, Singapore

http://www.stock-market-strategy.com/education/technical-analysis/moving-averages-ma/ http://www.learn-stock-options-trading.com/moving-average-analysis.html

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