THE COMPUTER INDUSTRY IN 1992

Profitability (ROE) for the Overall Industry Fell Steadily from 23% in 1988 to 11% in
1991 and Sales Had Been Flat for the Last of those Two Years;

In Early 1992, Typical PE Ratios in the Industry Were within the Range 9-12 while
Typical PB Ratios Were within the Range 1.0-1.4;
Consider the Factors that Determine PE and PB Ratios for the Four Firms in the Case. Based
Solely on the Information in the Case, Would You Expect PE and PB Ratios for Each Firm to
Be Higher than, Lower than, or within the Ranges Considered Typical for the Industry at this
Time?
TYPES OF PLAYERS (1)

Rising Stars:
Firms expected to enjoy:
- High growth;
- Abnormally high ROEs;

Falling Stars or Harvesters:
Firms expected to enjoy:
- High ROEs on existing investments;
- Slow growth;
TYPES OF PLAYERS (2)

Dogs;
Firms expected to enjoy:
- Little prospect for growth;
- Little prospect for high ROEs;

Recovering Dogs;
Firms expected to:
- Rebound from temporarily low earnings levels;
- Be prevented by competition from returning to abnormally high ROEs;
DETERMINANTS OF PRICE TO BOOK (PB) RATIOS

Expected AEs:
- Expected future abnormal ROEs;
- Expected future growth rates in the book value of equity;

The cost of equity capital;
DETERMINANTS OF PRICE TO BOOK (PB) RATIOS
Linkage to Value Drivers (Same as p 7.3 in Palepu, Bernard, and Healy)
i -1
*
t
VE
= 1+
SE t
i=+
E t [( ROE t+i - r E )  (1 + g j )]
i=1
(1 + r E )

j=0
i
where:
 ROEt+i Is the Return on Equity Obtaining in year t+i;
 gj Is the Growth in the Book Value of Equity SE from Year t+j-1 to Yeat t+j
(g0 = 0);
DETERMINANTS OF PRICE EARNINGS (PE) RATIOS

Expected future growth rates in AEs;

The cost of equity capital;
DETERMINANTS OF PE RATIOS (1)
[  AEt+1 ] E t [  AEt+2 ]
VEt + NDt 1+  E
=
[1+ E t
+
+ ... ]
2
(1
+
)


(1
+
E )
NI t
NI t
NI t
E
E
*
with:
 VEt* denoting the theoretical Value of Equity ex-dividend (the market value of equity in
efficient markets) obtaining at date t;
 NDt denoting Net Dividends paid at date t;
 AEt+1 denoting the change in Abnormal Earnings from date t to date t+1, that is:
 AEt+1 - AEt;
 E denoting the Cost of Equity Capital;
DETERMINANTS OF PE RATIOS (2)
Special Cases
Perfectly Competitive Industry
VEt + NDt 1+  E
=
E
NI t
*
If the cost of equity capital is 12%, the (Trailing) “Normal PE Ratio” is thus 9.3%;
DETERMINANTS OF PE RATIOS (3)
Special Cases
Long-Run Competitive Returns for
“Old Investments”
Let us assume that beyond year t+n :
 Any growth above rate rI comes in the form of normally profitable projects that do not
enhance current value;
 Growth below rate rI is generated by projects generating some constant expected
Abnormal ROE (AROE);
*
n
 AEt+n+1
 AEt+i
VEt + NDt 1 +  E
=
+
]
Et [ 1 + 
i
n
E
(1
+
(
)

)

NI t
i=1 NI t (1 +  E )
NI t
E
E rI
IMPLICATIONS
Firms
PB
PE
Dogs
Low
Low
Recovering Dogs
Low
High
Falling Stars
High
Low
Rising Stars
High
High
CRAY RESEARCH

High ROE as recently as 1988 (21.9%);

More recent ROEs are only moderately high (15% -17%);

Decline in profitability driven by a decline in gross margins;

Red flag about the quality of earnings:
- Large increase in receivables to sales
(14.6% in 1990 to 28.3% in 1991);
- Large increase in inventory to sales
( 22.4% in 1990 to 28.4% in 1991);
- Unchanged net income;

Analysts are expecting only moderate ROEs (14%) for the next 2 years with sales growth
of 10 to 11%, suggesting flat earnings;
Falling (Fallen) Star
CRAY RESEARCH
Assumptions for PE and PB Ratios
Assume:

The cost of equity capital E is 12%;

Future ROEs stay at 14%;

Future sales grow at a rate of 10%, as forecast by financial analysts;

The book value of equity also grows at 10%;

Beyond 3 years, any growth above the long-run inflation rate (assumed at 3.5%) comes in
the form of normally profitable projects which do not enhance current value;
CRAY RESEARCH
PE and PB Ratios

PE = 9.0 (about “Normal”);

PB = 1.3 (above “Normal”);
ATARI

Atari generated relatively high earnings in 1991 but would have reported a loss if not for
the gain on sale of their main manufacturing facility;

