Estimating the Intrinsic Value using Gordon's Dividend Growth Model

The assignment content discusses Gordon's Dividend Growth Model and its application to calculate the intrinsic value of Sherwin-Williams Company. The model considers two factors: FCF (free cash flow) in the year 2020, which is higher than the dividend value per share in 2016, and the fact that Gordon's model does not consider retained earnings. The company has a highly levered capital structure with debt being twice the equity. Moody's investor services downgraded the company's rating from A2 to A3 due to significant increase in debt. The assignment also discusses unlevered beta (βu) and its application to calculate the cost of equity. The value of an unlevered firm is obtained by subtracting the tax shield from the levered firm value.

Valuation: The Sherwin-williams company

Valuation: The Sherwin-Williams Company
Table of Contents
Problem 1.......................................................................................................................................................2
Problem 2.......................................................................................................................................................6
Problem 3.......................................................................................................................................................7
Problem 4.......................................................................................................................................................8
Problem 5.....................................................................................................................................................11
Problem 6.....................................................................................................................................................12
Problem 7.....................................................................................................................................................13
Problem 8.....................................................................................................................................................14
Problem 9.....................................................................................................................................................16
Problem 10...................................................................................................................................................17
Problem 11...................................................................................................................................................18
Problem 12...................................................................................................................................................19
Problem 13...................................................................................................................................................20
Problem 14...................................................................................................................................................21
Problem 15...................................................................................................................................................23
References....................................................................................................................................................24
1

Valuation: The Sherwin-Williams Company
Problem 1
Particulars 2015 2014 2013
Current Assets ($ 000) 26,58,874 25,66,780 31,58,717
Current Liabilities ($ 000) 21,41,859 26,80,666 25,28,557
Current Ratio 1.24 0.96 1.25
Table 1: Current Ratio
The current ratio of the Sherwin-Williams company is very low. The current assets do not
sufficiently cover liabilities.
Particulars 2015 2014 2013
Sales ($ 000) 1,13,39,304 1,11,29,533 1,01,85,53
2
Accounts Receivables ($ 000) 11,14,275 11,30,565 10,97,751
Receivables Turnover 10.18 9.84 9.28
Table 2: Receivable Turnover
The receivable turnover ratio of the company is also low which shows that it is not efficient in
managing the accounts receivables. The company takes large number of days to collect the
receivables.
Particulars 2015 2014 2013
Cost of Goods Sold ($ 000) 57,80,078 59,65,049 55,68,966
Inventory ($ 000) 10,18,530 10,33,527 9,70,815
Inventory Turnover 5.67 5.77 5.74
Table 3: Inventory Turnover Ratio
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Valuation: The Sherwin-Williams Company
The inventory turnover ratio depicts how efficient a company is in selling its inventories. The
company’s ratio is very low which depicts that it takes many days to sell its inventories.
Particulars 2015 2014 2013
Sales ($ 000) 1,13,39,304 1,11,29,533 1,01,85,532
Fixed Assets ($ 000) 29,23,431 28,35,260 27,41,380
Fixed Assets Turnover 3.88 3.93 3.72
Table 4: Fixed Assets Turnover Ratio
The fixed assets turnover ratio gives an idea about a firm’s efficiency in using its fixed assets to
generate revenue. The company has considerable fixed asset turnover ratio which denotes that it
is efficient in converting fixed assets into sales.
Particulars 2015 2014 2013
Total Liabilities ($ 000) 49,23,945 47,09,582 46,07,972
Shareholders' Equity ($ 000) 8,67,910 9,96,470 17,74,535
Debt-Equity Ratio 5.67 4.73 2.60
Table 5: Debt-Equity Ratio
The debt to equity ratio of the company is very high. It shows that the firm relies heavily on debt
rather than equity fund. The ratio is much higher than the ideal ratio of 0.30.
Particulars 2015 2014 2013
Sales ($ 000) 1,13,39,304 1,11,29,533 1,01,85,532
Operating Profit ($ 000) 16,45,708 13,41,518 11,48,885
Operating Margin 14.51% 12.05% 11.28%
Table 6: Operating Margin
3

