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Posted: March 28th, 2021

**Finance Valuation Case – General Electric (GE)**

One of the most basic principles of investing is that, in the long run, investors can do no better than the businesses in which they invest. Common stock represents share ownership in the corporation and entitles the owner to a proportionate share of the company’s earnings, dividends, and/or any proceeds in the event of a merger or dissolution. To make above-normal returns, investors must identify and invest in companies with above-normal business prospects. Moreover, these above-normal prospects must not be recognized in the marketplace and already factored into the company’s stock price.

General Electric Company operates as a digital industrial company worldwide. It operates through Power, Renewable Energy, Oil & Gas, Aviation, Healthcare, Transportation, Lighting, and Capital segments. General Electric Company was founded in 1892 and is headquartered in Boston, Massachusetts.

General Electric’ concerns include a cash shortage, cash flow worries, dividend trimming, being chucked from the Dow Jones Industrial Average, $29.0 billion unfunded pension obligations, a huge debt of $115.0 billion, WMC’s contingent liabilities, the US-China trade conflict, SEC investigations into accounting practices, and the GE Power business fundamentals. Since December 2016, the price per share for GE common stock has fallen from $29.10 per share to around $11.50 per share in September 2018.

RBC Capital Markets analyst Deane Dray said the bear investment thesis gained new momentum after GE disclosed issues with gas turbine fan blades, which drove a 9% stock sell-off, but there are “still a number of shoes to drop.” “The prospects for new charges associated with the fan blade issue have unexpectedly added to GE's already-full plate of looming negatives, including a likely 2018 guidance cut, ongoing SEC and DoJ investigations, potential dividend cut, and price-cost pressures compounded by US-China tariffs and trade war fallout.”

**Case Questions**

Before starting this case, please review **Chapters 5 and 6** in your text (Corporate Finance: Core Principles and Applications).

To get started, **collect at least five (5) years of the most recent historical annual financial statement data AND five (5) years of the most recent annual total return data** (annual dividends plus annual price changes) for **GE stock**. The reason for collecting five years of historical data is to help you form expectations about the future. One (1) year is not enough and 15 years may be too much given that firms change over time. You might also want to consider incorporating any CURRENT news articles and other available public information that you believe could be useful in forming expectations about future cash flows, growth and risk.

**Financial data for GE can be found at:**

**Use the Historical Adjusted Monthly Close (Adj Close*) prices to calculate the realized Annual Total Returns for your firm. The Adj Close* price can be found at:**

Type “**GE**” in the Quote Lookup box

Click on Go

Click on Historical Prices

Click on Monthly

Click on Get Prices

The date shown is the first trading day of the month. All prices, however, are recorded as the last trading day of the month. Hence, the Adj Close* price for Dec 1, 20xx is actually for the last trading day in December for that year. This fact can be checked by changing your search to Daily prices and comparing the prices on the last trading day of any month with those prices shown in the Monthly file.

**Annual Return = [Adj Close* Price December (t) – Adj Close* Price December (t-1)] / Adj Close* Price December (t-1)**

**Example:**

**Annual Total Return for 2018 = [Adj Close* Price December 2018 – Adj Close* Price December 2017] / Adj Close* Price December 2017**

**IMPORTANT:** ***The Adj Close** price for individual stocks in Yahoo.finance is adjusted for dividends and splits, so this price is all that you need to calculate a total return. For the indexes, Yahoo does NOT include dividends.

Using your five (5) years of the most recently published historical financial data (most recent public information) and your five (5) years of the most recent monthly stock market total return data, answer the following questions for **GE**:

**Q1)** Estimate a possible estimate of growth, **g1**, for the first stage of a **Two-Stage (Differential) Growth Dividend Discount Model** by computing the realized average annual historical growth, **g**, of **sales, earnings (net income) and dividends** over the past five (5) years. **Use these actual results to help you form an expectation for g1. Understand that g1 is YOUR EXPECTED growth rate for dividends in the first stage of the Two-Stage DDM.**

**IMPORTANT: Your estimate for g1 need not be positive. Your estimate for g1 can be 0 or negative!**

You should realize by now that your text and most other finance texts ASSUME that the average annual growth of sales, earnings and dividends will be the **SAME AND CONSANT** for the purpose of ** ESTIMATING** value. In the real world, the growth in sales, earnings and dividends will be

**IMPORTANT:** In the DDM, it is the **EXPECTED future growth rate in dividends** that is directly related to share value. The actual number of years that you build into the first stage of your Two-Stage DGDDM is up to you! I would suggest that you keep in simple, however, by making the first stage greater than three (3) years, but less than or equal to ten (10) years.

Now, if you find that the growth in dividends has been rising or falling at a faster rate than earnings (remember that dividends are paid from earnings) then you might want to lower your future growth in dividends in the first stage of the Two-Stage DDM to a level that is more consistent with the growth in earnings. This is something your team needs to discuss. Again, remember that your estimate for g1 need not be positive. I can be 0 or negative!

**KEY LEARNING POINT:** **The purpose here is for you to see that real world valuation requires personal estimates of input variables such as g1, which are uncertain. One thousand analysts can easily arrive at 1000 different estimates!**

**Q2**) **Estimate a possible future terminal (constant growth forever) growth value, g2**, for use in the second or terminal growth stage of the Two-Stage DDM based on your **expected long-term growth in the overall economy (Nominal GDP)**. **Remember, the terminal stage of the Two-Stage DDM is actually the Constant Growth DDM (CGDDM) and ASSUMES an infinite life for the firm!**

Before you decide on your estimate for g in the terminal stage of the Two-Stage DDM, make sure that you read the **Real World insert on page 176 (page number on the bottom of the page) in your text, “How Fast is Too Fast.”** Estimated values for g2 in the terminal stage of the Two-Stage DDM or the value of g in the CGDDM that are greater than 5 or 6 percent can often lead to high valuation estimates – all else constant.

