Ch04_Solutions - Chapter 4 Market-Based Valuation: Price...

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Chapter 4 – Market-Based Valuation: Price Multiples Solutions 1. A. Normal EPS is the level of earnings per share that the company could currently achieve under mid-cyclical conditions. B. Averaging EPS over the 1997–2000 period, we find that ($2.55 + $2.13 + $0.23 + $1.45)/4 = $1.59. According to the method of historical average EPS, SII’s normal EPS is $1.59. The P/E based on this estimate is $57.98/1.59 = 36.5. C. Averaging ROE over the 1997–2000 period, we find that (0.218 + 0.163 + 0.016 + 0.089)/4 = 0.1215. For current BVPS, we use the estimated value of $19.20. According to the method of average ROE, we have 0.1215 × $19.20 = $2.33 as normal EPS. The P/E based on this estimate is $57.98/$2.33 = 24.9. 2. A. The analyst can rank the two stocks by earnings yield (E/P). Whether EPS is positive or negative, a lower E/P reflects a richer valuation and a ranking from high to low E/P has a meaningful interpretation. In some cases, an analyst might handle negative EPS by using normal EPS in its place. Neither business, however, has a history of profitability. When year-ahead EPS is expected to be positive, leading P/E is positive. Thus the use of leading P/Es sometimes addresses the problem of trailing negative EPS. Leading P/E is not meaningful in this case, however, because next year’s earnings are expected to be negative. B. Hand has an E/P of –0.100, and Somersault has an E/P of –0.125. A higher earnings yield has a similar interpretation to a lower P/E, and Hand appears to be relatively undervalued. The difference in earnings yield cannot be explained by differences in sales growth forecasts. In fact, Hand has a higher expected sales growth rate than Somersault. Therefore, the analyst should recommend Hand. 3. A. Because investing looks to the future, analysts often feature leading P/E when earnings forecasts are available, as they are here. But a specific reason to use leading P/Es based on the facts given is that RUF had some unusual items affecting EPS for 2000. The data to make appropriate adjustments to RUF’s 2000 EPS are not given. In summary, Stewart should use leading P/Es. 1
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B. Because RUF has a complex capital structure, the P/Es of the two companies must be compared on the basis of diluted EPS. For HS: leading P/E = $44/2.20 = 20 For RUF: leading P/E per diluted share = $22.50/(30,000,000/33,333,333) = 25 Therefore, HS has the more attractive valuation at present. The problem illustrates some of the considerations that should be taken into account in using the P/Es and the method of comparables. 4. A. Your conclusion may be in error because of the following: The peer group stocks themselves may be overvalued. Stated another way, the mean P/E of 18 may be too high in terms of intrinsic value. If that is the case, using 18 as a multiplier of the stocks expected EPS will lead to an estimate of stock value in excess of intrinsic value. The stock’s fundamentals may differ from those of the mean food processing industry stock. For example, if the stocks expected growth rate is lower than the mean industry growth rate and its risk is higher than the mean, the stock may deserve a lower P/E than the mean.
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This note was uploaded on 07/02/2008 for the course FINA 410 taught by Professor Yaxuan during the Winter '07 term at Concordia CA.

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Ch04_Solutions - Chapter 4 Market-Based Valuation: Price...

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