Essentials of Investment 9ed Chaps 12-13

1 CHAPTER 12 MACROECONOMIC AND INDUSTRY ANALYSIS 1. A top-down approach to security valuation begins with an analysis of the global and domestic economy. Analysts who follow a top-down approach then narrow their attention to an industry or sector likely to perform well, given the expected performance of the broader economy. Finally, the analysis focuses on specific companies within an industry or sector that has been identified as likely to perform well. A bottom-up approach typically emphasizes fundamental analysis of individual company stocks and is largely based on the belief that undervalued stocks will perform well regardless of the prospects for the industry or the broader economy. The major advantage of the top-down approach is that it provides a structured approach to incorporating the impact of economic and financial variables, at every level, into analysis of a company’s stock. One would expect, for example, that prospects for a particular industry are highly dependent on broader economic variables. Similarly, the performance of an individual company’s stock is likely to be greatly affected by the prospects for the industry in which the company operates. 2. The yield curve, by definition, incorporates future interest rates. As such, it reflects future expectations and is a leading indicator. 3. c. A defensive firm. Defensive firms and industries have below-average sensitivity to the state of the economy. 4. It would be considered a supply shock which affects production capacity and costs. 5. a. Financial leverage increases the sensitivity of profits in the business cycle since the interest payments have to be made regardless of the business cycle. Companies would thus become more sensitive to the business cycle while increasing their financial leverage. b. Firms with high fixed costs are said to have high operating leverage. As small swings in business conditions can have large impacts on profitability, they are more sensitive to the business cycle. 6. d. Asset play. Some of the valuable assets of the company are not currently reflected in the present value. 7. A peak is the transition from the end of an expansion to the start of a contraction. A trough occurs at the bottom of a recession just as the economy enters a recovery. Contraction is the period from peak to trough. Expansion is the period from trough to peak. 2 CHAPTER 13 EQUITY VALUATION 1. Theoretically, dividend discount models can be used to value the stock of rapidly growing companies that do not currently pay dividends; in this scenario, we would be valuing expected dividends in the relatively more distant future. However, as a practical matter, such estimates of payments to be made in the more distant future are notoriously inaccurate, rendering dividend discount models problematic for valuation of such companies; free cash flow models are more likely to be appropriate. At the other extreme, one would be more likely to choose a dividend discount model to value a mature firm paying a relatively stable dividend. 2. It is most important to use multi-stage dividend discount models when valuing companies with temporarily high growth rates. These companies tend to be companies in the early phases of their life cycles, when they have numerous opportunities for reinvestment, resulting in relatively rapid growth and relatively low dividends (or, in many cases, no dividends at all). As these firms mature, attractive investment opportunities are less numerous so that growth rates slow. 3. The intrinsic value of a share of stock is the individual investor’s assessment o f the true worth of the stock. The market capitalization rate is the market consensus for the required rate of return for the stock. If the intrinsic value of the stock is equal to its price, then the market capitalization rate is equal to the expected rate of return. On the other hand, if the individual investor believes the stock is underpriced (i.e., intrinsic value > price), then that investor’s expected rate of return is greater than the market capitalization rate. 4. Intrinsic value = V0 = + + … + = + + = $30.60 5. Intrinsic value = V0 = : $32.03 = k = 0.089994 or 8.9994% 6. Intrinsic value = V0 = : $35 = k = 0.08 or 8% 3 7. Price = $41 = + PVGO = + PVGO PVGO = $0.56 8. Market value of the firm = Market value of assets – Market value of debts = ($10 million + $90 million) – $50 million = $50 million Book value of the firm = Book value of assets – Book value of debts = ($10 million + $60 million) – $40 million = $30 million Market-to-book ratio = 50 / 30 = 1.6667 9. g = ROE b = 0.10 0.6 = 0.06 or 6% P/E = = = 20 10. Market capitalization rate = k = r f + β [E(rM) – r f ] = 0.04 + 0.75 (0.12 – 0.04) = 0.10 Intrinsic value = V0 = = = $66.67 11. Given EPS = $6, ROE = 15%, plowback ratio = 0.6, and k = 10%, we first calculate the price with the constant dividend growth model: P0 = = = = = = $240 Then, knowing that the price is equal to the price with no growth plus the present value of the growth opportunity, we can solve the following equation: Price = $240 = + PVGO = + PVGO PVGO = $240 –$60 = $180 12. FCFF = EBIT(1 – tc) + Depreciation – Capital expenditures – Increase in NWC = $300 (1 – 0.35) + $20 – $60 – $30 = $125 13. FCFE1 = FCFF – Interest expenses(1 – tc) + Increases in net debt = $205 – $22 (1 – 0.35) + $3 = $193.70 (million) Market value of equity = = = $2,152.22 (million) 4 14. Cost of equity = r f + E(Risk premium) = 7% + 4% = 11% Because the dividends are expected to be constant every year, the price can be calculated as the no-growth-value per share: P0 = = = $19.09 15. k = rf + β [E(rM) – r f ] = 0.05 + 1.5 (0.10 – 0.05) = 0.125 or 12.5% Therefore: P0 = = = $29.41 16. a. False. Higher beta means that the risk of the firm is higher and the discount rate applied to value cash flows is higher. For any expected path of earnings and cash flows, the present value of the cash flows, and therefore, the price of the firm will be lower when risk is higher. Thus the ratio of price to earnings will be lower. b. True. Higher ROE means more valuable growth opportunities. c. Uncertain. The answer depends on a comparison of the expected rate of return on reinvested earnings with the market capitalization rate. If the expected rate of return on the firm's projects is higher than the market capitalization rate, then P/E will increase as the plowback ratio increases. 17. a. Using the constant-growth DDM, P0 = : $50 = g = 0.12 or 12% b. P0 = = = $18.18 The price falls in response to the more pessimistic forecast of dividend growth. The forecast for current earnings, however, is unchanged. Therefore, the P/E ratio decreases. The lower P/E ratio is evidence of the diminished optimism concerning the firm's growth prospects. 5 18. ROE = 20%, b = 0.3, EPS = $2, k = 12% a. P/E Ratio We can calculate the P/E ratio by dividing the current price by the projected earnings: P0 = = = = = $23.33 P/E = $23.33/$2 = 11.67 Or we can use Equation 13.8 in the chapter: = = = 11.67 b. Present Value of Growth Opportunities (PVGO) g = ROE b = 0.20 0.3 = 0.6 PVGO = P0 – = – = – = $6.67 c. Impacts of Reducing Plowback Ratio g = ROE b = 0.20 0.2 = 0.04 = 4% D1 = EPS (1 – b) = $2 (1 – 0.2) = $1.6 P0 = = = $20 P/E = $20/$2 = 10.0 PVGO = P0 – = $20.00 – = $3.33 19. ROE = 16%, b = 0.5, EPS = $2, k = 12% a. P0 = = = = = $25 b. P3 = = P0 (1 + g)3 = $25 (1.08)3 = $31.49 20. a. k = rf + β [E(rM) – r f ] = 0.06 + 1.25 (0.14 – 0.06) = 0.16 or 16% g = ROE b = 0.09 (2/3) = 0.06 or 6% 6 D1 = E0 (1 + g) (1 – b) = $3 1.06 (1/3) = $1.06 P0 = = = $10.60 b. Leading P0/E1 = $10.60/$3.18 = 3.33 Trailing P0/E0 = $10.60/$3.00 = 3.53 c. PVGO = P0 – = $10.60 – = $9.28 The low P/E ratios and negative PVGO are due to a poor ROE (9%) that is less than the market capitalization rate (16%). d. Now, you revise the plowback ratio in the calculation so that b = 1/3: g = ROE b = 0.09 1/3 = 0.03 or 3% D1 = E0 (1 + g) (1 – b) = 3 1.03 (2/3) = $2.06 Intrinsic value = V0 = = = $15.85 V0 increases because the firm pays out more earnings instead of reinvesting earnings at a poor ROE. This information is not yet known to the rest of the market. 