c




  

c


  

c

*  in discounted cashflow valuation. Errors in estimating the discount rate or

mismatching cashflows and discount rates can lead to serious errors in valuation.

* At an intutive level, the discount rate used should be consistent with both the  and the
 ! " being discounted.

# c$%

The cost of equity is the rate of return that investors require to make an equity investment in a
firm. There are two approaches to estimating the cost of equity;

* a risk and return model

* a dividend-growth model.

Models of Risk and Return

The Capital Asset Pricing Model

* Measures risk in terms on non-diversifiable variance

* Relates expected returns to this risk measure.

* It is based upon several assumptions -

(a) that investors have homogeneous expectations about asset returns and variances

(b) that they can borrow and lend at a riskfree rate

(c) that all assets are marketable and perfectly divisible

(d) that there are no transactions costs and that there are no restrictions on short sales.

à
 


£eta: The non-diversifiable risk for any asset can be measured by the covariance of its returns
with returns on a market index, which is defined to be the asset's beta.

The cost of equity will be the required return,

Cost of Equity = Rf + Equity Beta * (E(Rm) - Rf)

where,
Rf = Riskfree rate

E(Rm) = Expected Return on the Market Index

m
   


  


 



(a) the current risk-free rate

(b) the expected return on the market index and

(c) the beta of the asset being analyzed.

   


 




 

* It is generally based upon historical data, and the premium is defined to be the difference
between average returns on stocks and average returns on riskfree securities over the
measurement period.

  
 

Historical
Stocks - T. Bills Stocks - T.Bonds
Period
Arithmetic Geometric Arithmetic Geometric
1926-1990 8.41% 6.41% 7.24% 5.50%
1962-1990 4.10% 2.95% 3.92% 3.25%
1981-1990 6.05% 5.38% 0.13% 0.19%

* Generally, geometric averages provide better estimates of risk premiums in valuation.

¢? The risk premiums will vary across markets, depending upon their riskiness. While
historical data can be used to estimate premiums outside the United States, it is not very
reliable. An alternative way of estimating premiums is to use country bond ratings to
estimate these premiums relative to the U.S. premium. For instance, the risk premiums
for South American countries can be estimated as follows:

Country Rating Risk Premium

5.5% + 1.75% =
Argentina BBB
7.25%
Brazil BB 5.5% + 2% = 7.5%
 5.5% + 0.75% =
Chile AA
6.25%
5.5% + 1.25% =
Columbia A+
6.75%
Mexico BBB+ 5.5% + 1.5% = 7%
5.5% + 1.75% =
Paraguay BBB-
7.25%
Peru B 5.5% + 2.5% = 8%
Uruguay BBB 5.5% + 1.6% = 7.1%

      
    
 

 ! "## 

à
à 

The long-term government bond rate is the appropriate riskfree rate. When the long term
government bond rate is not available, it may make sense to look at the rate at which large
corporations can borrow in the local market.


  $m


  
 

Glaxo Holdings had an estimated beta of 1.10 at the end of 1994. At the same point in time, the
thirty-year treasury bond rate in the United States was 8.00%. The estimated cost of equity for
Glaxo in December 1994 was ñ

Cost of Equity = 8.00% + 1.10 (5.50%) = 14.05%

This is the cost of equity, if cash flows are estimated in dollars. The same estimation can be done
in British Pounds, using the long term Government Bond rate in the U.K., which was 8.50% at
the same point in time ñ

Cost of Equity (British Pounds) = 8.50% + 1.10 (5.50%) = 14.55%

This difference reflects differences in expected inflation in the two markets.

¢? Wellcome is planning an acquisition of Glaxo. Wellcome has a beta of 0.65. Which beta
would you use in valuing Glaxo?
   
%

!%




* The more sensitive a business is to market conditions, the higher is its beta. Thus cyclical firms
can be expected to have higher betas, other things remaining equal, than non-cyclical firms.

* The beta of a firm is the weighted average of the betas of its different business lines.

¢? Pharmaceutical companies are increasingly looking at expanding into biotechnology,

either through acquisitions or through projects. Biotechnology firms have an average beta
of 1.8. What would the impact of these actions be on pharmaceutical firmsí betas?