Valuation: The Sherwin-Williams Company
The operating margin of the company is appreciable though not substantial. The margin has
increased over time.
Particulars 2015 2014 2013
Sales ($ 000) 1,13,39,304 1,11,29,533 1,01,85,532
Net Profit ($ 000) 10,53,849 8,65,887 7,52,561
Net Profit Margin 9.29% 7.78% 7.39%
Table 7: Net Profit Margin
The net profit margin like the operating margin is average. The margin has improved over time.
Particulars 2015 2014 2013
Net Profit ($ 000) 10,53,849 8,65,887 7,52,561
Total Assets ($ 000) 57,91,855 57,06,052 63,82,507
Return on Assets 18.20% 15.17% 11.79%
Table 8: Return on Assets
The company has healthy return on assets ratio. It shows the efficiency of the company to
generate profits by using its assets.
Particulars 2015 2014 2013
Operating Profit ($ 000) 16,45,708 13,41,518 11,48,885
Total Assets ($ 000) 57,91,855 57,06,052 63,82,507
Current Liabilities ($ 000) 21,41,859 26,80,666 25,28,557
Capital Employed ($ 000) 36,49,996 30,25,386 38,53,950
Return on Capital Employed 45.09% 44.34% 29.81%
Table 9: Return on Capital Employed
4

Valuation: The Sherwin-Williams Company
The company generates significant profit on capital which is evident from its high return on
capital employed ratio. Besides, it has improved over time.
Particulars 2015 2014 2013
Prior Year Diluted EPS ($) 8.78 7.26 6.02
Dividend ($) 2.68 2.20 2.00
Dividend Payout Ratio 30.52% 30.30% 33.22%
Plough Back Ratio 69.48% 69.70% 66.78%
Market Value per Share ($) 255.67 271.27 183.26
Table 10: Dividend Payout Ratio and Market Valuation
Normally, the company ploughs back two third of its profits to expand the operations. One third
of its profit are paid out as dividend. The company’s market price is very high compared to its
diluted earnings per share which shows that the company is overvalued in the market.
5

Valuation: The Sherwin-Williams Company
Problem 2
Moody’s investor services gives the rating of A3 to the company. It shows that the chances of the
company defaulting on its debt is low. Though, the company is highly levered, it generates
enough profit to repay its debt along with its interest cost. However, Moody’s have downgraded
their rating from A2 to A3 only recently because the company is in talks for making acquisitions
in 2016. It will decrease the ability of the company to pay its debt smoothly due to profits getting
diverted for acquisition. The commercial paper rating of the company were also downgraded
from Prime-1 to Prime-2.
6

Valuation: The Sherwin-Williams Company
Problem 3
The free cash flow of generated by a company is obtained by subtracting maintenance capital
expenditure from the cash generated from operations given in the cash flow statement of the
annual report of 2015.
Net Operating Cash = $1447463000
Capital Expenditure = $234340000
Free Cash Flow = $1447463000 - $234340000 = $1213123000
The return on equity value is assumed as growth rate for free cash flows into the future. The
table below shows the calculation for Return on Equity (RoE) value.
Net Income ($ 000) 10,53,849
Shareholders' Equity ($ 000) 8,67,910
RoE (%) 121.42%
Table 11: Return on Equity
The table below shows the free cash flow projections for the period of coming five years from
2016 to 2020.
2015 2016 2017 2018 2019 2020
Free Cash Flow ($ 000) 1213123 268609
7
5947556 13169078 29158973 64563798
Growth Rate 121.42%
Table 12: Free Cash Flow Projections
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Valuation: The Sherwin-Williams Company
Problem 4
The calculation of Weighted Average Cost of Capital (WACC) initially requires calculation of
cost of equity and debt. The cost of equity is calculated using Capital Asset Pricing Model
(CAPM) as follows:
E(R) = Rf + β (Rm - Rf)
Where, Rf = Risk-free Return, E(R) = Cost of Equity, β = Measurement of Volatility, Rm =
Return on Market Portfolio.
The Rf value is taken as the yield on U. S. Government Treasury Bond of 10-year which is
1.78%. The Rm value is calculated by averaging return on S&P 500 Index over 10 years. The
value of β for the Sherwin-Williams Company is extracted from Yahoo Finance and its value is
1.31.
S&P 500 Index
Value
Return
2016 2098.86 1.73%
2015 2063.11 5.25%
2014 1960.23 22.04%
2013 1606.28 17.92%
2012 1362.16 3.14%
2011 1320.64 28.13%
2010 1030.71 12.12%
2009 919.32 -28.18%
2008 1280 -14.86%
2007 1503.35 18.36%
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Valuation: The Sherwin-Williams Company
Market Return 6.56%
Table 13: S&P 500 Return
The value of cost of equity is shown in the table below.
Risk-Free Rate 1.78%
Beta 1.31
Market Return 6.56%
Cost of Equity 8.05%
Table 14: Cost of Equity
While calculating the cost of debt, the debt item of each type is considered and its weighted
average cost is calculated as shown in the following table.
Debt Type Value ($000) Balance Proportion Interest Cost Weightage
Senior Notes: 699643 36.44% 1.35% 0.49%
399774 20.82% 3.45% 0.72%
397634 20.71% 4.55% 0.94%
298645 15.55% 4.00% 0.62%
Debenture: 119372 6.22% 7.38% 0.46%
3500 0.18% 7.45% 0.01%
Promissory Notes: 1628 0.08% 8.00% 0.01%
Total 1920196 3.25%
Table 15: Cost of Debt
The cost of debt for the Sherwin-Williams is calculated to be at 3.25%.
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Valuation: The Sherwin-Williams Company
The WACC is calculated using the following equation:
WACC = Equity Cost × Proportion of Equity + Cost of Debt × Proportion of Debt * (1 – Tax-
Rate)
Particulars Value ($
Billion)
Balance Proportion Cost Weightage
Equity 25.55 93.01% 8.05% 7.49%
Debt 1.92 6.99% 2.11% 0.15%
Total 27.47 100.00% 7.63%
Table 16: WACC
The cost of debt in the table is directly shown after-debt considering the tax-rate of 35%. Thus,
the WACC value is calculated to be at 7.63%.
10

