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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