CHAPTER 12

Question 1 Why would you expect a relationship between economic activity and stock price movements?

The reason for the strong relationship between the aggregate economy and the stock market is obvious if one considers
that stock prices reflect changes in expectations for firms and the results for individual firms are affected by the overall
performance of the economy. In essence, you would expect earnings of firms to increase in an expansion. Then, if the
P/E ratio remains constant or increases because of higher expectations you would expect an increase in stock prices
and vice versa in a contraction.

Question 2 At a lunch with some business associates, you discuss the reason for the relationship between the
economy and the stock market. One of your associates contends that she has heard that stock prices typically turn
before the economy does. How would you explain this phenomenon?

Stock prices turn before the economy for two reasons: First, investors attempt to estimate future earnings and thus
current stock prices are based upon future earnings and dividends, which in turn are determined by expectations of
future economic activity. The second possible reason is that the stock market reacts to various economic series that
are leading indicators of the economy - e.g., corporate earnings, profit margins, and money supply.

Question 3 Explain the following statements: (a) There is a strong, consistent relationship between money supply
changes and stock prices. (b) Money supply changes cannot be used to predict stock price movements.

Virtually all research has shown the existence of a strong relationship between money supply and stock prices as is
evident from high R2s when money supply is used to explain stock price changes. However, it is not possible to use
money supply changes to predict changes in stock prices, and this is not contradictory, since the stock market
apparently reacts immediately to changes in money supply or investors’ attempts to predict this important variable. As
a result, it is impossible to derive excess profits from watching current or recent past changes in the growth rate of the
money supply.

Question 6 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 information by itself is not sufficient to forecast an
increase in the stock market. The market level is a product of both corporate earnings and the earnings multiple. The
earnings multiple must likewise be projected since it is not stable over time. In addition, if the market already
anticipates this rise in earnings, market prices will already reflect this expectation.
Question 7 Find at least three sources of historical information on nominal and real GDP. Find two sources of an
annual estimate of nominal GDP.

Student exercise. Sources mentioned in the text can be used as can internet search engines.

Answers to Problems

1. Prepare a table showing the percentage change for each of the last 10 years in (a) the Consumer Price
Index (all items), (b) nominal GDP, (c) real GDP (in constant dollars), and (d) the GDP deflator. Discuss
how much of nominal growth was due to real growth and how much was due to inflation.

Student Exercise Analisis Sendiri

2. There has been considerable growth in recent years in the use of economic analysis in investment
management. Further significant expansion may lie ahead as financial analysts develop greater skills in
economic analysis and these analyses are integrated more into the investment decision-making process.
The following questions address the use of economic analysis in the investment decision-making process:

a. Differentiate among leading, lagging, and coincident indicators of economic activity, and give an
example of each. (2) Indicate whether the leading indicators are useful for achieving above-average
investment results. Briefly justify your conclusion.
b. Interest rate projections are used in investment management for a variety of purposes. Identify three
significant reasons why interest rate forecasts may be important in reaching investment conclusions.
c. Assume you are a fundamental research analyst following the automobile industry for a large
brokerage firm. Identify and briefly explain the relevance of three major economic time series,
economic indicators, or economic data items that would be significant to automotive industry and
company research.

(a).1. The National Bureau of Economic Research has conducted extensive analysis of leading, coincident,
and lagging indicators of general economic activity. Business Conditions Digest classifies economic
indicators by their partici¬pation in the stage of the economic process and their relationship to business cycle
movements.
The leading indicators include those economic time series that usually reach peaks or troughs before the
corresponding points in aggregate economic activity. The group includes 10 series. One of the 10 leading
series is common stock prices, which has a median lead of nine months at peaks and four months at troughs.
Another leading series is the money supply in constant dollars, which has a median lead of ten months at
peaks and eight months at troughs.

(a).2. Leading indicators have historically been a good tool for anticipating the economy. Investment
managers should be aware of this information and, where possible, investment decisions might reflect
projected trends. However, these indicators are by no means infallible. They often generate false signals. A
downturn in leading indicators might precede only a retardation of growth rather than a full blown recession
if the downturn is shallow or brief. One of the most consistent leading indicators is stock prices represented
by the S&P 500 Stock Composite Index. Thus, we are dealing with indicators that are roughly coincident with
the most significant determinant of stock returns and price changes. An efficient market should already reflect
this information. Thus, the attainment of above average returns using only these series is questionable.

(b). Interest rate forecasts are usually important in investment management for the following reasons:
Interest rates help determine the relative competitiveness of stocks versus bonds;
They have an effect on the stock returns from interest rate sensitive industries;
They help determine the maturity structure of bond portfolios;
They significantly affect investment in interest futures;
They affect the discount rate used in various equity valuation models.

(c). Three economic time series, indicators, or data items that might be of key relevance to an auto analyst
would be disposable personal income, consumer interest rate series, and consumer confidence survey results.
An increase in disposable personal income might mean more discretionary income is available with which to
purchase consumer durables such as automobiles. A decline in consumer interest rates might make the
effective price of a car, including borrowing charges, more affordable. Survey results that showed a high and
 growing level of consumer confidence about the future of the economy would likely have a positive
psychological effect on consumer willingness to commit to new, large ticket purchases.

In summary, the following variables constitute likely indicators of profits and performance in the automobile
industry:
Real disposable personal income per capita to indicate affordability of automobiles;
Installment debt as a percent of disposable income to indicate ability of consumer to finance new car
purchases;
The replacement cycle indicating the average age of cars on the road, suggesting the inclination of consumers
to consider new car purchases;
Trends in the cost of major components of auto production, including the prices charged by major suppliers.

