CHAPTER 13 Stock Market Analysis

1 An investor is convinced that the stock market will experience a substantial increase next year because corporate earnings are expected to rise by at least 12 percent. Do you agree or disagree? Why or why not? Although corporate earnings may rise by 12 percent next year, that in ormation by itsel is not su icient to orecast an increase in the stock market. !he market level is a product o both corporate earnings and the earnings multiple. !he earnings multiple must likewise be pro"ected since it is not stable over time !o arrive at an estimate o the net pro it margin, why would you spend time estimating the operating pro it margin and work down? !he investor can improve his net pro it margin estimate by working rom the gross margin down to the net pro it margin. $y this procedure, the investor explicitly considers each ma"or component that a ects the net pro it margin. !his level o analysis provides insights into the components which do not behave consistently over time. Also, the gross pro it margin should be easier to estimate since it has the lowest level o relative variability. &ou are convinced that capacity utili'ation next year will decline rom (2 percent to about )* percent. +xplain what e ect this change will have on the operating pro it margin. !he e ect o a decline in capacity utili'ation should be a decline in the aggregate pro it margin, all else the same, because it will mean greater overhead and depreciation per unit o output. Also more ixed inancial charges per unit. &ou see an estimate that hourly wage rates will increase by - percent next year. .ow does this a ect your estimate o the operating pro it margin? What other in ormation do you need to determine the e ect o this wage rate increase and why do you need it? !he increase in hourly wages o - percent will, all else held e/ual, cause the operating margin to decrease. 0n addition to the estimate o the changes in the hourly wage rate, an estimate o the productivity rate change is also needed to orecast the unit labor cost change. !he relationship is1 2 .ourly Wages 3 2 4roductivity 5 2 6nit 7abor 8ost 0t is estimated that next year hourly wage rates will increase by ) percent and productivity will increase by , percent. What would you expect to happen to until labor cost? Discuss how this unit labor cost estimate would in luence your estimate o the operating pro it margin.
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).93 ,.9 5 2.92 increase in the unit labor cost. !he unit labor cost is negatively related to the pro it margin. !his increase would, holding other actors constant, decrease the aggregate pro it margin. $ecause it is a low rate o increase, the e ect on the pro it margin should be small. ):a; ):b; ):c; ):d; !he return on e/uity increases. !he aggregate debt3e/uity ratio declines. <verall productivity o capital increases. !he dividend3payout ratio declines. An increase in the =<+ with no other changes should cause an increase in the multiple because it would imply a higher growth rate. An important /uestion is, how was the increase in =<+ accomplished? 0 it was due to operating actors :higher asset turnover or pro it margin; it is positive. 0 it was due to an increase in inancial leverage, there could be some o set due to an increase in the re/uired rate o return :k;. 0ncrease, because this will increase earnings growth by raising e/uity turnover. 0t could also cause a decrease because it will increase the inancial risk and, thus, the re/uired k. Decrease, because this will increase growth and there ore raise the real =>=. 0t could also reduce in lation, which would decrease the nominal =>=, causing the multiplier to rise. 0ncrease, because a decrease in the dividend payout rate increases the retention rate, raising the growth rate. 0t could also cause a decrease because it reduces the next period?s dividends. $rie ly discuss the two actors that must be considered :estimated; whether you are employing the present value o cash low approaches or the relative valuation ratio approaches. $oth the present value o cash low approaches and the relative valuation ratios approach re/uire two actors be estimated1 :1; re/uired rate o return on the stock, because this rate becomes the discount rate or is a ma"or component o the discount rate, and :2; growth rate o the variable used in the valuation techni/ues, such as, dividends, earnings, cash lows or sales. Discuss the di erence between the constant growth DD@ and the two stage growth model. 0n your discussion, explain when you would use each o these models. !he DD@ assumes that :1; dividends grow at a constant rate, :2; the constant
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growth rate will continue or an in inite period, and :#; the re/uired rate o return :k; is greater than the in inite growth rate :g;. !here ore, the in inite period DD@ cannot be applied to the valuation o stock or growth companies because the high growth o earnings or the growth company is inconsistent with the assumptions o the in inite period constant growth DD@ model. A company cannot permanently maintain a growth rate higher than its re/uired rate o return, because competition will eventually enter this apparently lucrative business, which will reduce the irmAs pro it margins and there ore its =<+ and growth rate. !here ore, a ter a ew years o exceptional growth :a period o temporary supernormal growth; a irmAs growth rate is expected to decline. +ventually its growth rate is expected to stabili'e at a constant level consistent with the assumptions o the in inite period DD@. 19 $ased upon that data contained in exhibit 1#.2), what would be your estimate o nominal BD4 growth or the united kingdom versus Capan in 299#? Dominal BD4 growth is e/ual to real BD4 growth plus the rate o in lation. >rom +xhibit 1#.2), we ind nominal BD4 or the 6nited Eingdom or 299# can be estimated as 2.(2 :real BD4; F 2.-2 :in lation; 5 ,.%2. >or Capan, the estimate is 1.92 F :39.)2; 5 9.#2. $ased upon the data in exhibits 1#.2), and 1#.2*, what is the main reason or the current interest rate in the 6nited Gtates versus Capan? !he nominal rate o interest is approximately the expected real rate o interest plus the expected rate o in lation. >urther, the real rate o interest can be approximated by the expected real growth rate in BD4. >rom the numbers in +xhibits 1#.2) and 1#.2*, we see that the 6nited Gtates has a higher real growth rate, both currently and orecasted, as well as a higher expected rate o in lation than Capan. $oth actors help explain the higher current interest rate in the 6.G. relative to Capan.

