Solutions for Chapter 9: Questions and Problems
CHAPTER 9
COMPANY ANALYSIS AND STOCK VALUATION
Answers to Questions
1.
Examples of growth companies would firms that have experienced very high rates of
return on total assets and returns on equity when compared to market values. They retain
high percentages of earnings to fund superior investment projects. For example, in past
years Google, Intel and Microsoft have been considered growth stocks since their P/E
ratios were above the industry average.
2.
A cyclical stock would be any stock with a high beta value. Examples of high beta stock
would include stocks of typical growth companies and some investment firms. As to
whether the issuing company is a cyclical company will depend on the specific selection.
3.
The biotechnology firm may be considered a growth company because (1) it has a growth
rate of 21% per year which well exceeds the growth rate of the overall economy, (2) it
has a very high return on equity and (3) it has a relatively high retention rate. However,
since a biotechnology firm relies heavily on continuous research and development, the
above-average risk will require a high rate of return. Therefore, it is unlikely that the
stock would be considered a growth stock due to the extremely high price of the stock
relative to its earnings.
4.
Student Exercise
5.
Student Exercise
6.
Student Exercise
7.
Student Exercise
8.
The DDM assumes that (1) dividends grow at a constant rate, (2) the constant growth rate
will continue for an infinite period, and (3) the required rate of return (k) is greater than
the infinite growth rate (g). Therefore, the infinite period DDM cannot be applied to the
valuation of stock for growth companies because the high growth of earnings for the
growth company is inconsistent with the assumptions of the infinite period constant
growth DDM model. A company cannot permanently maintain a growth rate higher than
its required rate of return, because competition will eventually enter this apparently
lucrative business, which will reduce the firm’s profit margins and therefore its ROE and
growth rate. Therefore, after a few years of exceptional growth (a period of temporary
supernormal growth) a firm’s growth rate is expected to decline. Eventually its growth
rate is expected to stabilize at a constant level consistent with the assumptions of the
infinite period.
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Solutions for Chapter 9: Questions and Problems
9.
Price/Book Value (P/BV) is used as a measure of relative value because, in theory,
market price (P) should reflect book value (BV). In practice, the two can differ
dramatically. Price reflects forward-looking market expectations for the firm and book
value may contain historical costs with little relation to current economic value or
potential. Some researchers have suggested that firms with low P/BV ratios tend to
outperform those with high P/BV ratios.
10.
A high P/BV ratio such as 3.0 can result from a large amount of fixed assets being carried
at historical cost. A low ratio, such as 0.6, can occur when assets are worth less than book
value, for instance, bad real estate loans by banks.
11.
The price/cash flow ratio (P/CF) has become more popular because of the increased
emphasis on cash by various analysts and because of the increased availability of cash
flow numbers. Differences could result from differences in net income or non-cash items.
Similar to P/E estimates derived from dividend growth models, P/CF ratios can differ
between firms due to perceived differences growth and risk.
12.
Price/sales ratio varies dramatically by industry. For example, the sales per share for
retail firms are typically higher than sales per share for technology firms. The reason for
this difference is related to the second consideration, the profit margin on sales. The retail
firms have high sales per share, which will cause a low P/S ratio, which is considered
good until one realizes that these firms have low net profit margins and possibly less
potential growth than a technology firm.
13.
The major components of EVA include the firm’s net operating profit less adjusted taxes
(NOPLAT) and its total cost of capital (in dollars) including the cost of equity. A positive
EVA implies that NOPLAT exceeds the cost of capital and that value has been added for
shareholders.
14.
Absolute EVA makes it difficult to judge whether a firm is succeeding relative to past
performance or if the growth rate can support additional capital. To overcome those
shortcomings and to facilitate the comparison of firms of different size, it is preferable to
compute an EVA return on capital ratio: EVA/Capital.
15.
While the EVA measures a firm’s internal performance, the MVA reflects the market’s
judgment of how well the firm performed in terms of the market value of debt and equity
vis-a-vis the capital invested in it. Since the latter measure is affected by external factors
such as interest rates, it is not surprising that the EVA and MVA share a weak
relationship.
16.
The two factors that determine a firm’s franchise value are (1) the difference between the
expected return on new opportunities and the current cost of equity and (2) the size of
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Solutions for Chapter 9: Questions and Problems
those new opportunities relative to the firm's current size. In the absence of a franchise
value, an equity cost of 11% would translate into a (base) P/E ratio of 9.1 (or 1/.11).
17.
Above average earnings growth is a characteristic of a growth company. Additionally, a
rather high retention rate of 80% implies that the firm will have the resources to take
advantage of high-return investment opportunities. These factors lend support to
classifying the firm as a growth company. However, as a result of the high retention rate,
investors will continue to require a high return on investment. Only if the firm can
continue to achieve returns above its cost of capital will the firm continue to be classified
as a growth company.
18.
In a perfectly competitive economy, if other companies see a particular firm achieving
returns consistently above risk-based expectations, it is expected that these other
companies will enter that particular industry or market and eventually drive prices down
until the returns are consistent with the inherent risk. In other words, the competition
would not allow the continuing existence of excess return investments and so competition
would negate such growth. The computer industry is a good example of increased
competition resulting in lower profit margins. The theory implies that in truly competitive
environments, a true growth company is a temporary classification.
19.
Because the dividend model assumes a constant rate of growth for an infinite time period,
the point is that a true growth company is earning a rate of return above its cost of capital
and this should not be possible in a competitive environment. Therefore, it is impossible
for a true growth firm to exist for an infinite time period in a purely competitive
environment. Changes in non-competitive factors, as well as changes in technology will
tend to cause various growth patterns. Therefore, we will consider special valuation
models that allow for finite periods of abnormal growth and for the possibility of
different rates of growth.