&  '( 

* DOL is a function of the cost structure of a firm, and is usually defined in terms of the
relationship between fixed costs and total costs.

* A firm which has high operating leverage -> higher variability in earnings before interest and
taxes (EBIT) -> higher beta

¢? Sticking again with pharmaceutical firms, there are some firms which have very high
fixed costs, either because they focus heavily on research, or because of the nature of
their business. (Synergen, for instance, had a beta of 1.65 in 1994. It had research and
development expenses which were 670% of sales in 1994.) These firms will have higher
betas than other firms which have more traditional cost structures. (Wellcome is a good
example.)

)   '( 

* An increase in financial leverage will increase the equity beta of a firm.

* If all of the firm's risk are borne by the stockholders, i.e., the beta of debt is zero, and debt has
a tax benefit to the firm, then,

Levered Beta = Unlevered Beta (1 + (1-t) (D/E))

where,

t = Corporate tax rate

D/E = Debt/Equity Ratio


  *+
)   '( %

Glaxo, with a beta of 1.10, had a debt/equity ratio of 4% in 1994. If Glaxo were to raise its
debt/equity ratio to 20%, its beta would be much higher (Tax rate was 30%) ñ

Current Beta (Levered) = 1.10

Unlevered Beta = 1.10 /(1+0.7*0.04) = 1.07

New Levered Beta = 1.07 (1+0.7*0.2) = 1.22

&  

   %

m
  # 


* Use the betas of publicly traded firms which are comparable in terms of business risk and
operating leverage.

* Correct for differences in financial leverage between the firm being analyzed and the
comparable firms.


  ,m
  # 

  #

Assume that you are trying to estimate the beta for a private firm that is in the business of
manufacturing, selling and servicing fax machines. The betas of publicly traded firms involved
in office equipment and supplies are as follows (They face an average tax rate of 40%). The
private firm had a debt/equity ratio of 30%.

Firm Beta Debt/Equity

General Binding 1.00 0.20
Hunt Manufacturing 0.80 0.03
Moore Coroporation 0.95 0.05
Nashua Company 0.90 0.10
Pitney Bowes 1.20 0.45
& 0.97 1.17
Unlevered Beta of office supply firms = 0.97 / (1 + (1-0.4) (0.17)) = 0.88

Beta for private firm involved in office supplies = 0.88 (1 + (1-0.4) (0.3)) = 1.04

m
   


* Combines industry and company-fundamental factors to predict betas.

* Income statement and balance sheet variables are important predictors of beta

* Following is a regression relating the betas of NYSE and AMEX stocks in 1991 to five
variables - dividend yield, coefficient of variation in operating income, size, debt/equity and
growth in earnings.

BETA = 0.9832 + 0.08 CV in Operating Income - 0.126 Dividend Yield + 0.15 Debt/Equity
Ratio + 0.034 Growth in Earnings per Share - 0.00001 Total Assets

where,

CV in Operating Income = Coefficient of Variation in Operating Income

= Standard Deviation in Operating Income/ Average Operating Income


  -m
      #

Assume that you are trying to estimate the beta for a private firm, with the following financial
characteristics (defined consistently with the regression):

Coefficient of Variation in Operating Income = 2.2

Dividend Yield = 0.04

Debt/Equity Ratio = 0.30

Growth in Earnings per share = 0.30

Total Assets = $ 10,000 (in thousands)

The estimated beta for this firm,

BETA = 0.9832 +0.08*2.2 - 0.126* 0.04 + 0.15* 0.30 + 0.034 * 0.30 - 0.00001*10,000 = 1.19

The Arbitrage Pricing Model

* Logic behind the arbitrage pricing model (APM) same as the logic behind the CAPM, i.e.,
(

"    (
 #
.

* Measure of this non-diversifiable risk in the APM, however, is not a single factor but is
determined by an asset's sensitivity to various economic factors that affect all assets.

* The number and the identity of the factors are determined by the data on historical returns.