11

CHAPTER 13
Answers to Problems

1.

&ou are told that nominal BD4 will increase by about 192 next year.6sing +xhibit 1#.19 and the regression e/uation,what increase would you expect in corporate sales?.ow would this estmate change i you gave more weight to recent observations in +xhibit 1#.11?
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1.

6sing only the graph and drawing a line over rom ten percent to the line o best it and down to the hori'ontal percent change indicates an estimate o slightly under 192 or the G H 4 series. Alternatively, i you apply the ollowing regression e/uation1 2 GH4 0ndustrials Gales 5 3.92% F 1.1- :2 in Dominal BD4; 5 3.92% F 1.1- :9.19; 5 3.92% F .115 .9*2 or *.22

+xhibit 1#.19 was based upon an analysis that encompassed the period1 1*),32999. !he overall average BD4 percentage change was ).%2, with -.#2 change in GH4 0ndustrials. During the 1**9s, the percentage change in BD4 was lower than the average over the period :approximately ,.,2; and lower than the 192 proposed in the problem. !here ore, one could argue that based upon recent observations, the percentage change in GH4 %99 Gales should also be lower1 2 GH4 0ndustrials Gales 5 3.92% F 1.1-x.9,, 5 3.92% F .9-#( 5 #.*(2

2.

currently ,the dividend payout ratio:dIe; or the aggregate market is -92,the re/uired return :k; is 112 and the expected growth rate or dividends :g; is ,2 :a; 8ompute the current earnings multiplier. :b; &ou expect the DI+ ratio to decline to ,92,but you assume there will be no other changes.What will be the 4I+? :c; Gtarting with the initial conditions,you expect the dividend payout ratio to be constant,the rate o in lation to increase by #2 and the growth rate to increase by 22.8ompute the expected 4I+. :d; Gtarting with the initial conditions,you expect the dividend payout ratio to be constant,the rate o in lation to decline by #2 and the growth rate to decline by 12.8ompute the expected 4I+. 1# 3 %

2:a; 4I+ 5

.-9 5 .-9I.9- 5 19x .1# 3 .9)

2:b;. 4I+ 2:c; 4I+ 2:d; 4I+ 5 5 5

.,9 5 .,9I.9- 5 (.#x .1# 3 .9) .-9 5 .-9I.9) 5 (.,)x .1- 3 .9* .-9 5 .-9I.9% 5 1,x .19 3 .9-

#. A 6.s pension plan hired two o 3shore irms to manage the non36.G e/uity portion o its total port olio.+ach irm was ree to own stocks in any country included in 8apital 0nternationalAs +urope,Australia and >ar +ast 0ndex:+A>+; and to use any orm o dollar andI or nondollar cash or bonds as an e/uity substitute or reserve.A ter three years had elapsed,the records o the managers and the +A>+ 0ndex were as ollows 1 G6@@+=&1 8<D!=0$6!0<DG !< =+!6=D
J 1.
2. #. %. @anager A @anager $ 8omposite o A H $ +A>+ 0ndex

8urrency
:*.92; :).%2; :(.22; :12.*2;