3. You are told that nominal GDP will increase by about 10 percent next year. Using Exhibit 12.13 and the
regression equation, what increase would you expect in corporate sales?
Using the exhibit in 12.13 and the regression equation the increase that I would expect in corporate sales is
14.94%

4. Currently, the dividend-payout ratio (D/E) for the aggregate market is 60 percent, the required return (k)
is 11 percent, and the expected growth rate for dividends (g) is 5 percent.
a. Compute the current earnings multiplier.
Dividend payout ratio 60%
Required return 11%
Expected growth rate 5%
Earning Multiple = Divdend Payout Rasio / (Required return – Expected
growth rate)
= 60% / (11%-5%)
= 10%

b. You expect the D/E payout ratio to decline to 50 percent, but you assume there will be no other changes.
What will be the P/E?
Dividend payout ratio changes to 50%

New P/E = Divdend Payout Rasio changes / (Required return – Expected

growth rate)
= 50% / (11%-5%)
= 8,33%

c. Starting with the initial conditions, you expect the dividend-payout ratio to be constant, the rate of
inflation to increase by 3 percent, and the growth rate to increase by 2 percent. Compute the expected P/E.
Given
Increase in rate of inflation = 3%
Increase in growth rate = 2%

New Required return will be

= 14,33%
New Growth rate will be = 7,00%

Expected P/E = Divdend Payout Rasio changes / (New Required return – New Expected growth
rate)
= 60% / (14,33%-7%)
= 8,1855388%

d. Starting with the initial conditions, you expect the dividend-payout ratio to be constant, the rate of
inflation to decline by 3 percent, and the growth rate to decline by 1 percent. Compute the expected P/E.
Given
decrease in rate of inflation = 3%
decrease in growth rate = 1%
 New Required return will be
= 7,67%
New Growth rate will be = 4,00%

Expected P/E = Divdend Payout Rasio changes / (New Required return – New Expected growth
rate)
= 60% / (7,67%-4%)

Question 4 asks you to analyze your industry in terms of the five factors that determine the
industry competition. This is an analysis of Porter’s Five Factors. Porter’s Five Factors is a well
known concept, so you should have no problem with this.
= 16,3487738%

5. As an analyst for Charlotte and Chelle Capital, you are forecasting the market P/E rasio using the dividend
discount model. Because the economy has been expanding for 9 years, you expect the dividend-payout ratio
will be at its low of 40 percent and that long-term government bond rates will rise to 7 percent. Because
investors are becoming less risk averse, the equity risk premium will decline to 3 percent. As a result,
investors will require a 10 percent return, and the return on equity will be 12 percent.

a. What is the expected growth rate?

b. What is your expectation of the market P/E ratio?
 c. What will be the value for the market index if the expectation is for earnings per share of $95?

a. What is the expected growth rate?

Answer:
Growth rate = ROE x Retention rate
Or
Growth rate = ROE x (1 – payout)
= 0.12 x (1 – 0.40)
= 0.12 x 0.60
= 0.072 or 7.20%
b. What is your expectation of the market P/E ratio?
Answer:
P/E = (D/E) / (k – g)
= 0.40 / (0.10 – 0.072)
= 0.40 / 0.028
= 14.29

c. What will be the value for the market index if the expectation is for earnings per share of $95?
Answer:
P/E = 14.29
P/95 = 14.29
P = 14.29 x 95
= 1375.55
6. You are given the following estimated per share data related to the S&P Industrials Indeks for the year
2013:
Sales $1,450.00
Depreciation 58.00
Interest expense 28.00
You are also informed that the estimated operating profit (EBIT) margin is 12 percent and the tax rate is
32 percent.
a. Compute the estimated EPS for 2013.
b. Assume that a member of the research committee for your firm feels that it is important to consider a
range of operating profit margin (OPM) estimates. Therefore, you are asked to derive both optimistic
and pessimistic EPS estimates using 11 and 13 percent for the OPM and holding everything else
constant.
 You are also informed that the estimated operating profit (EBIT) margin is 12 percent and the tax
rate is 32 percent. P.428
a. Compute the estimated EPS for 2013.
Operating Profit Margin = (Op. Income-Depreciation)/Sales = EBIT*/SALES = 0.12 (Consensus
Case)

b. Assume that a member of the research committee for your firm feels that it is important to
consider a range of operating profit margin (OPM) estimates. Therefore, you are asked to derive
both optimistic and pessimistic EPS estimates using 11 and 13 percent for the OPM and holding
everything else constant.

7. Given the three EPS estimates in Problem 6, you are also given the following estimates related to the
market earnings multiple:

Pessimistic Consensus Optimistic

D/E 0.65 0.55 0.45
Nominal RFR 0.10 0.09 0.08
Risk premium 0.05 0.04 0.03
ROE 0.11 0.13 0.15
a. Based on the three EPS and P/E estimates, compute the high, low, and consensus intrinsic market
value for the S&P Industrials Index in 2013.
b. Assuming that the S&P Industrials Index at the beginning of the year was priced at 2,050, compute
your estimated rate of return under the three scenarios from Part a. Assuming your required rate of
return is equal to the
 a. Based on three EPS and P/E estimates, compute the high, low and consensus intrinsic market value
for the S&P Industrials Index in 2013.

b. Assuming that the S&P Industrials Index at the beginning of year was priced at 2,050, compute your
estimated rate of return under the three scenarios from Part a. Assuming your required rate of return
is equal to the consensus, how would you weight the S&P Industrials Index in your global portfolio?

