Valuation Using the Gordon Growth Model (2).
As an analyst for a U.S. domestic equity income mutual fund, you are evaluating Connecticut Water Service, Inc. (Nasdaq NMS: CTWS) for possible inclusion in the approved list of investments. Not all countries have traded water utility stocks. In the United States, about 85 percent of the population gets its water from government entities. A group of investor owned water utilities, however, also supplies water to the public. CTWS is the parent company of three regulated water utility companies serving Connecticut and Massachusetts.
Because CTWS operates in a regulated industry providing an important staple to a stable population, you are confident that its future earnings growth should follow its stable historical growth record. CTWS’s return on equity has consistently come in close to the historical median ROE for U.S. businesses of 12.2 percent, reflecting the regulated prices for its product.
Estimated FY2001 and FY2002 EPS are $1.27 and $1.33 according to First Call/Thomson Financial, reflecting 4.7 percent growth. CTWS has a current dividend rate of $0.81. Although CTWS’s dividend payout ratio has been relatively stable (73 percent in 2000, 77 percent in 1999, 75 percent in 1998, 77 percent in 1997, and 78 percent in 1996), you conclude that CTWS has not followed an exact fixed payout dividend policy. CTWS has been conservative in reflecting earnings growth in increased dividends. Your forecast of dividends for FY2002 is $0.83 your nominal annual GDP growth estimate is 4 percent. Compared with a mean dividend payout ratio of 76 percent from 1996 2000, you expect a long term average dividend payout ratio of 70 percent going forward. You anticipate a 3.7 percent long term dividend growth rate. A recent price for CTWS is $30.00. You estimate CTWS’s cost of equity at 6.2 percent.
1. Calculate the Gordon growth model estimate of value for CTWS stock.
2. State whether CTWS appears to be overvalued, fairly valued, or undervalued based on the Gordon growth model estimate of value.
3. Justify the selection of the Gordon growth model for valuing CTWS.
4. CTWS’s beta is 0.16. Calculate the CAPM estimate of the cost of equity for CTWS. (Assume an equity risk premium of 5.7 percent. The risk free rate based on the long term T bond was also 5.7 percent as of the price quotation date.)
5. Calculate the Gordon growth estimate of value using the cost of equity from your answer to Question 4. Assuming that a price earnings ratio (PIE) of 24 based on estimated FY2002 EPS is an approximate guide to value, evaluate whether this Gordon growth estimate is plausible.
6. How does uncertainty in CTWS’s cost of equity affect your confidence in your answer to Question 2?