20.
The growth duration model attempts to compute the implied growth duration for a growth
firm given differential past growth rates for the market and for the firm and also
alternative P/E ratios. These major assumptions of the model are: (1) equal risk between
the securities compared; (2) no significant differences in the payout ratio of different
firms; and (3) the stock with the higher P/E ratio has the higher growth rate. While the
assumption of equal risk may be acceptable when comparing two larger, well-established
firms to each other or to a market proxy, it is probably not a valid assumption when
comparing a small firm to the aggregate market. Likewise, the assumption of no
significant differences in payout ratios could present a problem. For example, many
growth firms have low initial payout ratios in order to use retained earnings for future
investment projects. It might be inappropriate to compare a well-established company
with a new start-up firm on the basis of an equal payout ratio. Finally, while the model
assumes that the stock with the higher P/E ratios has the higher growth rate, in many
cases you will find that this is not true.
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Solutions for Chapter 9: Questions and Problems
21.
The projected growth rate for the company (11.3%) is above that of the market and the
growth company also has a higher P/E ratio than the aggregate market. It would be
necessary to investigate the company further to determine if the firm’s stock is a growth
stock. It is still necessary to estimate the average payout ratio and the ROE and its
components for both the firm and the aggregate market in order to make a proper
comparison of the growth company to the aggregate market. This should help you
determine if it is currently a true growth company and if this performance can be
sustained.
Shoppers seems to illustrate “simple long-run growth” since r>k and b>0. Its failure to
observe a constant retention rate precludes “dynamic growth”.
22.
Magna in recent years is likely an example of negative growth due to declining market
share and stock price.
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Solutions for Chapter 9: Questions and Problems
CHAPTER 9
Answers to Problems
1.
Student Exercise
2.
Student Exercise
3(a).
RMagoo = .07 + 1.75(.15 - .07) = .07 + .14 = .21 or 21%
3(b).
RMagoo = .07 + 1.75(.10 - .07) = .07 + .0525 = .1225 or 12.25%
4.
Student Exercise
5.
Present Value common stock =(2,000 × 3)/(0.10-0.066) × 1/(1.1)3 = $132,584
Present Value of Real Estate Investment
Year
Cash Flow
PV @ 14%
1
$38,155
33,469
2
$48,020
36,950
3
$92,100
62,165
total
132,584
Both investments have the same value so the investor should be indifferent to either.
The investor will have to decide which one they would prefer, based on their inherent
risks.
6.
$27.86 = $2(1+g)/(0.12-g)
Rearranging g = 4.5%
7.
g = RR × R.O.E. in year 11 the growth rate will be 0.3*20% = 6%
Constant growth period value10
= 4.00/(0.20 - 0.06) = 28.57
PV @ 20% = $4.61
8.
g = RR * R.O.E.
Years one, two, three g = 0.25, RR = 0.25/0.30 = 0.833
four, five g = 0.20, RR = 0.20/0.30 = 0.667
six and beyond g = 0.10, RR = 0.10/0.30 = 0.333
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Solutions for Chapter 9: Questions and Problems
0
1
2
3
4
5
6
25
25
25
20
20
10
2
2.5
3.125
3.75
4.5
4.95
PAYOUT RATIO
0.167
0.167
0.167
0.333
0.333
0.667
DIVIDEND
0.33
0.42
0.52
1.25
1.4985
0.29
0.33
0.37
0.79
0.85
GROWTH
EPS
1.6
PV DIVIDEND
0
Constant growth period value5
3.30
= 3.30/(0.12 - 0.10) = 165
PV @ 12% = 93.63
Maximum price = 0.29 + 0.33 + 0.37 + 0.79 + 0.85 + 93.63 = 96.25
9(a)
ROE = Profit Margin × Asset Turnover × Financial Leverage
ROE = (Net Income/Revenue) × (Revenue/Assets) × (Assets/Equity)
ROE20x1= 447/5750 × 5750/2300 × 2300/1360
7.7% × 2.5 × 1.69
= 32.83%
ROE20x2= 467/6140 × 6140/2692 × 2692/1725
7.61% × 2.28 × 1.56
= 27.07%
9(b)
Sustainable Growth = ROE × Retention Ratio (RR)
No mention of new equity issue so dividends paid = old retained earnings + net income –
new retained earnings
Dividends paid = 1,360 + 467 – 1,725 = 102
Dividends per share = 102/245 = $0.4163
so RR= 1 – Dividend payout ratio = 1 - .4163/1.91 = 0.782
g=
9(c). i.
ii.
iii.
27.02% × 0.782 =21.17%
Increased leverage to improve production can improve the ROE (leverage ratio
increases as does TATO). Effect on SGR is positive.
Increasing long term debt to reduce accounts payable will have no effect on ROE or
the SGR
Increasing the dividend affects the retention rate and will lower the SGR
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Solutions for Chapter 9: Questions and Problems
9(d)
FCFF for 20X2:
Earnings after tax
Plus: Amortization expense
Less: Capital expenditures
Less: Increase in NWC
Equals: FCFF
/ number of shares
Equals: FCFF per share
=
=
=
=
=
=
=
553 million
134
254
245
208 million
245 million
$0.849
At the given dividend payout ratio, FCFF equals the dividends paid.
9(e).
Growth rate (g)
FCFF
20X3
20X4
20X5
20X6
20%
1.019
20%
1.223
20%
1.468
14%
1.674
1.019
1.223
1.674/(.16-.14)
83.70
85.168
0.909
54.56
Terminal value
Total FCFF
Discounted value
0.878
Current value per share = 0.878 + 0.909 + 54.56 = 56.35
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=