Operating income has been negative since 1990 and continues to be negative in Q1 1992;

Ugly strategic position;

Steadily declining gross margins, SGA Expenses Out of Line with Competitors, Weak
Asset Turnover;
Should Be Priced as a Dog!
ATARI
Implications for PB and PE Ratios
PB
Lower than average;
No reason to expect ROEs to exceed the cost of equity in the near future (negative expected
AEs);
PB < 1
PE
Lower than average;
Compared with 1991, future abnormal earnings will almost certainly be lower;
PE << (1+E) / E = 9.3
TANDEM COMPUTERS

Tandem is facing difficulties:
- Heated competition from other fault-tolerant computer systems;
- Competition from substitute technologies;

Tandem’s ROEs have never within the last four years exceeded reasonable estimates
of the cost of equity capital (3% in 1991):
- Both ROS and AT are low;
- Higher leverage relative to competition;

Tandem is undergoing a restructuring in 1992:
- Analysts believe the restructuring will translate into improved though weak
performance ROE for 1993: 8%;
- Sales growth expected to remain low:
5% in 1992 and 1993;
Should Be Priced as a Recovering Dog!
TANDEM COMPUTERS
Implications for PB and PE Ratios
PB
Future ROEs are forecast at levels that lie below the cost of equity. Regardless of expected
growth, the firm is worth less than its book value;
PB < 1
PE
Higher than average;
Depending on abnormal earnings’ growth, which is expected to be high compared to 1991;
20 < PE < 30?
STRATUS COMPUTER

Strong performance as proxied by ROEs, 24% in 1988 and 17% in 1991;

Both margins and turnovers look strong relative to the market share leader Tandem;

The higher margins are consistent with Stratus being successfully differentiated as a highquality producer;

Stratus is almost debt-free. If leverage were increased from 1.3 to Tandem’s 1.6, ROE
could be pushed above 20%!

Financial analysts are forecasting ROEs to remain at the current level of 17% for 1992
and 1993;
STRATUS COMPUTER
Implications for PE and PB Ratios
Both higher than “normal”;
Both Higher PE and PB ratios than average in the industry;
FINANCIAL SUMMARY
Atari
NI
88
89
90
91
(36.9)
(4.2)
(34.2)
(23.0)
Performance (Adj, Avg)
ROE (%)
29.4
(5.0)
(36.5)
(20.3)
ROS (%)
8.2
(1.0)
(8.3)
(8.9)
AT
1.1
1.3
1.4
1.0
FL (%)
45.4
47.4
40.3
30.0
RNOA (%)
17.4
3.7
(17.3)
(11.5)
(8.3)
(6.3)
(2.9)
(37.3)
3.5
NR
NR
NR
Assets
(34.7)
(2.3)
(17.5)
(7.0)
SE
(50.4)
3.3
17.7
24.0
Growth Rate (%)
Sales
NI
FINANCIAL SUMMARY
Cray Research
NI
88
89
90
91
140.8
109.8
103.4
105.1
Performance (Adj, Avg)
ROE (%)
21.9
17.3
16.9
15.1
ROS (%)
18.6
14.0
12.9
12.2
AT
0.8
0.8
0.8
0.9
FL (%)
18.9
20.3
20.4
15.5
RNOA (%)
25.3
18.4
17.8
16.1
Growth Rate (%)
Sales
10.0
3.8
2.5
7.2
NI
4.9
(22.0)
(5.8)
1.6
Assets
9.9
(3.6)
(1.2)
14.3
SE
10.8
(12.2)
5.9
20.6
FINANCIAL SUMMARY
Stratus Computer
NI
88
89
90
91
28.9
33.3
34.7
45.8
Performance (Adj, Avg)
ROE (%)
23.9
20.7
16.8
16.8
ROS (%)
10.9
9.8
8.6
10.2
AT
1.5
1.4
1.4
1.3
FL (%)
6.2
10.7
9.4
3.0
RNOA (%)
22.0
18.6
15.8
16.6
Growth Rate (%)
Sales
44.1
28.7
18.3
11.1
NI
52.9
15.5
4.1
31.8
Assets
37.4
37.2
17.1
19.8
SE
35.8
32.4
25.2
36.4
FINANCIAL SUMMARY
Tandem Computers
NI
88
89
90
91
89.4
110.0
110.0
23.9
Performance (Adj, Avg)
ROE (%)
11.3
11.9
10.0
2.0
ROS (%)
6.8
6.7
5.9
1.2
AT
1.2
1.1
1.1
1.0
FL (%)
4.1
8.2
8.6
7.4
RNOA (%)
11.6
11.6
10.4
2.8
Growth Rate (%)
Sales
27.0
24.2
14.3
3.0
NI
(6.9)
22.9
0.0
(78.3)
Assets
36.3
22.8
16.0
2.9
SE
18.9
15.4
21.7
3.7