8ountry Gelection
1*.)2 1%.22 1-.*2 1*.*2

Gtock selection
#.12 -.92 %.,2 333333333

8ashI$ond Allocation
9.-2 2.(2 1.)2 333333333

!otal =eturn =ecorded

1%.%2 1,.-2 1,.92 ).92

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&ou are a member o the plan sponsorAs pension committeewhich will soon meet with planAs consultant to review manager per ormance.0nprepartaion or this meeting,you go through the ollowing analysis 1 a.$rie ly describe the strengths H weaknesses o each manager,relative to the +A>+ 0ndex data. b.$rie ly explain the meaning o the data in the K8urrencyL column.
#. #:a;. 8>A +xamination 0 :1*(,; <verall, both managers added value by mitigating the currency e ects present in the 0ndex. $oth exhibited an ability to Kpick stocksL in the markets they chose to be in :@anager $ in particular;. @anager $ used his opportunities not to be in stocks /uite e ectively :via the cashIbond contribution to return;, but neither o them matched the passive index in picking the country markets in which to be invested :@anger $, in particular;. G!=+DB!.G @ADAB+= A 8urrency @anagement @ADAB+= $ 8urrency @anagement Gtock Gelection 6se o 8ashI$ond >lexibility 8ountry Gelection

W+AED+GG+G 8ountry Gelection :to a limited degree; #:b;.

!he column reveals the e ect on per ormance in local currency terms a ter ad"ustment or movements in the 6.G. dollar and, there ore, the e ect on the port olio. 8urrency gainsIlosses arise rom translating changes in currency exchange rates versus the 6.G. dollar over the measuring period :# years in this case; into 6.G. dollars or the 6.G. pension plan. !he 0ndex mix lost 12.*2 to the dollar, reducing what would otherwise have been a very avorable return rom the various country markets o 1*.*2 to a net return o only ).92. As an analyst or @iddle,Diddle and <A7eary,you are orecasting the market 4I+ ratio using the dividend discount model.$ecause the economy has been expanding or * years,you expect the dividendMpayout ratio will be at its low o %92 and that long3term government bond rates will rise to )2.$ecause investors are becoming less risk averse,the e/uity risk premium will decline to #2.As a result,investors will re/uire a 192 return and the return on e/uity will be 122. a. What is the expected growth rate? b. What is your expectation o the market 4I+ ratio? c. What will be the value or the market index i the expectation is or earnings per share o N,#.99? d. What will be your rate o return i you ac/uired the index at a value o *,9,you sold the index at the value computed in part c and dividends during the year were N#9.99?

%.

%:a;.

Browth 5 .-9 x .12 5 .9)2 5 ).22 1# 3 -

%:b;. 4I+ 5

.%9 5 1%.2*x .19 3 .9)2

%:c;.

!he market price will rise to1 4rice 5 1%.2* x N,# 5 N),).#) ),).1% 3 *,9 F #9 5 *,9 31).1%2

%:d;. =ate o =eturn 5

,.

&ou are given the ollowing estimated per share data related to the GH 4 0ndustrials 0ndex or the year 299% 1 J Description Amount in N 1. Gales 1929.99 2. Depreciation %,.99 #. 0nterest expense 1(.99 &ou are also in ormed that the estimating operating pro it margin is 9.1,2 and the tax rate is #22. a. 8ompute the estimated +4G or 299%. b. Assume that a member o the research committee or your irm eels that it is important to consider a range o operating pro it margin:<4@; estimates.!here ore you are asked to derive both optimistic and pessimistic +4G estimates using 9.1%* and 9.1,, or the <4@ and holding everything aelse constant.

,:a;.

N(,9 x .1,2 N12*.29 3 N#( N*1.29 3 N1N),.29 x :13.#2;

5 5 5 5

N12*.29 :operating pro it margin; N *1.29 :depreciation; N ),.29 :interest; N ,1.1% :+stimated +4G; 1# 3 )

,:b;.

<ptimistic1 N(,9 x .1,, N1#1.), 3 N#( N*#.), 3 N1N)).),x :1 3.#2; 4essimistic1 N(,9 x .1%* N12-.-, 3 N#( N((.-, 3 N1N)2.-, x :1 3 .#2;

5 5 5 5

N1#1.), N *#.), N )).), N ,2.()

:operating pro it margin; :depreciation; :interest; :+stimated +4G;

5 5 5 5

N12-.-, N ((.-, N )2.-, N %*.%9

:operating pro it margin; :depreciation; :interest; :+stimated +4G;

-.