* The arbitrage pricing model relates expected returns to economic factors, with a beta specific
to each factor. If these factor-specific betas and the factor risk premia can be estimated, the cost
of equity can also be estimated.

where,

Rf = Riskfree rate

„j = Beta specific to factor j

E(Rj) - Rf = Risk premium per unit of factor j risk

k = Number of factors

m
 #  
  


  .m



  
 

Assume that the parameters for the arbitrage pricing model have been estimated, and that there
are three factors,

Riskfree rate = 3.35%

E(R1) - Rf = 3% : Risk Premium for factor 1

E(R2) - Rf = 4% : Risk Premium for factor 2

E(R3) - Rf = 1.5% : Risk Premium for factor 3

Assume that the betas specific to each of these factors are estimated for Pepsi Cola in 1992 and
that the estimates are as follows:

„1 = 1.20

„2 = 0.90

„3 = 1.10

Substituting into the APM,

Cost of Equity = 3.35% + 1.20 (3%) + 0.90 (4%) + 1.1 (1.5%) = 12.20%


  





* Capital asset pricing model can be considered to be a specialized case of the arbitrage pricing
model, where there is only one underlying factor and that underlying factor is completely
measured by the market index.

* In general, the CAPM has the advantage of being a simpler model to estimate and to use, but it
will underperform the richer APM when the company is sensitive to economic factors not well
represented in the market index.

Example: Oil companies, which derive most of their risk from oil price movements, tend to have
low CAPM betas.

* The biggest intuitive block in using the arbitrage pricing model is its failure to identify
specifically the factors driving expected returns.

Multi-factor Models for risk and return

* Unidentified factors in the arbitrage pricing model are replaced with macro-economic
variables,

* For example, Chen, Roll and Ross (1986) suggest that the following macroeconomic variables
are highly correlated with the factors that come out of factor analysis -- industrial production,
changes in default premium, shifts in the term structure, unanticipated inflation and changes in
the real rate of return. These variables can then be correlated with returns to come up with a
model of expected returns, with firm-specific betas calculated relative to each variable.

* Costs of going from the arbitrage pricing model to a macro-economic multi-factor model can
be traced directly to the errors that can be made in identifying the factors.

* The factors in the model can change over time, as will the risk premia associated with each
economic factor.
* Using the wrong factor(s) or missing a significant factor in a multi-factor model can lead to
inferior estimates of cost of equity.

ividend Growth Model

For a firm which has a stable growth rate in earnings and dividends, the present value of a share
of equity can be written as:

Po = Present Value of expected dividends = DPS1 / (ke - g)

where,

P0 = Price of the stock today

DPS1 = Expected dividends per share next year

ke = Cost of Equity

g = Growth rate in dividends (steady state)

A simple manipulation of this formula yields,

ke = DPS1 / P0 + g

= Expected Dividend Yield + Growth rate in earnings/dividends

More importantly, since the current price is a key input to the model, it is inappropriate to use
this approach to value stock in a firm. There is a strong element of circular reasoning involved
that will lead the analyst to conclude, using this cost of equity, that equity is fairly valued.


  /m
 ( 0"
  
 1"


%

In 1992, Southwestern Bell paid dividend per share of $2.82 and the stock traded at $66 in
December 1992. The estimated growth rate in dividends is 5.5% and the firm is assumed to be in
steady state. The dividend growth model can then be used to estimate the cost of equity;

Expected Dividends in 1993 = $2.82 *1.055 = $2.98

Cost of Equity = $2.98 / $66 + 5.5%

= 10%

To illustrate the circular reasoning involved in using this cost of equity to value stock,

Value of Equity = $ 2.98 / (.10 - .055) = $66

Not surprisingly, the stock is found to be fairly valued.

o!& 'o(

efinition of the Weighted Average Cost of Capital (WACC)

The weighted average cost of capital is defined as the weighted average of the costs of the
different components of financing used by a firm.