8. You are analyzing the U.S. equity market based upon the S&P Industrials Index and using the present
value of free cash flow to equity technique. Your inputs are as follows:

Beginning FCFE: $80

k = 0.09

Growth Rate:
Year 1–3: 9%
4–6: 8%
7 and beyond 7%
a. Assuming that the current value for the S&P Industrials Index is 2,050, would you underweight,
overweight, or market weight the U.S. equity market?
PV factor @
Year FCF 10.09% PV of FCF
1 87,20 0,917431193 80,00
 2 95,05 0,841679993 80,00
3 103,60 0,77218348 80,00
4 111,89 0,708425211 79,27
5 120,84 0,649931386 78,54
6 130,51 0,596267327 77,82

7 6.982,24 0,547034245 3.819,52

Market value 4.295,15

So Curreny US equity market is undervalued as 2050<4295.15
I would overweight the U.S. equity market.

b. Assume that there is a 1 percent increase in the rate of inflation—what would be the market’s value,
and how would you weight the U.S. market? State your assumptions.
% increase in rate of
inflation = 1%

New required return on

equity = 10,09%
PV factor @
Year FCF 10.09% PV of FCF
1 87,20 0,908347716 79,21
2 95,05 0,825095572 78,42
3 103,60 0,749473678 77,65
4 111,89 0,680782703 76,17
5 120,84 0,618387413 74,73
6 130,51 0,561710794 73,31

7 4.519,25 0,561710794 2.538,51

 Market
value 2.998,00

Curreny US equity market is undervalued as 2050<2998

the market value would decrease because the required rate of return would increase

CHAPTER 13

CHAPTER 13
Answers to Questions

1. Briefly describe the results of studies that examined the performance of alternative industries during specific time periods,
and discuss their implications for industry analysis.
The results of empirical studies concluded that there are substantial differences in absolute or relative performance among industries
during any given time period. In addition, industry performance differences are found in alternative time periods where the time periods
may vary in length. Therefore, the investor must examine alternative industries after he has forecasted market movements because of
the wide dispersion of industry performance around the expected market performance.

2. Briefly describe the results of the studies that examined industry performance over time. Do these results complicate or
simplify industry analysis?
Studies show that relative industry performance is inconsistent over time. When industries are ranked over successive time periods,
there is little correlation in the rankings. This result holds for different types of markets and for alternative length time periods. These
findings imply that simple extrapolation of past performance is not useful by itself. Therefore, the analyst must put additional effort into
his industry analysis by projecting industry performance based upon future expectations of industry conditions. This obviously makes
industry analysis more demanding.

3. 3. Assume all the firms in a particular industry have consistently experienced similar rates of return. Discuss what this implies
regarding the importance of industry and company analysis for this industry.
 A greater emphasis must be placed upon industry analysis when the performances of the individual
firms cluster about the industry performance. In contrast, once the industry performance is estimated,
the need for individual firm analysis is reduced since these results imply that all the firms will behave
similar to the industry.
4. Discuss the contention that differences in the performance of various firms within an industry limit the usefulness of industry
analysis.
Disagree. Although studies have shown a significant dispersion of individual firm performance within a
given industry, they also found that the industry component could partially explain individual firm
performance. Although the strength of the industry component varies among industries, industry
analysis is an important step before proceeding to the company analysis. The important implication is
that individual company analysis would be relatively more important for industries where individual
company returns are widely dispersed. The point is, the dispersion among companies within industries
indicates a need for company analysis after industry analysis.
5. Several studies have examined the difference in risk for alternative industries during a specified time period. Describe the
results of these studies, and discuss their implications for industry analysis.
For given time periods, there were significant differences in risk among alternative industries. An analysis of Beta coefficients for the
30 Barron’s industry groups indicated a wide range of systematic risk. The substantial dispersion in risk for alternative industries
implies that the analyst must examine the risk levels for alternative industries.

6. What were the results when industry risk was examined during successive time periods? Discuss the implication of these
results for industry analysis.
While there is substantial dispersion in industry risk during a given time period, studies indicate reasonably stable beta coefficients over
time. This implies that past industry risk analysis may be useful in estimating future risk.

7. Assume the industry you are analyzing is in the fourth stage of the industrial life cycle. How would you react if your industry-
economic analysis predicted that sales per share for this industry would increase by 20 percent? Discuss your reasoning.
The fourth stage of the industrial life cycle is stabilization and market maturity. During this stage, sales grow in line with the economy.
If sales per share for an industry in this stage of the life cycle were predicted to increase by 20 percent, this would imply a growth rate
of the aggregate economy of 20 percent. A sales growth rate of 20 percent is high for an industry in the fourth stage of the industrial life
cycle.

8. Discuss at what stage in the industrial life cycle you would like to discover an industry. Justify your decision.
As an investor, you would like to discover a firm just entering the rapid accelerating growth stage. During this stage, a firm will
experience high sales growth, high profit margins, and little competition.

9. Give an example of an industry in Stage 2 of the industrial life cycle. Discuss your reasoning for putting the industry in Stage 2
and any evidence that caused you to select this stage for the industry.
An industry that experienced the kind of explosive growth characteristics of stage two (rapid accelerating growth) was the internet-
related industry in the late 1990s.

10. Discuss the impact of substitute products on the steel industry’s profitability.
A substitute product for steel would limit the prices firms in that industry could charge. The degree of limitation would depend on
how closely the substitute product was in price and function to steel.

11. Discuss the two variables that must be considered whether you are using the present value of cash flow approach or the
relative valuation ratio approach to valuation. Why are these variables relevant for either valuation approach?
Both the present value of cash flow approaches and the relative valuation ratios approach require two factors be estimated: (1) required
rate of return on the stock, because this rate becomes the discount rate or is a major component of the discount rate, and (2) growth rate
of the variable used in the valuation techniques, such as, dividends, earnings, cash flows or sales.
 12. List the three variables that are relevant when attempting to determine whether the earnings multiple (P/E ratio) for an
industry should be higher, equal to, or lower than the market multiple.
Earnings multiplier (P/E) is determined by:
(1) the expected dividend payout ratio,
(2) the estimated required rate of return on the stock (k), and
(3) the expected growth rate of dividends for the stock (g).

