BUS 365: Investments
Solution to Practice Problems
Stocks
1) You wish to evaluate Diamond Offshore Drilling using the Comps valuation technique.
Information about Diamond and some of its competitors are listed below.
Company
Diamond
Transocean
Global Santa Fe
Nabors
Ensco
Rowan
Helmerich & Payne
Key Energy
Ticker
DO
RIG
GSF
NBR
ESV
RDC
HP
KEG
Price
$20.49
$20.95
$24.13
$36.50
$29.19
$21.42
$28.80
$8.15
Earnings per Share
$1.31
$0.86
$1.50
$2.18
$1.50
$0.80
$2.84
$0.38
Sales per Share
$5.32
$8.77
$8.60
$11.42
$4.87
$6.41
$14.13
$7.49
What is your estimate of Diamond’s value? Does Diamond appear to be overpriced,
underpriced, or properly priced on this basis? What is your recommendation concerning the
purchase or sale of Diamond stock? BRIEFLY justify your recommendation.
Answer:
Company
Ticker Price/Earnings
Price/Sales
Transocean
RIG
24.36
2.39
Global Santa Fe
GSF
16.09
2.81
Nabors
NBR
16.74
3.20
Ensco
ESV
19.46
5.99
Rowan
RDC
26.78
3.34
Helmerich & Payne
HP
10.14
2.04
Key Energy
KEG
21.45
1.09
Average
19.29
2.98
Estimate based on Price/Earnings: 19.29×$1.31 = $25.27
Estimate based on Price/Sales: 2.98×$5.32 = $15.85
Average based on equal weight (a subjective decision) = $20.56
This is very close to the current price, so we probably wouldn’t recommend buying or
selling the stock. Furthermore, we have only looked at a few variables. Before investing in
any company, we would need to do a much more thorough analysis.
2) A company with no excess cash reported the financial statements shown in the problem
statement.
a) What was the free cash flow for the firm in 2007?
Answer:
FCF = EBIT(1-T) – CapEx + D&A - NWC
= $340(1-0.25) - $270 + $110 – (($460-$200)-($420-$120))
= $135
b) Suppose that you believe the firm's free cash flow will grow at 3% per year forever starting
today (in other words, the free cash flow in one year will be 3% higher than your estimate of
the 2007 free cash flow). Suppose further that the company has no preferred stock or ESOs
outstanding. Finally, suppose that the company's WACC is 10%. What is your best estimate
of the value of the firm's equity using the DCF model?
Answer: Vfirm = $1351.03/(0.1-0.03) = $1,986
Vequity = Vfirm-LTD = $1,986 - $600 = $1,386
3) You wish to estimate the value of a stock using the Comps method. Selected financial
information for the company is shown below.
Company Information
Earnings per Share
$5
EBITDA
$2.2 million
Market Value of Long-Term Debt
$10 million
Market Value of Preferred Stock
$8 million
Cash
$2 million
Number of Shares Outstanding
50,000
The industry average P/E ratio is 18.5 and the industry average EV/EBITDA ratio is 9.7.
a) Using earnings as a basis, what is your best estimate of the value of a share of the company’s
stock?
Answer:
V = (P/E)E = 18.5$5 = $92.50
b) Using EBITDA as a basis, what is your best estimate of the value of a share of the
company’s stock?
Answer:
EV = (EV/EBITDA)EBITDA = 9.7$2.2 = $21.34 million
Vequity = EV-LTD-PS+Cash = $21.34-$10-$8+2 = $5.34 million
Value per share = $5,340,000/50,000 = $106.80
4) You wish to estimate the value of a set of peer companies using the Growth-Adjusted Comps
method with Sales as the underlying variable. The current price-to-sales ratio is 7.0 and you
believe that is a reasonable estimate of what it will be in five years. Selected information
(including growth forecasts for the next five years) for the companies is shown below.
Stock
A
B
C
D
Dividend0
$2
$0
$0
$0
Sales Per Share0
$14
$26
$9
$8
Stock Price0
$74
$79
$29
$41
Sales Growth0-5
10%
5%
0%
15%
Cost of Equity
12% 14% 13% 11%
WACC
10%
9%
8%
10%
a) What is your best estimate of the value of a share of each company’s stock?
Answer:
Stock
A
B
C
D
Dividend1
$2.20
$0.00
$0.00
$0.00
Dividend2
$2.42
$0.00
$0.00
$0.00
Dividend3
$2.66
$0.00
$0.00
$0.00
Dividend4
$2.93
$0.00
$0.00
$0.00
Dividend5
$3.22
$0.00
$0.00
$0.00
Sales5
$22.55
$33.18
$9.00
$16.09
Expected Price5
$157.83
$232.28
$63.00
$112.64
Value0
$99.03
$120.64
$34.19
$66.84
% misvaluation
-25.28% -34.52% -15.19% -38.66%
b) Suppose you decide to form a market-neutral portfolio to take advantage of the knowledge
you gained from your analysis. What specific portfolio would you form? BRIEFLY explain
your intuition.
Answer: Stock D appears to be the best buy and Stock C the worst buy, so you would
want to buy D and short C.
c) To the nearest integer, what is the market implied expected price-to-sales ratio (in five
years)? What might you conclude from this?
Answer: Using an expected P/S of 5 gives an average misevaluation very close to zero,
so this is the implied P/S ratio. Since that ratio is less than 7 (the ratio you believe is
appropriate), it is apparent that the market is less optimistic about the future of the
industry. We might conclude that the market has underpriced the industry as a result.
5) You are considering an investment in one of three stocks in a given industry. Information on
those stocks is shown below.
Company
A
B
C
Current sales per share
$2
$3
$4
Last Dividend (just paid)
$0
$0
$1
Expected annual sales growth, next five years
10%
8%
12%
1
0.8
1.2

Current share price
$12
$12
$25
In addition, the risk-free rate is 4.4% and the expected return on the market portfolio is 8.4%.
Finally, you have noted that the historical average price-to-sales ratio for the industry is 5. Based
on this information, which of the three stocks is most likely to be the best buy? Justify your
answer.
Answer: Using the Growth-Adjusted Comps technique, we have the following.
Company
A
B
C
Appropriate Discount Rate
8.40%
7.60%
9.20%
Dividend in 1 Year
Dividend in 2 Years
$0.00
$0.00
$0.00
$0.00
$1.12
$1.25
Dividend in 3 Years
Dividend in 4 Years
Dividend in 5 Years
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$1.40
$1.57
$1.76
Sales per Share in 5 Years
Expected Price in 5 Years
$3.22
$16.11
$4.41
$22.04
$7.05
$35.25
Estimated Stock Value Today
$10.76
$15.28
$28.10
11.52%
-21.47%
-11.02%
% misvaluation
From the table, we see that Stock B appears to be the most undervalued relative to its
peers. It is therefore likely to be the best buy.