WACC = ke ( E/ (D+E+PS)) + kd ( D/ (D+E+PS)) + kps ( PS/ (D+E+PS))

where,

WACC = Weighted Average Cost of Capital

ke = Cost of Equity

kd = After-tax Cost of Debt

kps = Cost of Preferred Stock

E/(E+D+PS) = Market Value proportion of Equity in Funding Mix

D/(E+D+PS) = Market Value proportion of Debt in Funding Mix

PS/(E+D+PS) = Market Value proportion of Preferred Stock in Funding Mix


  2   
   03  

In December 1994, Genzyme Corporation had

* a beta of 1.60. This results in

Cost of equity = 8.00%+1.60 (5.50%) = 16.80%

* an after-tax cost of debt of 6.30%. (Pre-tax cost of debt=9.00%; Tax rate=30%)

* Equity comprised 85.00% (in market value terms) of the funding mix and debt made up the
remaining 15.00%.
* The cost of capital for Genzyme can then be calculated as follows:

WACC = 16.80% (0.85) + 6.30% (0.15) = 15.23 %

c


 )
o

Cash flows to Equity for a Levered Firm

Revenues

- Operating Expenses

= Earnings before interest, taxes and depreciation (EBITDA)

- Depreciation & Amortization

= Earnings before interest and taxes (EBIT)

- Interest Expenses

= Earnings before taxes

- Taxes

= Net Income

+ Depreciation & Amortization

= Cash flows from Operations

- Preferred Dividends

- Capital Expenditures

- Working Capital Needs

- Principal Repayments

+ Proceeds from New Debt Issues

= Free Cash flow to Equity

Levered Firm at esired Leverage

Net Income
- (1- DR) (Capital Expenditures - Depreciation)

- (1- DR) Working Capital Needs

= Free Cash flow to Equity

For this firm,

Proceeds from new debt issues = Principal Repayments +DR (Capital Expenditures -
Depreciation + Working Capital Needs)


  4+
   
"     

(  
' #

The following is an estimation of free cash flows to equity for Warner-Lambert in 1994 and for
1995 (projected).

¢? The company had $1.5 billion in debt outstanding and $ 9 billion in market value of
equity, leading to a debt to capital ratio (ìdebt ratioî) of 14%. This debt ratio is assumed
to be stable. (How does one know?)
¢? The company reported net income of $695 million in 1994 and is projected to have a net
income of $765 million in 1995.
¢? The company reported depreciation of $180 million in 1994 and is expected to have
depreciation of $200 million in 1995.
¢? The company had capital expenditures of $362 million in 1994 and is expected to have
capital expenditures of $400 million in 1995.
¢? The companyís working capital increased to $225 million in 1994 from $203 million in
1993. It is expected to maintain working capital at the same percentage of sales in 1995,
and sales are expected to increase from $6420 million in 1994 to $7100 million in 1995.

22* +
22,
Net Income $ 695.00 $ 765.00
- (Cap Ex - Depreciation) (DR =
$ 156.52 $ 172.00
(1-DR) 14%)
- ( Change in Working (DR =
$ 18.92 $ 20.50
Capital) (1-DR) 14%)
FCFE $ 519.56 $ 572.50

Proposition : The Free Cash Flow to Equity will increase as the amount of debt financing used
by the firm increases. Thus FCFE will be an increasing function of _.

  1
 ( #à   ' #  

The following are the cash flows to equity for Warner Lambert, using a debt ratio of 40% instead
of a debt ratio of 14%.
22* +
22,
Net Income $ 695.00 $ 765.00
- (Cap Ex - Depreciation) (DR =
$ 109.20 $ 120.00
(1-DR) 40%)
- ( Change in Working (DR =
$ 13.20 $ 14.30
Capital) (1-DR) 40%)
FCFE $ 572.60 $ 630.70

The following graph illustrates the effect on free cash flows to equity of changing the debt ratios
from 0% to 100% ñ

 )
o 

)c


EBIT ( 1 - tax rate)

+ Depreciation

- Capital Spending

- Change in Working Capital

= Cash flow to the firm


  5+
   6
" 1 

Siemens AG, as a German-based multinational involved in a wide range of businesses, reported

earnings before interest and taxes of 3,482 million DM in 1992, prior to general provisions and
extraordinary charges. It had depreciation of 4,613 million DM and capital expenditures of 5,560
million DM in 1992. In addition, the working capital increased from 14,306 million DM in 1991
to 15,405 million DM in 1992. The earnings before interest and taxes is expected to increase to
3,967 million DM in 1993. Capital expenditures, depreciation and working capital are all
expected to increase by 5% in 1993. The firm had a tax rate of 38% in 1992. The free cashflows
to the firm for 1992 and 1993 (estimated) are provided below.