13. Discuss when you would use the two-stage growth FCFE model rather than the constant growth model.
The two-stage FCFE model would apply to the valuation of stock for growth companies because the high growth of earnings for the
growth company is inconsistent with the assumptions of the infinite period constant growth DDM model. A company cannot
permanently maintain a growth rate higher than its required rate of return, because competition will eventually enter this apparently
lucrative business, which will reduce the firm’s profit margins and therefore its ROE and growth rate. Therefore, after a few years of
exceptional growth (a period of temporary supernormal growth) a firm’s growth rate is expected to decline. Eventually its growth rate
is expected to stabilize at a constant level consistent with the assumptions of the infinite period DDM.

14. You are examining the P/CF ratio for an industry compared to the market and find that the industry ratio has always been at
a discount to the market—for example, the industrymarket ratio of ratios is about 0.80. Discuss the variable(s) you would
examine to explain this difference or to justify an increase in the industry-market ratio..
The reason for the difference in the P/CF ratios can be explained by differences in the growth rate of CF per share between the market
and industry, and the risk (volatility) of the CF series over time. Therefore, an increase in the growth rate of the industry CF compared
to the growth of the market CF, as well as the industry CF series becoming smore consistent in its growth, would cause an increase in
the industry-market ratio.

Problem

1. Select three industries from Standard and Poor’s Analysts’ Handbook, or some other source of
industry data with different demand factors. For each industry, indicate what economic series you would
use to predict the growth for the industry. Discuss why the economic series selected is relevant for this
industry.
Analysis sendiri, ga ada solmannya
2. Prepare a scatterplot for one of the industries in Problem 1 of industry sales per share and observations
from the economic series you suggested for this industry. Do this for the most recent 10 years using
information available in the Analysts’ Handbook or another source. Based on the results of the
scatterplot, discuss whether the economic series was closely related to this industry’s sales.
Analysis sendiri, ga ada solmannya

3. Based on an analysis of the results in Problem 2, discuss the stage of your industry in its life cycle.
Analysis sendiri, ga ada solmannya

4. Evaluate your industry in terms of the five factors that determine an industry’s intensity of competition.
Based on this analysis, what are your expectations about the industry’s profitability in the short run (1 or
2 years) and the long run (5 to 10 years)?

Porter identified five factors that act together to determine the nature of competition within an industry. These
are the:
 •Threat of new entrants to a market
•Bargaining power of suppliers
•Bargaining power of customers (“buyers”)
•Threat of substitute products
•Degree of competitive rivalry

According to Porter, these five competitive forces exist in every industry and together determines how
extensive the competition and profitability of the industry is. It is therefore, very critical that one understanding
how these forces influence profitability so as to create a short and long-term strategy. In automoyive industry,
airline operators have large fleets and are highly motivated to drive up ticket prices. cars are built to regulated
standards and offer similar if not the same features, so price competition is stiff. Unions exercise considerable
supplier power and customers have other options as a substitute such as travel bay road or rail.
The automotive manufacturing industry consists mainly of large-scale companies. Companies in large but
mature markets have looked to increase their market share inorganically in the face of limited growth. Ford
Motors is a prime example, owning brands such as F150, Expedition and holding a sizeable stake in executive
car manufacturer Mustang. Consolidation reduces the number of players in the industry, thus reducing rivalry
somewhat.
Rivalry is reduced slightly due to a degree of differentiation, with several different segments within the
market, such as luxury and budget. Some companies service various segments however, such as Mercedes, which
manufactures budget cars under the ‘smart’ brand in addition to its core luxury offering. Furthermore, a number
of players have diversified their business models through geographical expansion or by manufacturing a range of
goods, such as automobiles, watercraft, and industrial and farming machinery. Ford Motors, for example,
diversifies its revenue streams by serving a number of end markets, including the automobile, Commercial, power
products and financial services markets. Such diversification reduces dependence upon the automotive industry
to an extent, and consequently eases rivalry. However, the vast majority of leading players are heavily focused
on automobile production
Companies utilize a high level of design and marketing to promote their product, which increases costs
and fosters strong rivalry. The automotive manufacturing industry was one of the most severely hit by the global
economic downturn and performance continues to differ greatly between countries.
Nevertheless, solid overall industry growth in recent years ameliorates the degree of rivalry to an extent,
which is assessed as moderate.

5. Using Standard and Poor’s Analysts’ Handbook or another source, plot the latest 10-year history of the
operating profit margin for the S&P Industrials Index or another aggregate market series versus an
industry of your choice. Is there a positive, negative, or zero correlation?
 Correlation between S&P Operating Profit Margin and Automobile Industry is negative as shown in graph.
When the S&P 500 Operating Profit Margin rises then operating Profit Margin of automobile industry falls and
vice versa. This is because the influence of higher sales figures of the auto industry and subsequently results in
negative correlation.

6. Using the Analysts’ Handbook or another source of industry data, calculate the means for the following
variables of the S&P Industrials Index or another aggregate market series and the industry of your
choice during the last 10 years:

a. Price/earnings multiplier
b. Retention rate
c. Return on equity
d. Equity turnover
e. Net profit margin
Briefly comment on how your industry and the S&P Industrials Index differ for each of the variables.

7. Prepare a table listing the variables that influence the earnings multiplier for your chosen industry and
the market index series for the most recent 10 years.

a. Do the average dividend-payout ratios for your industry and the market index differ? How should the
dividend payout influence the difference between the multipliers?
b. Based on the fundamental factors, would you expect the risk for this industry to differ from that for
the market? In what direction, and why? Calculate the industry beta using monthly data for five years.
Based on the fundamental factors and the computed systematic risk, how does this industry’s risk
compare to the market? What effect will this difference in risk have on the industry multiplier relative to
the market multiplier?

c. Analyze and discuss the different components of growth (retention rate, total aset turnover, total
assets/equity, and profit margin) for your chosen industry and a market index during the most recent 10
 years. Based on this analysis, how would you expect the growth rate for your industry to compare with
the growth rate for the market index? How would this difference in expected growth affect the
multiplier?