Valuation: The Sherwin-Williams Company
Problem 5
The company’s terminal value is obtained by discounting the value of free cash flow at the end
of 2020 considering the discount rate of 7.63% which is same as the WACC. The perpetuity
growth rate of 1% for free cash flow value is also considered. This growth is an assumption that
the cash flows will grow at a constant rate of 1% each year till eternity. The equation for terminal
value is as follows:
Terminal Value = FCF in 2020 / (Discount Rate – Eternity Growth Rate)
= 64563798000 / (0.0763 – 0.01)
= 973314190000
11

Valuation: The Sherwin-Williams Company
Problem 6
The value of a firm is obtained by adding the present value of the free cash flow during the
forecast period and the present value of the terminal value. The terminal value calculated in
problem 5 is obtained at the end of the year 2020. Its value is discounted back to the present to
calculate the total firm value. The discount rate used here is the risk-free rate from problem 4.
Terminal Value ($ 000) 973314190
Risk-Free Rate 1.78%
PV of Terminal Value ($ 000) 891129503
Table 17: Terminal Present Value
The table below shows the calculation of firm value.
NPV of Free Cash Flows ($ 000) 107154839
PV of Terminal Value ($ 000) 891129503
Firm Value ($ 000) 998284343
Table 18: Firm Value
The following table shows the incremental changes in firm value with respect to the incremental
changes in terminal value.
FCF Growth Rate 25% 50% 75% 100% 125% 150%
Terminal Value ($ billion) 55.81 138.87 300.16 585.21 1054.58 1785.94
Firm Value ($ billion) 62.81 149.61 315.48 605.70 1080.27 1816.04
Table 19: Sensitivity Analysis
12

Valuation: The Sherwin-Williams Company
Problem 7
The intrinsic value per share is obtained when firm value is divided by the total number of shares
outstanding for the company. However, the debt outstanding is subtracted from the firm value to
obtain an after-debt intrinsic value per share.
Firm Value = $998284343000
Outstanding Debt = $1920196000
After-debt Firm Value = $996364147000
Common Shares Outstanding = 92246525
Intrinsic Value per Common Stock = $10801
13

Valuation: The Sherwin-Williams Company
Problem 8
The Economic Value Added (EVA) of any firm is calculated from the following equation.
EVA = NOPLAT – WACC × Capital Employed
The capital employed into the firm to run the operations is obtained by subtracting current
liabilities form total assets.
The table below shows the calculation for NOPLAT which stands for Net Operating Profit Less
Adjusted Taxes.
Particulars Value
Revenue ($ 000) 11339304
less: Cost of Sales ($ 000) 5780078
Gross Profit ($ 000) 5559226
less: Operating Expenses ($ 000) 3943786
Operating Income ($ 000) 1615440
Tax Rate 35%
NOPLAT ($ 000) 1050036
Table 20: NOPLAT
Using the WACC obtained in table 16, the EVA value is calculated as shown in table below.
NOPLAT ($ 000) 1050036
WACC 7.63%
Total Assets ($ 000) 5791855
Current Liabilities ($ 000) 2141859
Invested Capital ($ 000) 3649996
14

Valuation: The Sherwin-Williams Company
EVA ($ 000) 771417.3
Table 21: EVA
The positive value of EVA denotes that the Sherwin-Williams company is able to obtain profit
by overcoming the hurdle value of cost of capital employed. The capital cost is the minimum
value which must be covered to increase the shareholder value thereafter.
Problem 9
The Market Value Added (MVA) is the difference between market capitalization of the company
and its invested capital. It shows if the company has created market value for shareholders by
overcoming the amount equal to the capital employed into the firm.
15