1992 Projected 1993

EBIT (1 - tax rate) 2,159 mil DM 2,460 mil DM

+ Depreciation 4,613 mil DM 4,844 mil DM

- Capital Expenditures 5,560 mil DM 5,838 mil DM

- Change in Working Capital 1,098 mil DM 770 mil DM

Free Cashflow to firm 114 mil DM 696 mil DM



  


*: Nominal cash flows should be discounted at nominal discount rates;

Real cash flows should be discounted at real discount rates.


  $!+  
"
 
à 

Consider a firm which has cash flows to equity currently of $100 million and is expected to
grow, in real terms, at 5% a year for the next three years and 3% a year after that. The firm has a
beta of 1.0 and the current T.Bond rate is 6.5%. The expected inflation rate is 3% in both the
firm's cash flows and the general economy. The valuation of this firm can be done on either a
real or a nominal basis:

The estimates of growth on a real and nominal basis are done first
Real Nominal

Growth Rate in first 3 years 5% (1.05)(1.03)-1 = 8.15%

Growth Rate after year 3 3% (1.03)(1.03)-1 = 6.09%

The discount rate can similarly be estimated on a real and nominal basis:

Real Nominal

Discount Rate 1.12/1.03 -1 = 8.74% E(R) =6.5% +1(5.5%) =12%

The expected nominal return is estimated using the CAPM, with a historical premium earned by
stocks over T.Bonds of 5.5%.

Using these growth rates the cash flows can be generated in both nominal and real terms:
à 
"
7  
"

!   7  
 !  
8  )+ 
9  "
9 
1 $105 $108
2 $110 $117
3 $116 $2,078 $126 $2,271

The terminal values are calculated as follows for real and nominal cash flows:

Terminal value (Real Cash flows) = $ 116 * 1.03 / (.0874 - .03) = $ 2,078

Terminal value (Nominal Cash flows) = $ 126 * 1.0609 / (.12 - .0609) = $ 2,271

This calculation assumes that the growth rates after year 3 are steady state growth rates and will
continue through infinity.

The present values of the cash flows to equity and the terminal value can then be calculated
using the appropriate discount rate:

Present value (using real cash flows) = $105/1.0874 + $ 110 / 1.08742 + ($116 + $2,078) /
1.08743 = $ 1,896

Present value (using nominal cash flows) = $108/1.12 + $ 117 / 1.122 + ($126 + $2,271) / 1.123
= $ 1,896


  $ !+
  
"
 
 

à 
"
:7   7  
"
:à 
   
 !   7  
 !  
8  )+ 
9  "
9 
1 $105 $108
2 $110 $117
3 $116 $1,325 $126 $5,068

The terminal values are miscalculated because cash flows and discount rates are not matched.

Terminal value (using nominal rate and real cash flows) = $ 116 *1.03 / (.12-.03) = $1,325

Terminal value (using real rate and nominal cash flows) = $ 126 * 1.0609 / (.0874 -.0609) = $
5,068

If real cash flows are discounted at the nominal discount rate, the present value is:

Present value (real cash flows discounted at nominal rates) = $105/1.12 + $ 110 / 1.122 + ($116
+ $1,325) / 1.123 = $ 1,207 < True value of $1,896

If nominal cash flows are discounted at the real discount rate, the present value is:

Present value (nominal cash flows discounted at real rates) = $108/1.0874 + $ 117 / 1.08742 +
($126 + $5,068) / 1.08743 = $4,293 > True value of $1,896

+c   


,- Pre-tax cash flows should be discounted at pre-tax discount rates;

After-tax cash flows should be discounted at after-tax discount rates.

 ./& !

