B8110, Fall 2009
Solution to Practice Exercise Set 1
Exercise 1.
Cash Flow and Earnings: Kimberly-Clark Corporation
Part a.
Adjust cash flow from operations for after-tax net interest payments and cash investment
for net investments in interest-bearing assets:
Cash flow from operations reported
Interest paid
Interest income
Net interest
Tax on net interest (at 35.6%)
$2,969.6
$175.3
(17.9)
157.4
56.0
Cash flow from operations
Cash flow from investing reported
Net investment in debt securities (38) + 11.5
Net investment in time deposits
101.4
$3,071.0
$(495.4)
( 26.5)
22.9
Free cash flow
(499.0)
$2,572.0
Note: As cash interest receipts are not reported (as is usual), use interest income from the
income statement.
Part b.
Accruals = Net income – Cash flow from operations
= $1,800.2 – 2,969.6
= $(1,169.4)
Exercise 2. Challenging the Level of the S&P 500 Index with Analysts’ Forecasts
The required return = risk free rate + risk premium
= 5% + 5%
= 10%
To develop the pro forma for the implied growth rate, first apply the forward P/E ratio to
get an earnings forecast for 2006, then convert the PEG ratio to an earnings forecast for
2007:
Forward P/E = Price/Earnings2006
Treat the 1271 as dollars to get earnings in dollars:
$1,271/Earnings2006 = 15
Thus Earnings2006 = $84.73
PEG =
Forward P / E
= 1.47
Growth Rate for 2007
Thus, for a forward P/E of 15, the 2007 growth rate for 2007 earnings is 10.2%.
Thus, 2007 earnings forecasted is $84.73 × 1.102 = $93.37
a. The pro forma to calculate abnormal earnings growth (AEG) is as follows:
Earnings
Dividends (payout = 27%)
Reinvested dividends (at 10%)
Cum-dividend earnings
Normal earnings ($84.73 x 1.10)
AEG
2003
2004
84.73
22.88
93.37
2.288
95.658
93.203
2.455
b. If cum-dividend earnings are expected to grow at the required rate of return, 10%, after
2006, the P/E should be normal:
P/E =
1
= 10
0.10
At this P/E, the index should be $84.73 × 10 = 847.3
The normal P/E is appropriate if (cum-dividend) earnings are expected to grow at a rate
equal to the required return, 10%. The P/E based on analysts forecast (15) is higher than
this because the market sees earnings growing at a higher rate. Is this assessment
reasonable?
c. Applying the abnormal earnings growth (AEG) pricing model with the long-term
growth rate for AEG of 4%:
V 
1 
2.455 
84.73 

0.10 
1.10  1.04 
= 1256
d. The S&P 500 index is appropriately priced (approximately) at 1271. This will not
always be the case. The estimated level can different from the actual level for a number
of reasons:
1. Analysts’ forecasts are too optimistic relative to how the rest of the market sees it.
2. The market agrees with analysts’ forecasts for 2006 and 2007, but sees the longterm growth rate at less than 4%.
3. The market requires a higher or lower required return than 10%.
4. The market is mispriced.
With respect to point 1, sell-side analysts’ forecasts are often overly optimistic,
particularly two-year ahead forecasts on which the AEG is calculated.
This exercise is dangerous when both the market and analysts are too optimistic (as in the
bubble). Then you have to challenge the price with your own forecasts. Notice that the
next exercise works with actual earnings numbers, not analysts’ forecasts.
Exercise 3. Reverse Engineering the S&P 500 Index Using Book Rates of Return
(a)
With a P/B ratio is 2.5, investors are paying $2.50 for every dollar of book value in the
S&P 500 companies. With an ROCE of 18%, the current residual earnings on a dollar of
book value is:
RE0 = (0.18 – 0.10)  1.0
= 0.08
That is, 8 cents per dollar of book value. The value of an asset (with a constant growth
rate is mind) is calculated as:
V 0  B0 
RE 0  g
g
(One always capitalizes the one-year-ahead amount, which is the current residual
earnings, RE0, growing one year at 10%.) So, for every dollar of book value worth $2.50,
2.50  1.0 
0.08  g
1.10  g
Solving for g,
g = 1.044 (a 4.4% growth rate)
A good benchmark growth rate for the market as a whole is the GDP growth rate. This
has historically been an average of about 4.0%. So, if history is an indication of the
future, a 4.4 % implied growth rate suggests that the S&P 500 stocks, as a portfolio, are a
little overpriced.
What does a growth rate of 4.4% for residual earnings mean? If the S&P 500
firms can maintain an ROCE of 18%, then investment in net assets must grow by 4.4%.
Alternatively, if ROCE were to improve, a growth in residual earnings of 4.4% can be
maintained with a lower growth rate. Is a 4.4% growth rate for residual earnings
reasonable? What is the prospect for ROCE for the market as a whole? Is the market
appropriately priced?
(Analysis in Module II of the course will help answer these questions.)
(b)
See the last paragraph. With a constant ROCE, the growth in residual earnings is
determined by the growth in net assets (book value). Remember, residual earnings is
driven by two factors:
1. Profitability of net assets: ROCE
2. Growth in net assets
(c)
For all U.S. listed firms, the historical (arithmetic) average ROCE (since 1960) has been
10.3% and the median ROCE has been 12.5%. Since 1977, the average ROCE for the
S&P 500 (a weighted average of the 500 stocks in the index) has been about 17%, but it
was 14% in 1983 and again in 1987, and 20% in 1999.
(d)
See Figure 2.2 on page 44 of the text. Since 1977, the P/B ratio for the S&P 500 (a
weighted average of the 500 stocks in the index) has been about 2.8, but it was 1.2 in
1981 and 5.1 in early 2000.
Exercise 4. Forecasting from market prices: Cisco Systems
a. Book value of shareholders’ equity (from the 2003 balance sheet) = $28,029
million
Shares outstanding = 6,998 million
Book value per share = $4.005
Forward P/E = 31.25
Forward earnings = 0.64
Current price = 31.25 x 0.64 = $20.00
Price-to-book ratio = 4.99
b. Prepare the pro forma and calculate residual earnings by charging prior book
value at 9%:
Eps
Dps
Bps
2003
2004
2005
4.005
0.640
0.0
4.645
0.740
0.0
5.385
0.2796
0.3220
Residual earnings
c. Reverse engineer the residual earnings model:
V0E
0.3220  g
0.2796 0.3220
 4.005 

