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1、CHAPTER 15COMPANY ANALYSIS AND STOCK VALUATIONAnswers to Questions1. 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
2、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. A cyclical stock would be any stock with a high beta value. Examples of high beta stock would include stocks o
3、f typical growth companies and some investment firms. As to whether the issuing company is a cyclical company will depend on the specific selection.3. 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 r
4、ate 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 th
5、e stock would be considered a growth stock due to the extremely high price of the stock relative to its earnings.4. Student Exercise5. Student Exercise6. Student Exercise7. Student Exercise8. The DDM assumes that (1) dividends grow at a constant rate, (2) the constant growth rate will continue for a
6、n 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
7、 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 firms profit margins and therefore its ROE and growth ra
8、te. Therefore, after a few years of exceptional growth (a period of temporary supernormal growth) a firms 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. Price/Book Value (P/BV) is u
9、sed 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. A high P/BV ratio such as 3.0 can r
10、esult 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. The price/cash flow ratio (P/CF) has become more popular because of the increased emphasis on c
11、ash by various analysts and because of the increased availability of cash flow numbers. Differences could result from differences in net income or noncash items.12. Price/sales ratio varies dramatically by industry. For example, the sales per share for retail firms are typically higher than sales pe
12、r 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.
13、 The major components of EVA include the firms 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. Absolute EVA mak
14、es 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、.15. While the EVA measures a firms internal performance, the MVA reflects the markets judgment of how well the firm performed in terms of the market value of debt and equity visavis the capital invested in it. Since the latter measure is affected by external factors such as interest rates, it is no
16、t surprising that the EVA and MVA share a weak relationship.16. The two factors that determine a firms 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 firms current size
17、. 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. 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
18、take advantage of highreturn 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 c
19、ost of capital will the firm continue to be classified as a growth company.18. In a perfectly competitive economy, if other companies see a particular firm achieving returns consistently above riskbased expectations, it is expected that these other companies will enter that particular industry or ma
20、rket 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 compe
21、tition resulting in lower profit margins. The theory implies that in truly competitive environments, a true growth company is a temporary classification.19. 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
22、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 noncompetitive factors, as well as changes in technology will
23、 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. The growth duration model attempts to compute the implied growth duration for a growth firm given dif
24、ferential 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 ha
25、s the higher growth rate. While the assumption of equal risk may be acceptable when comparing two larger, wellestablished 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 di
26、fferences 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 wellestablished company with a new startup firm on the basis of an equal payout r
27、atio. Finally, while the model assumes that the stock with the higher P/E ratios has the higher growth rate, in many cases you will find that this is not true.21. 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
28、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 firms stock is a growth stock. It is still necessary to estimate the average payout ratio and the ROE and its components for
29、 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. Walgreen seems to illustrate “simple longrun growth” since
30、rk and b0. Its failure to observe a constant retention rate precludes “dynamic growth”.23. GM is likely an example of “expansion” since r=k and b0.24. CFA Examination I (1993) The computation of book value is: (assets liabilities) / # of sharesAccounting conventions can affect this computation by in
31、creasing 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 assets value. This is particularly tru
32、e 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 re
33、cognized. 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: Different estimates result in different values (estimates of different asset live
34、s can affect depreciation calculations and then the book value of an asset) Different accounting standards can result in changes in balance sheet values (the decision to adopt SFAS 106 immediately or over 20 years) Adoption of different accounting choices can affect asset values LIFO/FIFO inventory
35、Straight line/accelerated depreciation Shortterm/longterm 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 choicesIncreasing or Decreasing Li
36、abilities Offbalancesheet liabilities will change book value. Contingent liabilities and offbalancesheet 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
37、rates change longterm 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 comput
38、ation of book value or not. The purchase or sale of shares at a value different from book value will change book value.25. CFA Examination II (1995)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 f
39、und 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
40、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
41、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 longterm prospects of the corporation.Some arguments against a high dividend payout pol
42、icy are:1. No effect on value. A firms 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.2. Less cash available for investments. Paying high dividends reduces the cash available
43、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.3. Taxes. Investors can defer taxes on capital appreciation until r
44、ealized but pay taxes on dividends (except taxexempt investors) even if dividends are reinvested. Also, double taxation exists on corporate profits and dividends paid to investors.4. Violation of an indenture. High dividend payouts may violate bond indentures or loan covenants.5. Financial distress.
45、 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 stocks value, P0, will
46、be greater1. 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 d
47、enominator 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 firms leverage ratios. The o
48、ther 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 rateThe internalgrowth rate of dividends, g, is calculated as: g = ROE x bwhere: ROE =
