Constant Growth DDM Assignment: Utility Company
This is assignment #2. What I want is for students to find a utility company that operates in a area of the country with low growth potential. The constant growth model implicitly assumes that a company will grow at the same rate in perpetuity. Therefore, choosing a utility provider in an area with fast growth doesn’t make sense for this model.
The DDM Constant growth model (dividend discount model):
P0 = D1 / (Rs – g)
In this model, dividends are a proxy for the cash flow available to equity holders. This is another reason I want you to analyze a utility company. Most utility providers pay out a substantial portion of their cash flows to shareholders as dividends.
Step 1: Open an Excel spreadsheet. This time you will be uploading this spreadsheet to when you submit the assignment.
Step 2: Use your Google skills to find an area of the country experiencing slow growth. I used West Virginia in my class example so you must use a different state/region. Next, use another Google search to find publicly traded utility providers in that state/region and select one. It could be an electric utility, water utility, gas utility, etc. Label a cell on the spreadsheet “State / Region:” and to the right of that input the state / region you have chosen to find a publicly traded utility provider. Under that, label a cell “Industry:” and input the industry that you have chosen, such as General Utilities, Utilities: Electricity, etc… Next, label a cell “Company:” and input the name of the company you have chosen. Last, label a cell “Ticker” and input next to it the ticker symbol of your utility company.
Step 3: Collect the data that is necessary for us to value this company. Remember, we are using a single stage, constant growth, DDM. This means we only need to find 3 variables. We need the expected dividend next period, D1, the cost of equity, and an estimate for the company’s constant growth rate. Similar to above, fill out a space on your spreadsheet with labels for these three inputs.
Step 4: Even though we have not yet learned about each of the variables that come together to give us the cost of equity (Rs), I want you to go ahead and calculate it for this valuation using the Capital Asset Pricing Model. Create another section on your spreadsheet with labels for the items we need to solve for the cost of equity (beta, risk free rate, market risk premium).
Using the CAPM:
Rs = Risk Free Rate + Beta * Market Risk Premium
Step 5: This is our final step in setting up our spreadsheet. Create one more label on your spreadsheet for our valuation. Label it “Estimated Value (P0)”.
Step 6: We now need to find each of the variables we have listed / labeled on our spreadsheet. Here is where this information can be located for my valuation of Dominion Energy, Inc. Some of these items will be the same for you, such as constant growth rate, risk free rate, and market risk premium, but your valuation will have different values for dividend next period and beta.
The following two variables can be found on the same page (links and screenshot below):
Dividend Next Period: https://finance.yahoo.com/quote/D?p=D
Beta: https://finance.yahoo.com/quote/D?p=D
Often we will use the 10 year US Treasury rate as our estimate of a long-run growth rate for a company’s cash flows. However, in this case we are going to use the 30 year US Treasury yield. We will discuss when it makes sense to use each later in the class.
Constant Growth Rate (g): https://finance.yahoo.com/quote/%5ETYX/?p=%5ETYX
The 30 Year US Treasury yield is quoted as 1.3750. This translates to a yield of 1.3750%.
In this case, we will also use the 30 year US Treasury yield for our estimate of the current risk free rate. Again, we will not always use the 30 year US Treasury yield for our estimate of the risk free rate. We will discuss this in further detail later in the class and how to choose the best estimate when performing valuations.
Risk Free Rate: https://finance.yahoo.com/quote/%5ETYX/?p=%5ETYX
Later in the class we will also discuss the calculation of the Market Risk Premium, what it is, what it means, how to interpret it, and how to calculate a market implied estimate of it on our own. However, for this assignment I would like you to use the estimate maintained by the author of our textbook. We will use the Implied ERP as of September 1, 2020 of 5.00%.
Step 7: After inputting the variables into your spreadsheet you should now have the information necessary to calculate the cost of equity (Rs) and the Expected Value (P0) of the stock. You can use your Excel skills and the formulas listed above in these instructions to solve for both of these items. Make sure to always link cells in your formulas. Never hardcode cells unless you absolutely have to. This is the number 1 rule of financial modeling.
Below (on the next page) you will find the results of my valuation. The first screenshot shows the final DDM model. In the second screenshot I have instructed Excel to “Show Formulas” and you can see where I used formulas and where I did not. How can you tell if a cell has a formula in it, the font is in black. The blue fonts show where you needed to manually type in an input. The black font shows a cell that was calculated with a formula. Color coding a spreadsheet in this manner is also an Excel best practice for financial modeling.
Once you have completed the model and arrived at an estimate for the company’s value, please save your Excel workbook and upload it to the assignment.
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