E(Rj) = Rf + D
+ D
„j + D2 (j - Rf)

where,

E(Rj) = Expected pre-tax return on asset j

Rf = Riskfree rate

„j = Beta of asset j
j = Dividend Yield of asset j

D0 = A constant term

D1 = Market premium for systematic risk

D2 = Influence of dividend payout on expected returns


  *+
  6

"
 
 
+ ' 

The expected dividends and the terminal price were estimated for Eli Lilly at the beginning of
1992 for the next five years (before personal taxes). The firm had a beta of 1.05 and the treasury
bond rate wass 7.15%. The following example values Eli Lilly on the basis of cash flows after
personal taxes for an investor with a tax rate of 40% for ordinary income and 28% for capital
gains. The cash flows on a pre and post tax basis are as follows:
%
  6

  6

 ( 
 !    ( 
 !  
8 

   
   
1 $2.27 $1.36
2 $2.60 $1.56
3 $2.98 $1.79
4 $3.41 $2.05
5 $3.91 $93.43 $2.35 $84.41

The discount rate can be estimated before personal taxes and used to calculate the present value
per share:

Discount rate before personal taxes = 7.15% + 1.05 (5.5%) = 12.93%

Present Value per share (based upon pre-tax cash flows and pre-tax discount rates)

=$ 2.27/1.1293 + $ 2.60 / 1.12932 + $2.98/1.12933 + $3.41/1.12934 + ($3.91+$93.45)/1.12935

= $ 62.20

The initial price is assumed to be $62.20. The cash flows after personal taxes are estimated after
personal taxes as follows:

Dividends per share after taxes = Dividends per share before taxes * (1 - Ordinary tax rate)

Terminal price after taxes = Terminal price before taxes - (Terminal price - Initial price) *
Capital Gains tax rate = $ 93.43 - ($93.43 - $62.20) * 0.28 = $84.41

The discount rate before personal taxes can be apportioned into dividend yield and price
appreciation:
Expected Dividend Yield = Expected Dividends next year/ Initial Price

=$2.27 / $62.20 = 3.71%

Expected Price Appreciation = Expected Return - Expected Dividend Yield

= 12.93% - 3.71% = 9.22%

Discount rate after personal taxes = 3.71% (1 - 0.40) + 9.22% (1 - 0.28) = 8.86%

Present Value per share (based upon after-tax cash flows and after-tax discount rates)

=$ 1.36/1.0886 + $ 1.56 / 1.08862 + $1.79/1.08863 + $2.05/1.08864 + ($2.35+$84.41)/1.08865

= $ 62.20

Thus the value is unaffected by whether cash flows are before or after personal taxes, as long as
the discount rates are adjusted accordingly.

c

o
)
c

Ê Estimating and Using Historical Growth Rates

¢? Historical growth rates can be estimated in a number of different ways -

j? Arithmetic versus Geometric Averages
j? Simple versus Regression Models
¢? Historical growth rates can be sensitive to
j? the period used in the estimation
¢? In using historical growth rates, the following factors have to be considered
j? how to deal with negative earning
j? the effect of changing size


  ,m
    ( (

  (  


The following are the earnings per share at Glaxo Pharmaceuticals, starting in 1989 and ending
in 1994:

Growth
Year EPS
Rate
1989 $0.66
1990 $0.90 36.36%
1991 $0.91 1.11%
1992 $1.27 39.56%
1993 $1.13 -11.02%
1994 $1.27 12.39%
Arithmetic mean = (36.36%+1.11%+39.56%-11.02%+12.39%)/5 = 15.68%

Geometric mean = (1.27/0.66)1/5 -1 = 13.99%


  -1
 ( 
  " 

    0 6

The following table provides earnings per share at Glaxo, starting in 1988 instead of 1989 and
uses six years of growth rather than five to estimate the arithmetic and geometric averages.

