Valuing a Company Using the General Residual Income Model.
Robert Sumargo, an equity analyst, is considering the valuation of Dell Computer (NYSE: DELL), which closed on 19 April 2002 at $27.34. Sumargo notes that DELL has had very high ROE in the past 10 years and that consensus analyst forecasts for EPS for fiscal years ending in January 2003 and 2004 reflect expected ROEs of 50 percent and 48 percent, respectively. Sumargo xpects that high ROEs may not be sustainable in the future. Sumargo often takes a present value approach to valuation. As of the date of the valuation, DELL does not pay dividends; although a discounted dividend valuation is possible, Sumargo does not feel confident about predicting the date of dividend initiation. He decides to apply the residual income model to value DELL, using the following data and assumptions:
According to the capital asset pricing model (CAPM), DELL has a required rate of return of 14 percent.
DELL’S book value per share at 1 February 2002 was $1.78.
ROE is expected to be 50 percent for fiscal year end January 2003. Because of competitive pressures, Sumargo expects ROE to decline by 2 percent each year thereafter until it reaches the CAPM required rate of return.
DELL does not currently pay a dividend. Sumargo does not expect one to be paid in the foreseeable future, so that all earnings will be reinvested.
1. Compute the value of DELL using the residual income model.
2. After reviewing Sumargo’s valuation, a colleague points out that DELL has been issuing stock options to employees, which are not recorded as an expense, and repurchasing shares on the market to offset the dilutive impact of the stock options. These activities have resulted in a large decline in book value per share in recent years. At the same time, the colleague expects that the diminution of book value per share from the use of employee stock options will continue into the future. Discuss the potential impact on Sumargo’s estimate of value if the colleague is correct.