The following table represents the various variables that influence the earnings multiplier/ Price Earning (P/E)
ratios:

Variable Impact on P/E

Stock Price Stock prices are used to calculate the Price earnings ratios and therefore a
fluctuation in the stock price directly impacts the P/E. An increase in stock
prices will cause an increase in earnings multiplier.

Earnings Earnings per share are another variable that impacts the earnings multiplier.

Market Expectations Based on the future profit growth the price earnings ratios are calculated to
determine the P/E ratio of stocks for the future.

Market Index Values Apple (Past 10 years)

Date Open High Low Close/Last Volume

12/31/2004 4.635 4.6429 4.5736 4.6 69,662,082

12/30/2005 10.1114 10.3471 10.0486 10.27 156,085,067

12/29/2006 11.9936 12.2 11.9086 12.12 70,000,014

12/31/2007 28.5 28.6428 28.25 28.2971 134,248,000

12/31/2008 12.2814 12.5343 12.1914 12.1929 151,882,756

12/31/2009 30.4471 30.4786 30.08 30.1046 87,907,426

12/31/2010 46,1357 46.2114 45.9014 46.08 48,344,906

12/30/2011 57.6443 58.04 57.6414 57.8571 44,900,596

12/31/2012 72.9328 76.4857 72.7143 76.0247 164,519,649

12/31/2013 79.1671 80.1828 79.1428 80.1457 55,761,100

 08/08/2014 94.26 94.82 93.28 94.74 41,783,300

The current dividend payout ratio of Apple is around 29.00% ($4.7). Whereas the current market index ratio of Apple
is maintained at a 0.28%. So overall, both the ratios from the current dividend payout as well as for the market index
differ slightly. Dividend payout has a significant influence over the earnings multiplier ratio (P/E ratio). A difference in
the PE ratio influences the dividend payout ratios equally. For example, if the dividend payout ratios increase, the
earnings multiplier ratios would increase as well. Similarly, a decrease in the earnings multipliers ratio would influence
the dividend payout ratios by causing a decrease.

Apple Key Growth Components

Retention Rate 76%-89%

Total Asset Turnover 0.89

Total Assets Equity 25.67

Profit Margin 21.64%

Apple’s retention rate in the past 10 years has continued to increase. The costumer market has increased persistently as
Apple continues to offer new unique quality products with high cost-effectiveness. Apple customers have continued to
remain loyal throughout the years and allowed the company to achieve a retention rate of 76%-89%, with huge returns.
With Apple’s current growth rate will eventually go on to increase its shares and stock prices. Furthermore, as the
market index (stock prices) would increase, this would ultimately cause an increase in Apple’s earnings multiplier
ratios (P/E ratios). Moreover, with the coming release of iPhone 6, the stock prices would raise even more leading to a
rise in the P/E ratios of the company that would allow the company to gain huge returns in the near future.
 CHAPTER 14
1. Give an example of a growth company, and discuss why you identify it as such. Based on its P/E, do you think it is a growth stock?
Explain.
Examples of growth companies would include technology firms such as Intel and Microsoft. These firms have experienced very high rates
of return on total assets and returns on equity when compared to market values. They retain high percentages of earnings to fund superior
investment projects. Stock issues of Intel and Microsoft have been considered growth stocks since their P/E ratios are above the industry
average.

2. Give an example of a cyclical stock, and discuss why you have designated it as such. Is it issued by a cyclical company?
A cyclical stock would be any stock with a high beta value. Examples of high beta stock would include stocks of typical growth companies
and some investment firms. As to whether the issuing company is a cyclical company will depend on the specific selection.

3. A biotechnology firm is growing at a compound rate of more than 21 percent a year. (Its ROE is over 30 percent, and it retains
about 70 percent of its earnings.) The stock of this company is priced at about 65 times next year’s earnings. Discuss whether you
consider this a growth company and/or a growth stock.
The biotechnology firm may be considered a growth company because (1) it has a growth rate of 21 percent per year which probably exceeds
the growth rate of the overall economy, (2) it has a very high return on equity and (3) it has a relatively high retention rate. However, since
a biotechnology firm relies heavily on continuous research and development, the above-average risk will require a high rate of return.
Therefore, it is unlikely that the stock would be considered a growth stock due to the extremely high price of the stock relative to its earnings.

4. Select a company outside the retail drugstore industry and indicate what economic series you would use for a sales projection.
Discuss why this is a relevant series.

5. Select a company outside the retail drugstore industry and indicate what industry series you would use in an industry analysis.
(Use one of the industry groups designated by Standard & Poor’s.) Discuss why this industry series is appropriate. Were there
other possible alternatives?

6. Select a company outside the retail drugstore industry and, based on reading its annual report and other public information,
discuss what you perceive to be its competitive strategy (i.e., low-cost producer or differentiation).
7. Discuss a company that is known to be a low-cost producer in its industry and consider why it is a cost leader. Do the same for a
firm known for differentiating.

