Improvements offered by the twostage model include:
(1) The twostage model is more realistic.
It accounts for low, high, or zero growth
in the first stage, followed by constant longterm growth in the second stage.
(2) The model can be used to determine stock value when the growth rate in the
first stage exceeds the required rate of return.
12.
a.
In order to determine whether a stock is undervalued or overvalued, analysts
often compute priceearnings ratios (P/Es) and pricebook ratios (P/Bs); then,
these ratios are compared to benchmarks for the market, such as the S&P 500
index.
The formulas for these calculations are:
Relative P/E =
P/E of specific company
P/E of S&P 500
Relative P/B =
P/B of specific company
P/B of S&P 500
To evaluate EO and SHC using a relative P/E model, Mulroney can calculate the
fiveyear average P/E for each stock, and divide that number by the 5year
average P/E for the S&P 500 (shown in the last column of Table 19E).
This gives
the historical average relative P/E.
Mulroney can then compare the average
historical relative P/E to the current relative P/E (i.e., the current P/E on each
stock, using the estimate of this year’s earnings per share in Table 19F, divided by
the current P/E of the market).
For the price/book model, Mulroney should make similar calculations, i.e.,
divide the fiveyear average pricebook ratio for a stock by the five year
average price/book for the S&P 500, and compare the result to the current
relative price/book (using current book value).
The results are as follows:
P/E model
EO
SHC
S&P500
5year average P/E
16.56
11.94
15.20
Relative 5year P/E
1.09
0.79
Current P/E
17.50
16.00
20.20
Current relative P/E
0.87
0.79
Price/Book model
EO
SHC
S&P500
5year average price/book
1.52
1.10
2.10
Relative 5year price/book
0.72
0.52
Current price/book
1.62
1.49
2.60
Current relative price/book
0.62
0.57
197
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From this analysis, it is evident that EO is trading at a discount to its historical 5
year relative P/E ratio, whereas Southampton is trading right at its historical 5
year relative P/E.
With respect to price/book, Eastover is trading at a discount to
its historical relative price/book ratio, whereas SHC is trading modestly above its
5year relative price/book ratio.
As noted in the preamble to the problem (see
problem 10), Eastover’s book value is understated due to the very low historical
cost basis for its timberlands.
The fact that Eastover is trading below its 5year
average relative price to book ratio, even though its book value is understated,
makes Eastover seem especially attractive on a price/book basis.
b.
Disadvantages of the relative P/E model include: (1) the relative P/E measures
only relative, rather than absolute, value; (2) the accounting earnings estimate
for the next year may not equal sustainable earnings; (3) accounting practices
may not be standardized; (4) changing accounting standards may make
historical comparisons difficult.
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 Spring '13
 Ohk
 Generally Accepted Accounting Principles

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