Peter Tanner Case Scenario
Peter Tanner recently accepted a position as a domestic equity analyst with a large US pension fund. The fund uses a bottom-up team approach to stock selection. The fund’s equity manager, Cindy Bradley, is responsible for the results of the domestic equity portfolio.
Tanner’s first assignment is to evaluate a packaged foods company, GreenSnacks, Inc. (GNSK), which trades on the NASDAQ at a current price of $21.875 per share. His analysis is to include a long-term outlook for the company in the context of the well-established packaged foods industry, which is dominated by several large companies in the United States.
The major players compete vigorously for market share. The industry has been growing at a rate very similar to that of GDP for many years. GNSK competes in the rapidly growing health food category, which has been gaining about 1%–2% of relative share per year within the broader packaged foods industry because of external factors, such as changes in social preference and an aging population.
Originally a spin-off from one of the industry’s key players, GNSK has shown promising growth for the past few years because of a new and bold new patented process it developed to enhance the preservation, packaging, and distribution of fruity snacks. GNSK expects to face little competition for the next few years. The combination of its efforts has allowed GNSK to create products that maintain a fresh taste without preservatives and with a shelf-life much longer than the established products of the leading brands.
Although the healthy snack category has been gaining market share rapidly because of social changes, GNSK was not able to break through the established shelf-space barrier controlled by the large competitors until its new process was perfected. As national chains begin to pick up the product line, GNSK is experiencing substantial market share gains and accelerating sales, although prices are lower than desired due to the size of the aggressive buying practices of supermarkets. The outlook for the company’s future sales growth exceeds 17%, and profit margins are increasing well beyond the levels of competitors.
Tanner expects short-term rapid earnings growth of 20% in 2018 for GNSK, with the rate of growth linearly diminishing over the next five years to match industry conditions thereafter. He assumes that starting in Year 6, GNSK’s long-term dividend growth rate will be equal to the current level of sustainable growth rate for the industry. Given these assumptions and the data in Exhibit 1, Tanner decides to use the H-model for valuing GNSK’s stock.
Exhibit 1
Selected Financial Information for the Fiscal Year Ending 31 December 2017
GNSKIndustry AverageReturn on equity (%)23.112.8Earnings per share (EPS) 2017 ($)2.45n/aDividend payout ratio 2017 (%)2565Required return (%)n/a11Trailing dividend yield (%)2.83.7
Note: n/a indicates not available.
Tanner meets with Bradley for her advice. Bradley states that the industry growth rate may be slower than that of GNSK because the packaged foods industry is mature and stable. She suggests that Tanner calculate the implied long-term dividend growth rate for GNSK using the Gordon growth model. Furthermore, Bradley believes that the required return and dividend yield for the industry are the most stable indicators and should be used in the valuation computations.
Bradley suggests that Tanner also analyze the investment appeal of industry peer Star Cakes (STCK). She provides the following data and assumptions for STCK:
- The company paid a dividend of $2.48 last year.
- Its earnings are dropping about 2% every year permanently.
- I assign a required return of 7.4% for this company due to its low beta.
As they continued their discussion, the following additional points were made about alternative dividend valuation methods:
- “Free cash flow valuation is especially appropriate for investors who want to take a control perspective in takeovers. Also, free cash flow to equity is the cash flow available to be distributed to shareholders without impairing the company’s value.”
- “Remember that the Gordon growth model is based on indefinitely extending future dividends, and the intrinsic value derived by the model is very sensitive to small changes in the assumed growth rate and required rate of return.”
- “You can use the residual income approach as well, a simpler model that does not require holding of clean surplus relation, and the valuation is not impacted by book values.”
Tanner prepares a list of issues he needs to consider and begins his analysis for his report.
Question
Using Bradley’s assumptions regarding GNSK and the data from Exhibit 1, GNSK’s implied long-term dividend growth rate is closest to:
- 8.0%.
- 7.0%.
7.3%.
