NEWSWIRE - January 17, 2000

Topic: The Role of Expectations in Stock Valuation

Source: "Street Seeks Real Thing on Coke Outlook," by Betsy McKay, The Wall Street Journal, January 17, 2000, pages C1-C2.

Synopsis: Coca-Cola has experienced considerable volatility and poor stock performance over the past two years. This follows a lengthy period of robust growth in sales, earnings, and stock value. This article details the role that analyst’s expectations play in the valuation process. It also underscores the importance of management credibility. Typically, we see the role of expectations in valuation when a firm releases earnings figures that are materially above or below the market’s (analysts’) expectations. The value of the firm’s stock adjusts rapidly, evidence that markets are highly efficient at incorporating new information into prices. However, Coca-Cola raises a different issue. Their new chairman has affirmed growth targets of 7% to 8% in sales volume and 15% to 20% in earnings per share (EPS). Many analysts simply don’t think that this is realistic. Without a credible forecast from management, analysts are uncertain how to value Coke’s stock.

Discussion Questions:

1. Why are expectations so important in the valuation of stock? Why shouldn’t analysts accept the growth forecasts provided by Coca-Cola’s management?
2. If we accept management’s estimates of EPS growth and assume that Coke’s payout ratio remains the same, estimate the stock’s expected rate of return. Coke’s price is $61.4375 and its dividend is $0.62 over the past year.
3. Suppose investors require an 18% return for a security with the risk level of Coke. Using the constant dividend growth model, estimate the intrinsic value of the stock assuming a 15% to 20% growth in dividends in 1% increments. What can you say about the market’s assessment of dividend growth for Coke?
4. How can an estimated growth in sales of 7% to 8% translate into an estimate of 15% to 20% in EPS growth?

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