Level II Equities item sets

Hannah Lindqvist is an equity analyst at Corvid Research, an independent research firm whose clients are mainly long-only fund managers. She has just taken over coverage of Aldgate Software, a listed provider of payroll and accounting software for small businesses. Aldgate Software sells its products on annual subscriptions, has no debt and pays a regular dividend.

Lindqvist's predecessor valued Aldgate Software with a dividend discount model. Lindqvist prefers a residual income model for this company. She explains to her clients that most of the value in a dividend model for Aldgate Software comes from the terminal value, many years in the future, whereas a residual income model recognises value earlier because it starts from the current book value of equity. She also notes that the company's accounting is straightforward: it capitalises little of its development spending, has no significant off-balance-sheet items and reports few items directly in other comprehensive income, so she does not need to make large adjustments to book value or earnings.

Exhibit 1 shows Lindqvist's inputs. She expects Aldgate Software to earn a constant return on equity on beginning-of-year book value and to retain a constant share of its earnings, paying out the remainder as dividends. On that basis, book value, earnings and residual income would all grow at the same constant rate. She estimates the required return on equity using a capital asset pricing model with inputs that she has checked against those of other analysts, and she considers the estimate reasonable.

Lindqvist first wants to confirm the residual income Aldgate Software is expected to earn in the coming year. She then plans to value the shares with a single-stage residual income model, using the inputs in Exhibit 1. A colleague at Corvid Research points out that the single-stage model assumes the return on equity and growth rate continue indefinitely, which is a strong assumption for a software company. Lindqvist accepts the point but uses the single-stage model as a starting estimate before building a more detailed multistage model.

Aldgate Software's shares currently trade at $40.00. Rather than simply comparing her estimate with the market price, Lindqvist wants to know what the market price implies about the growth rate of residual income, holding her estimates of return on equity, the required return and current book value unchanged. She thinks this will help her explain to clients whether the market is more or less optimistic than she is.

For her multistage model, Lindqvist must decide how residual income will behave after an explicit five-year forecast period. She expects Aldgate Software's return on equity to stay above its cost of equity for some years, because customers rarely switch payroll providers once their staff and data are set up on a system. However, she also expects several larger software companies to enter the small-business market, and she thinks price competition will gradually reduce the company's return on equity towards the cost of equity over the following decade. She does not expect return on equity to fall below the cost of equity.

Before finalising her inputs, Lindqvist compares Aldgate Software's return on equity with those of three listed competitors. Two of them earn returns on equity close to their estimated costs of equity, and one, which has a larger share of the market, earns a return several percentage points higher. She concludes that Aldgate Software's current excess return is plausible for a company of its size and customer base, but that it would be unrealistic to assume it widens from here.

Lindqvist plans to publish both the single-stage and multistage estimates in her initiation report, together with a table showing how the single-stage value changes for different growth rates and required returns.