MPF753 Finance T2 2018: Equity Valuation Using Gordon's Model

This report applies the Gordon's dividend discount model to estimate the cost of equity for three companies: Commonwealth Bank (CBA), BHP Billiton (BHP), and Woolworths Limited (WOW). It analyzes the dividend history of each company over the past ten years, annualizes the dividends considering interest earned on interim dividends, and derives a proxy dividend growth rate. The report then calculates the expected return on equity using the Gordon Dividend Model, taking into account factors such as industry stability, commodity price cycles, and competitive pressures. The analysis includes a discussion of the reasonableness of the derived return on equity in relation to the risk-free rate and specific business risks associated with each company. The report concludes that Woolworths' share price may be overvalued based on the model's findings. Desklib provides access to this and many other solved assignments for students.

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a) The requisite companies for the given task are indicated as follows.
 Commonwealth Bank (CBA) – (Financial Services Sector)
 BHP Billiton (BHP) – (Mining Sector)
 Woolworths Limited (WOW) – (Retail Sector)
For the last ten years i.e. 1st July 2008 to 30th June 2018, the relevant dividend history is
indicated below.
b) It is known that the interim dividends tend to be announced during the year and therefore
the annualised dividends would not only contain final dividend and interim dividend but
also interest earned on the interim dividend. In this case, it is assumed that the interim
dividends have all been given in the middle of year and hence interim dividends would
earn interest over 6 month period approaching the closing of the financial year. These
dividends would be invested at the risk free rate of interest which is 2.64% pa. The

relevant formula for computation of the annualised dividends is highlighted below
(Damodaran, 2015).
The annualised dividends have been computed using the above approach and summarised in
the tabular manner shown below.
c) The aim is to compute the expected next year dividend by deriving the proxy dividend
growth rate on the basis of the annualised dividend outcome that has been obtained in the
above part. The dividend growth rate for the given companies is represented in the tabular
manner shown below.
CWB – It is apparent that the annual rate of change of dividends for the company has been in
a narrow range and has not shown any significant movements on the upside or on the

downside. As a result, it would be prudent to assume the dividend growth rate for the given
company as the annual growth rate observed on average during the period under
consideration. Additionally, from the perspective of the banking industry, this period closely
mirrors a full business cycle considering that 2008-2010, there was impact of the global
financial crisis and since then the banking industry has shown a robust growth to attain
stability (Brealey, Myers and Allen, 2014). The growth rate of dividends would be thus
assumed as 1.33% p.a.
Thus, dividend payable next year = $4.34*1.0133 = $4.39
BHP Billiton- Unlike CWB, the annual dividend growth rate for BHP has shown a significant
variation on either side. To a large extent, this may be attributed to the business model which
is sensitive to commodity prices cycles. During the above period, the prices of certain
commodities saw a sharp fall because of which there was an adverse impact on profit and
thereby dividends were lowered (Arnold, 2015). However, it is noteworthy that the
commodity prices have firmed in the recent years owing to which the profitability has
increased leading to better dividends for the shareholders (BHP, 2016). Since, there is a large
variation, hence the average rate of 8.72% cannot be accepted as the dividend growth rate.
As a result, a period (i.e. 2009-2011) where dividend growth was stable has been selected for
growth rate computation and the resultant growth rate computed is 1.67% p.a.
Thus, dividend payable next year = $2.37*1.0167 = $2.41
Woolworths – Woolworths also has been volatile in relation to annual changes in payment of
dividend which is not surprising taking the difficult times and loss in market share that the
company has witnessing which has led to business restructuring (Woolworths, 2017). The
only period when dividend growth rate was stable corresponds to 2009-2010. Taking the
average, the proxy dividend growth rate is 1.1%
Thus, dividend payable next year = 1.04*1.011 = $1.047
d) The key aim is to calculate the expected return on equity taking into consideration the
Gordon Dividend Model as highlighted below (Damodaran, 2015).

Commonwealth Bank
Price of stock (June 30, 2018) = $ 72.87
Proxy growth rate of dividend = 1.33%
Dividend payable next year = $ 4.39
In accordance with the modern portfolio theory, it is essential that the risk and returns should
be related. The financial services industry is quite stable owing to the presence of a large
domestic consumer base. Additionally, CBA is a big bank and part of the big 4 in Australia
which further lowers down the risk. However, there is high competition amongst these banks
for market share as the industry is largely saturated (Petty et. al., 2015). Taking the above
factors into consideration, the derived return on equity seems quite reasonable given that
2.64% is the risk free rate.
BHP Billiton
Price of stock (June 30, 2018) = $ 33.91
Proxy growth rate of dividend = 1.67%
Dividend payable next year = $ 2.41
The profitability of the company is closing linked to the commodity prices which tend to be
cyclical in nature. The end result is that there is high volatility on the stock on either side
driven by the underlying commodity price trend. Thus, it is obvious that the underlying risks
would be greater in this business in comparison with the financial services business. Also, the
company has a significant exposure to Chinese clients owing to which there is a
concentration risk (BHP, 2016). Some comfort with regards to business risks is provided by
the fact that the company has a global presence in mining assets and has significant financial
strength owing to which it is profitable at the trough of the commodity cycle. Taking the

above factors into consideration, the derived return on equity seems quite reasonable given
that 2.64% is the risk free rate.
Woolworths
Price of stock (June 30, 2018) = $ 30.52
Proxy growth rate of dividend = 1.1%
Dividend payable next year = $ 1.047
Woolworths is one of the largest supermarket chains in Australia. While the company does
have a diverse portfolio of related forays in the retail segment, however, more than 55% of
the company’s business is obtained from the supermarket segment. In this segment, the
company enjoys a virtual duopoly with Coles (Wesfarmers) as the other major player.
However, offlate the industry is experiencing cut throat competition as discount retailers like
Aldi, Costco coupled with online retailers like Amazon are trying to make a foray in this
market. As a result, the retailers are not able to pass on incremental costs to the consumers
and even retailers such as Woolworths are facing pressure on the margins front (Woolworths,
2017). Considering that this cut throat competition is not likely to ease anytime in the near
future, the investment in the company would be considered as risky as despite the high
market share, the profitability is on the decline. However, despite the high risk inherent in
the business, only about 200 basis points is the risk premium when compared to the risk free
rate. Clearly, this is significantly less which clearly highlights that the share price seems to be
overvalued at the given time as the underlying expected returns should be atleast 300-400
basis points higher than the current level.

References
Arnold, G. (2015) Corporate Financial Management. 3rd ed. Sydney: Financial Times
Management.
BHP Billiton (2016), Annual Report 2016, [online] Available at
http://www.bhp.com/-/media/bhp/documents/investors/annual-reports/2016/
bhpbillitonannualreport2016_interactive.pdf (Accessed September 5, 2018)
Brealey, R. A., Myers, S. C., and Allen, F. (2014) Principles of corporate finance, 2nd ed.
New York: McGraw-Hill Inc.
Damodaran, A. (2015). Applied corporate finance: A user’s manual 3rd ed. New York:
Wiley, John & Sons.
Parrino, R. and Kidwell, D. (2014) Fundamentals of Corporate Finance, 3rd ed. London:
Wiley Publications
Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M., & Nguyen, H. (2015).
Financial Management, Principles and Applications, 6th ed.. NSW: Pearson Education, French
Forest Australia
Woolworths (2017) Annual Report 2017, [Online] Available at
https://www.woolworthsgroup.com.au/icms_docs/188795_annual-report-2017.pdf [Accessed
September 5, 2018]