8. Under what conditions would you use a two- or three-stage cash flow model rather than the constant-growth model?

The DDM assumes that (1) dividends grow at a constant rate, (2) the constant growth rate will continue for an infinite period, and (3) the
required rate of return (k) is greater than the infinite growth rate (g). Therefore, the infinite period DDM cannot be applied to the valuation
of stock for growth companies because the high growth of earnings for the growth company is inconsistent with the assumptions of the
infinite period constant growth DDM model. A company cannot permanently maintain a growth rate higher than its required rate of return,
because competition will eventually enter this apparently lucrative business, which will reduce the firm’s profit margins and therefore its
ROE and growth rate. Therefore, after a few years of exceptional growth (a period of temporary supernormal growth) a firm’s growth rate
is expected to decline. Eventually its growth rate is expected to stabilize at a constant level consistent with the assumptions of the infinite
period.

9. What is the rationale for using the price/book value ratio as a measure of relative value?
Price/Book Value (P/BV) is used as a measure of relative value because, in theory, market price (P) should reflect book value (BV). In
practice, the two can differ dramatically. Some researchers have suggested that firms with low P/BV ratios tend to outperform those with
high P/BV ratios.

10. What would you look for to justify a price/book value ratio of 3.0? What would you expect to be the characteristics of a firm with
a P/BV ratio of 0.6?
A high P/BV ratio such as 3.0 can result from a large amount of fixed assets being carried at historical cost. A low ratio, such as 0.6, can
occur when assets are worth less than book value, for instance, bad real estate loans by banks.

11. Why has the price/cash flow ratio become a popular measure of relative value during the recent past? What factors would help
explain a difference in this ratio for two firms?
The price/cash flow ratio (P/CF) has become more popular because of the increased emphasis on cash by various analysts and because of
the increased availability of cash flow numbers. Differences could result from differences in net income or non-cash items.

12. Assume that you uncover two stocks with substantially different price/sales ratios (e.g. 0.5 versus 2.5). Discuss the factors that
might explain the difference.
Price/sales ratio varies dramatically by industry. For example, the sales per share for retail firms are typically higher than sales per share for
technology firms. The reason for this difference is related to the second consideration, the profit margin on sales. The retail firms have high
sales per share, which will cause a low P/S ratio, which is considered good until one realizes that these firms have low net profit margins.

13. Specify the major components for the calculation of economic value added. Describe what a positive EVA signifies.
The major components of EVA include the firm’s net operating profit less adjusted taxes (NOPLAT) and its total cost of capital (in
dollars) including the cost of equity. A positive EVA implies that NOPLAT exceeds the cost of capital and that value has been added for
stockholders.

14. Discuss why you would want to use EVA return on capital rather than absolute EVA to compare two companies or to evaluate a
firm’s performance over time.
Absolute EVA makes it difficult to judge whether a firm is succeeding relative to past performance or if the growth rate can support
additional capital. To overcome those shortcomings and to facilitate the comparison of firms of different size, it is preferable to compute
an EVA return on capital ratio: EVA/Capital.

15. Differentiate between EVA and MVA, and discuss the relatively weak relationship between these two measures of performance. Is
this relationship surprising to you? Explain.
While the EVA measures a firm’s internal performance, the MVA reflects the market’s judgment of how well the firm performed in terms
of the market value of debt and equity vis-a-vis the capital invested in it. Since the latter measure is affected by external factors such as
interest rates, it is not surprising that the EVA and MVA share a weak relationship.

16. Discuss the two factors that determine the franchise value of a firm. Assuming a firm has a base cost of equity of 11 percent and
does not have a franchise value, what will be its P/E?
 The two factors that determine a firm’s franchise value are (1) the difference between the expected return on new opportunities and the
current cost of equity and (2) the size of those new opportunities relative to the firm's current size. In the absence of a franchise value, an
equity cost of 11% would translate into a (base) P/E ratio of 9.1 (or 1/.11).

17. You are told that a company retains 80 percent of its earnings and its earnings are growing at a rate of about 8 percent a year
versus an average growth rate of 6 percent for all firms. Discuss whether you would consider this a growth company.
Above average earnings growth is a characteristic of a growth company. Additionally, a rather high retention rate of 80 percent implies that
the firm will have the resources to take advantage of high-return investment opportunities. These factors lend support to classifying the firm
as a growth company. However, as a result of the high retention rate, investors will continue to require a high return on investment. Only if
the firm can continue to achieve returns above its cost of capital will the firm continue to be classified as a growth company.

18. Discuss the reasoning behind the contention that in a completely competitive economy, there would never be a true growth
company.
In a perfectly competitive economy, if other companies see a particular firm achieving returns consistently above risk-based expectations,
it is expected that these other companies will enter that particular industry or market and eventually drive prices down until the returns are
consistent with the inherent risk. In other words, the competition would not allow the continuing existence of excess return investments
and so competition would negate such growth. The computer industry is a good example of increased competition resulting in lower profit
margins. The theory implies that in truly competitive environments, a true growth company is a temporary classification.

19. Why is it not feasible to use the dividend discount model in the valuation of true growth companies?
Because the dividend model assumes a constant rate of growth for an infinite time period, the point is that a true growth company is earning
a rate of return above its cost of capital and this should not be possible in a competitive environment. Therefore, it is impossible for a true
growth firm to exist for an infinite time period in a purely competitive environment. Changes in non-competitive factors, as well as changes
in technology will tend to cause various growth patterns. Therefore, we will consider special valuation models that allow for finite periods
of abnormal growth and for the possibility of different rates of growth.

20. Discuss the major assumptions of the growth duration model. Why could these assumptions present a problem?
The growth duration model attempts to compute the implied growth duration for a growth firm given differential past growth rates for the
market and for the firm and also alternative P/E ratios. These major assumptions of the model are: (1) equal risk between the securities
compared; (2) no significant differences in the payout ratio of different firms; and (3) the stock with the higher P/E ratio has the higher
growth rate. While the assumption of equal risk may be acceptable when comparing two larger, well-established firms to each other or to a
market proxy, it is probably not a valid assumption when comparing a small firm to the aggregate market. Likewise, the assumption of No.
significant differences in payout ratios could present a problem. For example, many growth firms have low initial payout ratios in order to
use retained earnings for future investment projects. It might be inappropriate to compare a well-established company with a new start-up
firm on the basis of an equal payout ratio. Finally, while the model assumes that the stock with the higher P/E ratios has the higher growth
rate, in manycases you will find that this is not true.

