I. The Dividend Discount Model Suppose a stock with price P0 pays dividend D1 one year from now, D2 two years from now, and so on, for the rest of time. P0 is then equal to the discounted value of the future dividends: (1) P=D1 + D2 + D3 +L 0 The discount factor, k, is the firm's cost of equity capital and is given by the CAPM's required rate of return for holding the stock: k=Rf +?(RM ?Rf). k is sometimes called the firm's capitalization rate. II. Some Simplifications and Extensions We can simplify equation (1) by assuming that the company pays the same expected dividend forever. For some companies, this is not a bad approximation. Then: P0=D+ D + D +L 1+k (1+k)2 (1+k)3 P0 is simply a perpetuity with cash payment D and discount rate k. Using the formula for perpetuities:
Medtronic Analysis
Company Overview
Medtronic, Inc. is one of the world's leading suppliers of medical technologies used in a variety of therapies and procedures in hospitals, private practice offices, and other medical settings (Medtronic, 2012; Yahoo Finance, 2012). As many of their products, especially some of those that are more profitable to the company, are generally associated with aging and medical conditions that become more common and/or severe with age, the company would seem to be a solid investment in the coming years as the "baby boomer" generation ages (Yahoo Finance, 2012). Determining whether or not this is truly the case requires a financial analysis of the company as well, however. This analysis, broken down into areas of risk, return, and equity valuation, is presented below, with a conclusion providing a summary of the findings and the current advisability of Medtronic, Inc. As an investment opportunity.
Risk
Given the company's strong sales and fiscal performance over the more-than-half-century of its existence, there is relatively little risk associated with this investment, and stock increases (assuming the overall industry/economic environment remains stable) will almost certainly exceed inflation and "risk free" investments (Medtronic, 2012; Yahoo Finance, 2012). Certain indicators within the company do raise some cause for concern, however the stock is priced more attractively than in some time, which further increases the reward potential and reduces the overall risk burden (Medtronic, 2012). Overall, this stock should be considered low-risk.
Return
As stated above, the return on an investment in this company is almost certain to be higher than the rate on "risk-free" investments such as U.S. Treasury bonds, and due to the drop in price now is an especially attractive time to invest in this company from a returns perspective (Yahoo Finance, 2012). Currently trading at a price-to-earnings ratio of under thirteen compared to more than eighteen just three years ago, the expected return on continued ownership of the stock is likely to be substantial (Yahoo Finance, 2012). This is true not only in terms of gains in the stock price and the potential for a split in the not-too-distant future, but also in the regular dividends paid out and the increasing value of the company's earnings and these dividends (Medtronic, 2012; Yahoo Finance, 2012). Given the relatively low risk, the return prospects for this stock are quite attractive from this examination.
Equity Valuation
Though the return on an investment in this company is expected to be fairly attractive, it will not likely yield substantial payouts in the short-term, but rather it is long-term equity in the company that is a truly attractive prospect (Yahoo Finance, 2012). Not only do ongoing an increasing dividend payouts make this ownership attractive, but the value of the company -- recently in decline -- is likely to substantially increase as economic stability returns and the market for the industry increases (Yahoo Finance, 2012). The profit margin for the company remains strong and sales have continued to grow, meaning equity is currently undervalued (Medtronic, 2012).
Summary and Conclusion
The risks of this company are relatively low -- it has high liquidity, strong sales and a substantial profit margin, meaning it is very unlikely that an investment would be lost or fail to return a rate at least equal to that of a risk-free investment, and probably much higher. Returns in general are expected to be much higher than risk-free investments over the long-term, and even short-term dividend payouts will start to generate a significant return in the short-term. The equity valuation of the company is thus fairly high, especially given the relatively low cost of equity in the current market. The drop in the price-to-earnings ratio that occurred over the past several years combined with the increased revenue that the firm shows and its higher profit margin offset the slightly reduced current ratio, making a long-term investment in this company quite valuable. In all three interrelated areas considered above, Medtronic, Inc. appears to be a very solid investment opportunity.
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