Biven the +4G estimates in 4roblem ,,you are also given the ollowing estimates related to the market earnings multiple 1 J Description 4essimistic 8onsensus optimistic 1. DI+ 9.-, 9.,, 9.%, 2. Dominal =>= 9.19 9.9* 9.9( #. =isk 4remium 9.9, 9.9% 9.9# %. =<+ 9.19 9.1# 9.1a. $ased on the three +4G and 4I+ estimates,compute the high,low and consensus intrinsic market value or the GH 4 0ndustries 0ndex in 299%. b. Assuming that the G H 4 0ndustrial 0ndex at the begining o the year was priced at 1-99,compute your estimated rate o return under the three scenarios rom 4art a.Assuming your re/uired rate o return is e/ual to the consensus,how would you weight the G H 4 0ndustrials 0ndex inyour global port olio?

-:a;.

Browth =ates1 .igh 5 :1 3 9.%,; x 9.1- 5 .9(( 7ow 5 :1 3 9.-,; x 9.19 5 .9#, 8onsensus 5 :1 3 9.,,; x 9.1# 5 .9,(, 4I+ =atios1

=e/uired return1 .igh 5 9.9( F 9.9# 5 9.11 7ow 5 9.19 F 9.9, 5 9.1, 8onsensus 5 9.9* F 9.9% 5 9.1#

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.igh 5 9.%,I:9.11 M 9.9((; 5 9.%,I.922 5 29.%,%, 7ow 5 9.-,I:9.1, M 9.9#,; 5 9.-,I.11, 5 ,.-,22 8onsensus 5 9.,,I:9.1# M 9.9,(,; 5 9.,,I.9)1, 5 ).-*2# 4rice1 .igh 5 ,2.() x 29.%,%, 5 N 19(1.%# 7ow 5 %*.%9 x ,.-,22 5 N 2)*.22 8onsensus 5 ,1.1% x ).-*2# 5 N #*#.#( -:b;. .igh 7ow 8onsensus 5 :19(1.%#I1-99; M1 5 3.#2%1 5 :2)*.22I1-99; M1 5 3.(2,, 5 :#*#.#(I1-99; M1 5 3.),%1

Biven that large losses are expected, one should underweight the 6.G. stocks in a global port olio.

).

you are analy'ing the u.s e/uity market based upon the s H p industrials index and using the present value o ree cash low to e/uity techni/ue.your inputs are as ollows1 beginning c e1 N%9.99, k 5 9.9* J 1. 2. #. year 13# %3) H beyond growth rates *2 (2 )2

a. Assuming that the current value or the G H 4 0ndustrials 0ndex is 1-99,would you underweight,overweight or marketweight the 6.G e/uity market? b. Assume that there is a 12 increase in the in lation3what would be the marketAs value and how would you weight the 6.G market?Gtate your assumptions. ). ):a;.

>8>+9 >8>+1 5 N%9x:1.9*; >8>+2 5 N%9x:1.9*;2 >8>+# 5 N%9x:1.9*;# >8>+% 5 N,1.(9x:1.9(; >8>+, 5 N,1.(9x:1.9(;2

5 N%9 5 N%#.-9 5 N%).,2 5 N,1.(9 5 N,,.*% 5 N-9.%2 1# 3 *

>8>+- 5 N,1.(9x:1.9(;# >8>+) 5 N-,.2,x:1.9); Oalue at time t 5 91

5 N-,.2, 5 N-*.(2

N-*.(2 N%#.-9 N%).,2 N,1.(9 N,,.(% N-9.%2 N-,.2, .9* .9) Value = + + + + + + (1.9* ) ) 1.9* (1.9* ) 2 (1.9* ) # (1.9*) % (1.9* ) , (1.9* ) = N%9 + N%9 + N%9 + N#*.,- + #*.2* + N#(.*9 + 1*9*.)9 = N21%).%#

0 the current value o the 0ndex were 1,-99, one would overweight the 6.G. e/uity market in the port olio. ):b;. A one percent increase in the rate o in lation would have two possible e ects1 <ne, the re/uired return would increase rom *2 to 192, decreasing the valueP and two, the nominal cash low growth rates would increase or all time periods by one percentage point. 0 both e ects are at work, they would cancel each other out, as the increase in ree cash low is discounted back at an e/uivalently higher discount rate.

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