21. You are told that a growth company has a P/E ratio of 13 times and a growth rate of 15 percent compared to the aggregate
market, which has a growth rate of 8 percent and a P/E ratio of 16 times. What does this comparison imply regarding the growth
company? What else do you need to know to properly compare the growth company to the aggregate market?
The projected growth rate for the company (15%) is above that of the market (8%); however, the growth company also has a lower P/E ratio
than the aggregate market. This implies that the stock of the growth company might be undervalued. It would be necessary to investigate
the company further to determine if the firm’s stock is a growth stock. It is still necessary to estimate the average payout ratio and the ROE
and its components for both the firm and the aggregate market in order to make a proper comparison of the growth company to the aggregate
market. This should help you determine if it is currently a true growth company and if this performance can be sustained.

22. Given the alternative companies described in the chapter (negative growth, simple growth, dynamic growth), indicate what your
label would be for Walgreens. Justify your label.
Walgreen seems to illustrate “simple long-run growth” since r>k and b>0. Its failure to observe a constant retention rate precludes
“dynamic growth”.

23. Indicate and justify a growth label for General Motors.

GM is likely an example of “expansion” since r=k and b>0.

24. Using book value to measure profitability and to value a company’s stock has limitations. Discuss five such limitations from an
accounting perspective. Be specific.
 The computation of book value is: (assets - liabilities) / # of shares
Accounting conventions can affect this computation by increasing or decreasing any of the three components: assets, liabilities, or number
of shares.

Increasing or Decreasing Assets

 Accountants’ use of historic cost does not recognize the replacement value of assets and is, therefore, not an accurate
measurement of an asset’s value. This is particularly true of real estate assets.
 Several assets with real economic value are ignored by accountants. Internally developed goodwill, management expertise,
market share, and technological innovation are just a few of the assets ignored by accountants.
 Some assets that are on the balance sheet should not be recognized. Purchased goodwill is an accounting convention that is often
placed on or stays on the balance sheet when there is no economic reason for it to exist.
 Assets can change value for any of the following reasons:
o Different estimates result in different values (estimates of different asset lives can affect depreciation calculations and
then the book value of an asset)
o Different accounting standards can result in changes in balance sheet values (the decision to adopt SFAS 106
immediately or over 20 years)
o Adoption of different accounting choices can affect asset values
LIFO/FIFO inventory
Straight line/accelerated depreciation
Short-term/long-term marketable securities
Purchase/pooling acquisitions
Cost/equity recognition
Lower of cost or market
Capitalization of costs
Pension options
Deferral of taxes
Foreign currency translations
Revenue recognition choices

Increasing or Decreasing Liabilities

 Off-balance-sheet liabilities will change book value. Contingent liabilities and off-balance-sheet financing are two such liabilities
that sometimes are not included on the balance sheet that should be included.
 Changes in the value of existing liabilities can affect book value. When interest rates change long-term debt which is on the
balance sheet does not change even though the economic value of these liabilities do change.
Increasing or Decreasing # of Shares
 The existence of warrants or options can increase the number of shares depending upon the decision to include them in the
computation of book value or not.
 The purchase or sale of shares at a value different from book value will change book value.

25. On your visit to Alessandra Chemical Corp. (ACC), you learned that the board of directors has periodically debated the
company’s dividend-payout policy.

a. Briefly discuss two arguments for and two arguments against a high dividend payout policy A director of ACC said that the
use of dividend discount models by investors is “proof that “the higher the dividend, the higher the stock price.”
b. Using a constant-growth dividend discount model as a basis of reference, evaluate the director’s statement.
c. Explain how an increase in dividend payout would affect each of the following (holding all other factors constant):
(1) Internal (implied, normalized, or sustainable) growth rate
(2) Growth in book value

25(a). Some arguments for a high dividend payout policy are:

1. Limited investment opportunities. If a firm has cash flows greater than those needed
to fund projects with positive net present values, it should return the capital to
shareholders as higher dividends.
2. Clientele effect. Some investors require some income from investments. The higher
 the dividend, the greater the proportion of investors who will be satisfied with the income
of a given investment.
3. Certainty of dividends versus capital gains. The “bird in hand” argument says that
(a) cash dividends are a definite return whereas capital appreciation is less certain, or (b) investors
should apply a lower discount rate to cash dividends versus capital appreciation because
dividends are more certain.

4. Tax effects. Corporate and tax exempt investors in some tax jurisdictions pay no
income tax on dividends.
5. Informational content. Management uses the dividend payout policy to communicate
the long-term prospects of the corporation.

Some arguments against a high dividend payout policy are:

1. No effect on value. A firm’s investment decisions determine its profitability. Dividend

policy does not affect investment decisions, but it does affect the amount of outside
financing needed by a firm.

Less cash available for investments. Paying high dividends reduces the cash available to
finance profitable investment projects. With less internal financing, a firm may resort to
external financing to finance projects, which may reduce earnings per share because of greater
interest expense or more shares outstanding.
2. Taxes. Investors can defer taxes on capital appreciation until realized but pay taxes on
dividends (except tax-exempt investors) even if dividends are reinvested. Also, double
taxation exists on corporate profits and dividends paid to investors.
3. Violation of an indenture. High dividend payouts may violate bond indentures or loan
covenants.
4. Financial distress. Paying high dividends while financing investment projects may force
the firm to increase its leverage ratios and lead to a higher level of risk. This could
eventually lead to financial distress.

