FOFM - TUTORIAL 9

Case Study: Aether Systems

Common Stock Valuation: Dividend Growth Model

It seems the whole world is going wireless. On the shuttle bus from SFO airport to my hotel downtown, I
couldn't help but overhear an attorney discuss his legal strategy. First he called his office on his cell phone
to see if a settlement offer had been reached. Then he pulled out his Palm Pilot to log the next sequence
of motions to be filed.
Not wanting to seem nosey, I busied myself by tracking the latest stock performance within my portfolio
via PocketBroker, a hand-held wireless investment service through Charles Schwab. With my RIM
(Research in Motion) 950, I can access my account, download the latest quotes and even execute trades
all while being driven on Highway 101. With my TradeStation 2000 technical analysis based automated
software package, I was able to identify several sell signals and lock in a hefty profit all before arriving at
my hotel. The shuttle driver used his antenna to obtain my credit card approval and I was off to my
meeting.
If you think only business people use wireless technology to this extent, think again. On board the USS
McFaul, Naval crew members are now able to move freely throughout the ship while sending vital
information back and forth over their wireless Palm handheld devices. Not only does the mobility directly
translate into greater efficiency, but the need to keep extensive paper records and hold clipboards is a way
of the past.
The Wake Forest University School of Medicine uses wireless handheld devices not only to track patient
records, but update them as well. Updated records are automatically sent back to the central computer via
the system's intranet. Aether Systems, Inc., is the firm responsible for many of these advancements. Their
commitment to increasing mobility, productivity, and efficiency has allowed them to grow at an
exponential rate.
Your task is to determine, using the discounted cash flow method, whether or not Aether is fairly, over-, or
under-valued. To complicate matters, since the firm only came into existence in 1998 and because they
are growth oriented, they have yet to pay a dividend and do not plan to do so in the short to intermediate
run.
Instead, Aether will only begin to pay a dividend 10 years from now. The expected annualized dividend at
the end of year 10 will be $2.50 per share. This dividend is expected to grow at a rate of 9% over the next
5 years and will then taper off to a steady 4%, a rate at which it is assumed to grow forever. Answer the
following questions using a discount rate of 13%.
Questions
1.

Calculate the dividends over the first growth stage.

2.

Using the Gordon Growth Model, calculate the value of all remaining dividends at time 15.

3.

Calculate the present value (at time 0) of ALL future dividends.

4.

Assuming Aether was currently trading at $10 per share, what would be your long-term
recommendation for this stock: buy, sell, or hold?

CASE Solution

Case : Aether Systems

Purpose: The purpose of this case is to have students work through the Variable Growth Model. Along
the way, they will have to use the Gordon Growth Model. An additional wrinkle is thrown in here.
The stream of dividends will not start right way.
1. Starting with the dividend of $2.50, simply multiply by (1 + i) n
t = 10 $2.50(1.09)0 = $2.50

t = 11 $2.50(1.09)1 = $2.73
t = 12
t = 13
t = 14
t = 15

$2.50(1.09)2 = $2.97
$2.50(1.09)3 = $3.24
$2.50(1.09)4 = $3.53
$2.50(1.09)5 = $3.85

2. $3.85(1.04)/(.13-.04) = $44.45. This represents the present value equivalent at time t = 15 of all the
dividends starting at time t = 16 and going through to infinity.
3. Discounting all 6 amounts, then adding them together yields a (t = 0) stock price of $11.17.
$2.50 /(1.13)10 = $0.74
$2.73 /(1.13)11 = $0.71
$2.97 /(1.13)12 = $0.69
$3.24 /(1.13)13 = $0.66
$3.53 /(1.13)14 = $0.64
$3.85 /(1.13)15 = $0.62
$44.45/(1.13)15 = $7.11
$11.17
4. Since the intrinsic value of $11.17 is greater than the market price of $10, this represents a buy
signal. Shares should be purchased up until the point where the present value of the dividends is
exactly equal to the trading price of the stock.