Time (t) Year EPS

1 1988 $0.65
2 1989 $0.66
3 1990 $0.90
4 1991 $0.91
5 1992 $1.27
6 1993 $1.13
7 1994 $1.27

Arithmetic average = 13.32%

Geometric mean = (1.27/0.65)1/6 -1 = 11.81%


  .'   '  
"0 6

The earnings per share from 1988 until 1994 is provided for Glaxo., and the linear and log linear
regressions are done below:

Time (t) Year EPS ln(EPS)

1 1988 $0.65 -0.43
2 1989 $0.66 -0.42
3 1990 $0.90 -0.11
4 1991 $0.91 -0.09
5 1992 $1.27 0.24
6 1993 $1.13 0.12
7 1994 $1.27 0.24

Linear Regression : EPS = 0.5171 + 0.1132 t

Log-linear Regression: ln (EPS) = -0.5536 + 0.1225 t

Expected EPS (1995) : linear regression = 0.5171 + 0.1132 (8) = $1.42

Expected EPS (1995): log-linear regression = e (-0.55536 + 0.1225 (8))

= $ 1.53

  "   (  

Calculating growth rates when earnings become negative is problematic, since the traditional
growth rate measures often fail. For instance, if earnings per share goes from <$1.00> to $1.00,
the traditional growth rate measures would be ñ

Arithmetic Growth Rate = = EPSt/EPSt-1 -1 = $1.00/<$1.00> - 1 = -200 %

Geometric growth rate = $1.00/<$1.00> = -100%

There is a solution to this problem,

Modified growth rate =(EPSt-EPSt-1)/Max(EPSt,EPSt-1)


  /  "   (  
1   


The following series lists earnings per share from 1988 to 1994 for Sterling Chemicalsñ
Growth Modified
Time (t) Year EPS log(EPS)
Rate Growth Rate
1 1988 $3.56 1.27
2 1989 $1.77 0.57 -50.28% -50.28%
3 1990 $1.07 0.07 -39.55% -39.55%
4 1991 $0.67 -0.40 -37.38% -37.38%
5 1992 $0.08 -2.53 -88.06% -88.06%
-
6 1993 ($0.10) NMF -225.00%
225.00%
-
7 1994 $0.34 -1.08 129.41%
440.00%
   Using the slope coefficient from the linear regression

EPS =3.1114 - 0.5139 t

Average EPS (1988-94) = $ 1.06

Growth rate = - 0.5139 / 1.06 = -48.48%

 5 Using the minimum or maximum of earnings as the denominator

Arithmetic average, using modified growth rates = - 51.81%


  2!+
3" 

Amgen increased its net income from $19.1 million in 1989 to $430 million in 1994. The
following table shows the growth in net income for Amgen from 1989 to 1994, in both
percentage and dollar terms.
;0" <7
8  7
à  
1989 $19.10
1990 $86.20 351.31% $67.10
1991 $186.30 116.13% $100.10
1992 $306.70 64.63% $120.40
1993 $354.90 15.72% $48.20
1994 $430.00 21.16% $75.10

Geometric Average Growth Rate = 86.42%

Assuming that this growth rate continues for the next five years,
;0" <7
8  7
à  
1995 $801.60 86.42% $371.60
1996 $1,494.32 86.42% $692.72
1997 $2,785.67 86.42% $1,291.35
1998 $5,192.98 86.42% $2,407.31
1999 $9,680.63 86.42% $4,487.65

ÊÊ Analystsí Forecasts Of Earnings: How Good Are They?

Studies indicate that analysts do better than mechanical models at forecasting earnings in the
short term, but do not do much better than such models over the long term.
 à  ( #
+

1  
0  
   

)



Collins & Hopwood Value Line Forecasts 31.7% 34.1%

1970-74

Brown & Rozeff Value Line Forecasts 28.4% 32.2%

1972-75

Fried & Givoly Earnings Forecaster 16.4% 19.8%

1969-79


  

  
=

Some analysts are better at predicting earnings than other analysts. They are also usually better at
picking stocks. Studies examining how effective analysts are conclude the following ñ

¢? On average, analysts affect stock prices with their recommendations; Buy

recommendations affect prices less than sell recommendations. The prices tend to drift
back to their original levels.
¢? The recommendations made by the ëbestí analysts (Institutional Investorís All American
Analysts) have a greater impact on stock prices (3% on buys; 4.7% on sells). For these
recommendations the price changes are sustained, and they continue to rise in the
following period (2.4% for buys; 13.8% for the sells).