25(b). The constant growth dividend discount model, P0 = Dl/(k - g), implies that a stock’s value, P0, will
be greater
1. the larger its expected dividend per share, D1;
2. the lower the market capitalization rate, k, (also called the required rate of return);
3. the higher the expected growth rate of dividends, g.
The director has ignored the denominator used to convert the dividend to a present value. The
denominator consists of two variables, both of which dividend policy could influence. One
variable is the market capitalization rate, k, which risk affects. Investors may view a higher
dividend payout as increasing risk because a higher payout may lead to an increase in a firm’s
leverage ratios. The other variable is the expected growth rate of dividends, g, which is likely to
 be lower if firms pay higher dividends in the short run. In summary, a higher dividend payout
may increase k and lower g. Therefore, the statement by the director that the use of dividend
discount models by investors is “proof” that “the higher the dividend, the higher the stock price”
is potentially misleading and possibly inaccurate.

25(c). (i) Internal (implied, normalized, or sustainable) growth rate

The internal-growth rate of dividends, g, is calculated as: g =

ROE x b

where: ROE = return on equity

b = plowback or earnings retention ratio (1 - dividend payout ratio).
As the dividend payout ratio increases, the expected growth rate in dividends decreases. If the
firm pays out all earnings as dividends, the expected growth rate in dividends would be zero.
Valuation would also decrease to the degree investors would pay a lower ratio of price to earnings
for the lower growth rate calculated in this manner.

(ii) Growth in book value

A higher dividend payout ratio would slow the increase in book value (all other factors being
equal) because the retained earnings included in stockholders’ equity would increase at a slower
rate (reflecting the higher dividend payout)
26. Sophie Corporation (SC) is planning to acquire a slower-growth competitor, which will materially
increase SC’s sales volume. The company to be acquired has pretax margins that are approximately the
same as those of SC. SC plans to issue $300 million in longterm debt to finance the entire cost of the
acquisition.

a. Discuss how SC’s potential acquisition might decrease its valuation based on a constant- growth
dividend discount model. Be sure to comment on each of the three factors in such a model.
b. Discuss two reasons why SC’s potential acquisition might increase the P/E multiple investors are
willing to pay for SC.

Soft Corporation’s acquisition of a slower-growth competitor might

decrease its valuation based on a constant-growth DDM because
SC’s $300 million in new long-term debt and related interest
costs decreases the likelihood that the dividend will be
increased next year (D1);
the acquisition of a slower-growth company reduces the
acquirer’s long-term growth rate for dividends;
the higher financial leverage resulting from the acquisition will
increase the perceived riskiness of SC, raising investors’
required rate of return (k);
everything else being equal, these factors (lower dividend
growth rate and higher required rate of return) could interact
to increase the denominator and decrease the numerator of the
DDM.

26(b). Possible Increase in P/E Multiple

The acquisition might increase the P/E multiple investors will be willing
to pay for SC for the following reasons:
The acquisition could provide internal sources of growth.
Synergies (the opportunity for cost cutting, economies of scale,
etc.) from the combination might well emerge in time, which
would increase the earnings growth rate in the intermediate
term. Investors might anticipate this improved growth rate,
which would enhance the P/E multiple.
The acquisition could provide external sources of growth.
Particularly if the acquired company is an important direct
 competitor, investors’ perceptions of reduced competition and
improved pricing in the future could lead to a higher multiple on
the stock on current earnings.
The acquisition will add value if returns exceed costs. The use of
debt to finance the acquisition will enhance the ROE of SC if the
incremental profitability exceeds the after-tax cost of debt
capital. If investors perceive this higher ROE to be sustainable,
their expectations for growth and, consequently, the multiple
they are willing to pay for the stock are likely to increase.
Investors may decide that the external sources of growth (see
above) justify viewing the riskiness of the combined entity as
less than that of SC alone, which would justify a higher P/E
multiple.
Short-term EPS may drop because of the expenses related to
the acquisition, but investors looking beyond this short-term
drop may believe that longer-term earnings growth prospects
have improved. The multiple on current earnings may rise as a
result of this expectation.
If SC is currently underleveraged, the debt load taken on in this
acquisition may actually optimize SC’s leverage, which would
produce a lower overall cost of capital and justify a higher P/E
multiple.

27. A generalized model for the value of any asset is the present value of the expected cash flows:

Value =
XN
t=1
CFt
ð1+kÞt
where:
N =life of the asset
CFt = cash flow in Period t
k=appropriate discount rate
Both stock and bond valuation models use a discounted cash flow approach, which includes
the estimation of three factors (N, CFt, k).
Explain why each of these three factors is generally more difficult to estimate for
common stocks than for traditional corporate bonds.

1 Life of the asset (N). Typically, bonds have a stated maturity. Bond
investors will be paid coupons and repaid principal at or before that
maturity. The life of the bond is contractually determined and creates an
obligation to honor the promised payments. There is no maturity for
common stocks; indeed the life of the corporation is assumed to be
infinite.
2. Contractual nature of the cash flows (CF). The contractual nature of
bond payments creates an obligation, which makes the estimation
of these payments a fairly routine task especially for high quality
bonds. Dividend payments on common stocks, on the other hand,
are much more difficult to estimate because dividends are
discretionary or indeterminate based on factors such as
profitability, financial structure, capital expenditures, management
discretion, etc.

3. Appropriate discount rate (k). The discount rate, or required

rate of return, reflects the risk of the asset. The required rate of
return on a bond is observable and typically determined by
comparison with other bonds of similar maturity (as given by the
yield curve) and the issuer credit risk (as given by the bond rating).
The estimation of the required rate of return for a common stock is
more subjective, often relying on an estimated risk proxy such as
beta or similar measures of riskiness.