**Q3)** Some investors use a firm’s historical returns as a basis for estimating a required return on equity. Given the extreme drop in value for GE Stock over the past five years, the annual average historical returns for GE stock that you were asked to calculate before answering Q1 may not be a good predictor of future annual returns**. One simple method for estimating a required return on equity for a given firm is to use the YTM + Equity Risk Premium method. That is, to estimate an initial value for R (required return on equity – the appropriate discount rate) by an equity risk premium to the observable YTM on the firm’s long-term bonds. Assuming a 3% equity risk premium for GE, add 3% to the YTM on a GE bond that has at least 20 years to maturity.** If **GE** has a bond that has an even longer term to maturity then use it. Since R is assumed constant forever, use the longest-term **GE** bond that you can find information on. If your firm does not have a 20-year+ bond outstanding, then add 3% to the YTM on a 20-year+ corporate bond with the same bond rating (i.e. A, AA, or AAA). You must find the YTM on your firm’s 20-year+ bond or the YTM on a comparable corporate 20-year+ bond. **Realize that a 20-year corporate bond must have a YTM that is greater than a 20-year Treasury bond.** Again, keep in mind that your R estimates are nothing more than estimates and subject to forecast error. **You will learn more about estimating values for R in Chapter 10. For now, use the YTM + Equity Risk Premium method described above.**

Your estimates for R (the cost of equity) in any DDM should always be greater than the YTM (the cost of long-term deb) on **GE’s** long-term bonds (bonds with 20 years to maturity). This is because the markets generally require, on average, a **3 to 5** percent risk premium on a firm’s required return on equity (cost of equity) over its required return on its own long-term debt (cost of debt). Suppliers of debt capital are paid from the firm’s earnings before interest and taxes (EBIT). Suppliers of equity capital are paid from net income (NI). More specifically, a firm’s equity is riskier than its debt and, therefore, requires a higher cost of capital. Second, when estimating R and g values for the final phase of the DGDDM, which is the CGDDM, realize that you are estimating these g and R values to hold forever!

**Websites for bond information:**

**FINRA Bond Market Data**

**Yahoo Finance:**

**Morningstar**

As you know, **the Constant Growth DDM ASSUMES that R and g** are constant (sustainable) **FOREVER** for the purpose of ESTIMATING value! **For simplicity, assume that R remains constant for GE in both stages of the Two-Stage DDM.** Again, the purpose here is for you to see that real world valuation requires personal estimates of input variables, which can be highly uncertain.

**Q4)** **GE** has been in business for a long time and has exhibited spurts of GROWTH and DECLINE over many historical periods. As such, **a Two-Stage Differential Growth Dividend Discount Model may be a more appropriate valuation model than the Constant Growth Dividend Discount Model (CGDDM).** **LIST** your estimates for **g1, g2** and **R** and **EXPLAIN** (provide a written statement) defending **your choices for g1, g2 and R**.

**KEY LEARNING POINT: After estimating both g1, g2 and R and most likely (I hope!) arriving at a variety of values, you should now have a better understanding of the forecasting risk concept and its effect on valuation estimates.**

**Q5)** Estimate a current fair market price per share for **GE** common stock based on what you learned in **Chapter 6 using a Two-Stage Differential Growth Model (DGDDM – Case 3)**. Realize that you could build a **Multi-Stage** DGDDM with more than two stages, but that this question only requires a Two-Stage DGDDM. **You must decide (form your own opinion about) on the number of first stage finite (unique) growth periods when estimating equity value using the Two-Stage DDM.**

Remember, the final stage of the Two-Stage DDM (terminal value stage) is nothing more than the CGDDM. That is, at some point you must stop trying to estimate unique g and R values that will hold over some finite period and simply assume that g and R will be constant forever. If you do not assume the CGDDM holds at some future point in time, you would spend “forever” discounting unique cash flows to the investors.

**Q6)** Perform **Sensitivity Analysis (SA**) on your estimate for a fair market price per share in by **varying your expected growth rates g1, g2 and discount rate R** by +/- 2.0 percent in .5 percent increments while holding the other parameters (growth or discount rate) constant. That is, vary g1 holding g2 and R constant. Next, vary g2 holding g1 and R constant. Finally, vary R holding g1 and g2 constant. How sensitive are your value estimates to your growth and discount rate estimates**?**

**A simple way to perform SA in Excel is to use the Data Table feature.** Based on your studies in C520, you should know how to use the Data table feature in Excel. If you cannot remember, open Excel, click on Help and look up “Data table.” Do this and you will find a description and instructions like the following:

*“Data tables are part of a suite of commands sometimes called what-if analysis tools. A data table is a range of cells that shows how changing certain values in your formulas affect the results of the formulas. Data tables provide a shortcut for calculating multiple versions in one operation and a way to view and compare the results of all of the different variations together on your worksheet.”*

**Q7)** **COMPARE and CONTRAST** your estimate of fair market value with the current market value. How big of a difference in price do you observe between your estimate and the current market price? Is it significant? Can the difference be explained by small changes in your estimates of g and R? Look at your Sensitivity Analysis results in order to answer this question for **GE**. Get Finance homework help today

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