 1.09  g
1.1881
1.09
1.1881
Setting V E0 = $20.00, then g = 1.0713 ( a 7.13% growth rate)
(You may have calculated 1.0712 with rounding in an Excel spreadsheet)
d. Eps2006 = (Bps2005 x 0.09) + RE2006
RE2006 is RE2005 growing at 7.13% = 0.322 x 1.0713 = 0.3449
So, Eps2006 = (5.385 x 0.09) + 0.3449
= 0.8296 (83 cents)
e. Set up the pro forma. Normal eps is prior year’s eps x 1.09.
2003
Eps
Dps
2004
2005
2006
0.640
0.0
0.740
0.0
0.8296
0.0
0.7400
0.6976
0.0424
0.8296
0.8066
0.0230
Cum-dividend eps (no divs)
Normal eps
Abnormal eps growth (AEG)
f. Reverse engineer the AEG model:
V0E
0.023




1
0.0424 1.09  g


0.64 
1.09 
0.09 
1.09



Setting VoE  20.0 , then g = 1.0713 (a 7.13% growth rate)
(You may have calculated 1.0712 with rounding)
g. Complete the pro forma above to include residual earnings (charging prior book
value at 9%):
Eps
Dps
Bps
2003
2004
2005
2006
4.005
0.640
0.0
4.645
0.740
0.0
5.385
0.8296
0.0
6.2363
0.2796
0.3220
0.0424
0.3450
0.0230
Residual earnings
Change is RE
The last line is equal to abnormal earnings growth (AEG).
h. From the pro forma in part e, eps growth rates for each year are:
2004
2005
2006
Eps
Growth rates
0.64
0.74
15.63%
0.8296
12.11%
These growth rates are cum-dividend growth rates because the firm pays no
dividends.
i. A long-term growth rate of 7.13% is high against a benchmark of 4% for GDP.
With the telecom sector less vibrant than it was, the market for routers may not
sustain such a growth rate. Does Cisco have other strategies for growth?
Exercise 5.
Inferring Implied Eps Growth Rate: Kimberly Clark Corporation
Price, March 2005
$64.81
a.
Trailing P/E 
64.81  1.60
 18.24
3.64
Forward P/E 
64.81
 17.01
3.81
Normal trailing P/E 
1.089
 12.24
0.089
Normal forward P/E 
1
 11.24
0.089
b.
Calculate AEG for 2006:
2004
2005
2006
Eps
3.64
3.81
4.14
Dps
1.60
1.80
1.96
Dividends reinvested at 8.9%
0.1602
Cum-dividend earnings
4.3002
Normal eps (3.81 x 1.089)
4.1491
Abnormal earnings growth (AEG)
0.1511
P  64.81 =
1 
0.1511 
3.81
+
0.089 
1.089 - g 
g  1.012 1.2% growth rate 
c.
2005
2006
2007
2008
2009
3.81
1.80
4.14
1.96
2.14
2.33
2.54
2.77
0.1529
0.1547
0.1566
0.1585
(0.1744)
(0.1905)
(0.2074)
(0.2261)
Normal earnings
4.5085
4.8863
5.2822
5.6970
Eps
4.4870
4.8505
5.2314
5.6294
8.38%
8.10%
7.85%
7.61%
Eps
Dps
AEG
0.1511
(growing at 1.2%)
Reinvested dividends
2010
(at 8.9%)
Eps growth rate
8.66%
Note: Normal earnings are the earnings in the prior year growing at 8.9%. So, for 2008,
normal earnings = $4.487 x 1.089 = 4.8863.
d.
The market was pricing approximately the same growth rates as forecasted by analysts.
Put another way, the market was pricing KMB based on consensus analysts’ forecasts.
e.
Yes, as analysts were forecasting the same growth rates as those implied in the market
price, they are saying that the market price is reasonable. The 2.6 rating – a HOLD – has
integrity.
(If you are following the Continuing Case in the text, some of this material will be
familiar to you.)