Valuation: The Sherwin-Williams Company
MVA = Market Capitalization – Invested Capital
= $25550 million - $3650 million
= $21900 million
The market capitalization and invested capital values are obtained from table 16 and table 21
respectively. The positive value of MVA denotes that the Sherwin-Williams company has
created shareholder wealth over and above the minimum requirement equal to the invested
capital.
Problem 10
2013 2014 2015
Prior Year Diluted EPS ($) 6.02 7.26 8.78
Dividend Per Share ($) 2 2.2 2.68
16

Valuation: The Sherwin-Williams Company
Dividend Payout Ratio 33.22
%
30.30% 30.52%
Table 22: Dividend Pay-out Ratio
The dividend pay-out of the company is consistent and the pay-out ratio is greater than 30% each
year. The ratio extracted from the annual report is 37.7% and 34.7% in 2012 and 2011
respectively. This ratio depends upon the diluted EPS of the year prior to the one in which the
dividend is paid.
Problem 11
The Gordon’s dividend growth model is used to calculate intrinsic value per share of the
company using the dividends paid by the company. The equation to calculate the intrinsic value
is as follows:
17

Valuation: The Sherwin-Williams Company
P = D1 / (k - g)
Where, D1 = Projected dividend pay-out in the year 2016
k = Cost of equity/Discount rate
g = Eternity growth rate per year of dividend
The growth rate of 121.42% used to project FCF values is also used to project the dividend value
for 2016. The eternity growth rate of dividend is assumed to be as 1%. The table below shows
the calculation of the intrinsic value using Gordon’s dividend growth model.
Particulars Value
Current Year Dividend ($) 2.68
Growth Rate 121.42%
D1 ($) 5.93
k 8.05%
g 1.00%
Intrinsic Value ($) 84.19
Table 23: Gordon’s Dividend Growth Model
Problem 12
The intrinsic value obtained in problem 7 is $10801 per share and that obtained in problem 11 is
$84.19 per share. The vast difference in both the values is because of the two factors:
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Valuation: The Sherwin-Williams Company
1) The terminal value calculation used in problem 7 considers FCF value in the year 2020
while in the problem 11 the dividend value of the year 2016 is taken. The FCF value per
share in 2020 will be much higher than the dividend value per share in 2016.
2) Gordon’s model does not consider retained earnings into consideration and only
concludes calculation based on the dividends paid to the shareholders. The retained
profits are also used to increase shareholder value by expanding profits.
Problem 13
The table below shows the capital structure of the company. It shows the proportion of book
values of both equity and debt in total capital of the firm.
Particulars Book Value ($ 000) Proportion
Equity 867910 31.13%
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Valuation: The Sherwin-Williams Company
Debt 1920196 68.87%
Total 2788106 100%
Table 24: Capital Structure
The company has debt value twice than that of the equity. It shows that the Sherwin-Williams
company is highly levered. Moody’s investor services downgraded the company’s rating from
A2 to A3 due to significant increase in debt that will arise due to the acquisitions that the
company will make in the year 2016. It will decrease the ability of the company to pay its debt
smoothly due to profits getting diverted for acquisition. The commercial paper rating of the
company were also downgraded from Prime-1 to Prime-2.
Problem 14
The value of β extracted from Yahoo Finance is a levered β. The unlevered β does not involve
debt value into calculation. It only considers volatility of a debt-free firm. The equation to
calculate unlevered value of β is as follows:
βu = βL / (1+ (1- Tc) × (D/E))
Where, Tc = Tax-rate of 35%
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Valuation: The Sherwin-Williams Company
D/E = Debt to Equity Ratio of the Company
The table below shows the calculation for unlevered β value.
Particulars Value
Total Liabilities ($000) 4923945
Shareholders’ Equity ($000) 867910
Debt-Equity Ratio 5.67
βL 1.31
Tax-rate 35%
βU 0.28
Table 25: Unlevered Beta
The cost of equity calculated using unlevered value of β is called unlevered cost of equity. The
table below shows its calculation.
Particulars Value
Risk-free Rate 1.78%
βU 0.28
Market Return 6.56%
Unlevered Cost of Equity 3.12%
Table 26: Unlevered Cost of Equity
21

Valuation: The Sherwin-Williams Company
Problem 15
The value of an unlevered firm is obtained by subtracting the tax shield from the levered firm
value. The tax shield is the product of the interest expense of a firm and the tax-rate. The interest
expense value can be obtained from table 15 which shows the calculation for cost of debt.
Cost of Debt = 3.25%
Outstanding Debt = $1920196000
Interest Expense = $62406370
Tax-rate = 35%
Tax Shield = Interest Expense × Tax-rate
22