ÊÊÊ Expected Growth And Fundamentals

Retention Ratio and Return on Equity

gt = Retained Earningst-1/ NIt-1 * ROE

= Retention Ratio * ROE

= b * ROE
Proposition 1: The expected growth rate in earnings for a company cannot exceed its return on
equity in the long term.

1 
 à&+

Small changes in return on equity can lead to large shifts in the growth rate for some firms. The
relationship between growth rates and changes in return on equity is as follows ñ

gt = [BV of Equityt-1 * (ROEt - ROEt-1) / NIt-1]+ b * ROE


  54 
 à&+ " 


The following table provides information on the retention ratio and the return on equity for
Merck for 1994 and projections for 1995.

1994 1995

BV of Equity 11700

Net Income 3010

Retention Ratio 52.00% 52%

Return on Equity 26.0% 25.5%

Growth Rate = 0.52*0.26 = (11700*(.255-.26)/3010)

= 13.52% + 0.52*0.255 = 11.32%

A drop in the return on equity of 0.5% translates into a drop in the growth rate of 2.20%. If the
ROE drops by 2% the expected growth rate in 1995 would be 4.72%.

à&+ '( 

ROE = ROA + D/E (ROA - i (1-t))

where,

ROA = (Net Income + Interest (1 - tax rate)) / BV of Total Assets

= EBIT (1- t) / BV of Total Assets

D/E = BV of Debt/ BV of Equity

i = Interest Expense on Debt / BV of Debt

t = Tax rate on ordinary income

Note that BV of Assets = BV of Debt + BV of Equity.

Return on Assets, Profit Margin and Asset Turnover

ROA = EBIT (1-t) / Total Assets

= [EBIT (1-t) / Sales] * [Sales/Total Assets]

= Pre-interest profit margin * Asset Turnover


  55+(   
 
 "  ( 


0 #

Procter & Gamble decided to reduce prices on their disposable diapers in April 1993 to compete
better with low-price private label brands. The pre-interest, after-tax profit margin is expected to
drop from 7.43% to 7% as a consequence and the asset turnover is expected to increase from
1.6851 to 1.80. The following table provides projections in profit margins, asset turnover and
growth rates after the shift in corporate strategy:

225 
  
 

EBIT (1- tax rate) $ 2181

Sales $ 29,362

Pre-interest, after-tax profit margin 7.43% 7.00%

Total Assets $17,424

Asset Turnover 1.6851 1.80

Return on Assets 12.52% 12.60%

Retention Ratio 58.00% 58.00%

Debt/Equity 0.7108 0.7108

Interest rate on debt (1 - tax rate) 4.27% 4.27%

0"à 4--;4.*;


  5$ >
  
 7 

The following table provides estimates of return on assets, retention ratio and interest rates for
Neutrogena, a cosmetics manufacturer. Neutrogena is expected to grow at an extraordinary rate
in the first five years (growth phase) and at a stable rate after that (steady state).

0"
1 1 

Retention Ratio 76% 50%

Return on Assets 19.5% 15%

Debt/Equity 0% 25%

Interest rate on debt 10% 8.00%

Growth Rate 14.82% 8.375%


  5*  #

  (  
 


Consider Autodesk Inc,a software company, with earnings per share available from 1987 to
1992. The following table also provides analyst forecasts of expected growth over the next five
years from nine analysts following Autodesk.

?
  +
1  
+
  

Growth Analyst Estimated
Year EPS
Rate Number Growth
1987 $0.89 1 10.00%
1988 $1.35 51.69% 2 10.50%
1989 $1.91 41.48% 3 12.00%
1990 $2.30 20.42% 4 12.50%
1991 $2.31 0.43% 5 13.00%
1992 $1.98 -14.29% 6 16.00%
7 16.00%
 8 18.00%

Arithmetic mean = 19.95% Consensus Forecast = 14%

Standard Deviation = 27.49% Standard Deviation = 3.45%?