21. FI Corporation a. P0 = = = $160.00 b. The dividend payout ratio is 8/12 = 2/3, so the plowback ratio is b = (1/3). The implied value of ROE on future investments is found by solving as follows: g = b ROE 0.05 = (1/3) ROE ROE = 15% c. PVGO = P0 – = $160.00 – = $40.00 22. Nogro Corporation a. D1 = E1 (1 – b) = $2 0.5 = $1 g = b ROE = 0.5 0.20 = 0.10 or 10% Therefore: 7 k = + g = + 0.10 = 0.20 or 20% b. Since k = ROE, the NPV of future investment opportunities is zero: PVGO = P0 – = $10 – = $0 c. Since k = ROE, the stock price would be unaffected if Nogro were to cut its dividend payout ratio to 25%. The additional earnings that would be reinvested would earn the ROE (20%). Again, if Nogro eliminated the dividend, this would have no impact on Nogro’s stock price since the NPV of the additional investments would be zero. 23. Xyrong Corporation a. k = rf + β [E(rM) – r f ] = 0.08 + 1.2 (0.15 – 0.08) = 0.164 or 16.4% g = b ROE = 0.6 0.20 = 0.12 r 12% V0 = = = $101.82 b. P1 = V1 = V0 (1 + g) = $101.82 (1 + 0.12) = $114.04 E(r) = = = 0.1852 = 18.52% CFA 1 Answer: a. This director is confused. In the context of the constant growth model, it is true that price is higher when dividends are higher holding everything else (including dividend growth) constant. But everything else will not be constant. If the firm raises the dividend payout rate, then the growth rate (g) will fall, and stock price will not necessarily rise. In fact, if ROE > k, price will fall. b. i. An increase in dividend payout reduces the sustainable growth rate as fewer funds are reinvested in the firm. ii. The sustainable growth rate is (ROE plowback), which falls as the plowback ratio falls. The increased dividend payout rate reduces the growth rate of book value for the same reason—fewer funds are reinvested in the firm. CFA 2 Answer: 8 a. It is true that NewSoft sells at higher multiples of earnings and book value than Capital. But this difference may be justified by NewSoft's higher expected growth rate of earnings and dividends. NewSoft is in a growing market with abundant profit and growth opportunities. Capital is in a mature industry with fewer growth prospects. Both the price-earnings and price-book ratios reflect the prospect of growth opportunities, indicating that the ratios for these firms do not necessarily imply mispricing. b. The most important weakness of the constant-growth dividend discount model in this application is that it assumes a perpetual constant growth rate of dividends. While dividends may be on a steady growth path for Capital, which is a more mature firm, that is far less likely to be a realistic assumption for NewSoft. c. NewSoft should be valued using a multi-stage DDM, which allows for rapid growth in the early years, but also recognizes that growth must ultimately slow to a more sustainable rate. CFA 4 Answer: a. k = rf + β [E(rM) – r f ] = 0.045 + 1.15 (0.145 0.045) = 0.16 or 16% b. Year Dividends 2010 $1.72 2011 $1.72 1.12 = $1.93 2012 $1.72 1.122 = $2.16 2013 $1.72 1.123 = $2.42 2014 $1.72 1.123 1.09 = $2.63 Present value of dividends paid in years 2011 to 2013: Year PV of Dividends 2011 $1.93/1.16 = $1.66 2012 $2.16/1.162 = $1.61 2013 $2.42/1.163 = $1.55 Total: $4.82 P2013 = = = $37.57 PV (in 2010) of P2013 = $37.57/(1.16 3) = $24.07 Intrinsic value of stock = $4.82 + $24.07 = $28.89 9 c. The table presented in the problem indicates that QuickBrush is selling below intrinsic value, while we have just shown that SmileWhite is selling somewhat above the estimated intrinsic value. Based on this analysis, QuickBrush offers the potential for considerable abnormal returns, while SmileWhite offers slightly below-market risk-adjusted returns. a. Strengths of two-stage DDM compared to constant growth DDM: The two-stage model allows for separate valuation of two distinct periods in a company’s future. This approach can accommodate life cycle effects. It also can avoid the difficulties posed when the initial growth rate is higher than the discount rate. The two-stage model allows for an initial period of above-sustainable growth. It allows the analyst to make use of her expectations as to when growth may shift to a more sustainable level. A weakness of all DDMs is that they are all very sensitive to input values. Small changes in k or g can imply large changes in estimated intrinsic value. These inputs are difficult to measure.