1

SOLUTIONS TO
EXERCISES AND CASES

For

FI NANCI AL STATEMENT ANALYSI S AND SECURI TY VALUATI ON



Stephen H. Penman



Fifth Edition
















2
CHAPTER ONE

Introduction to Investing and Valuation

Concept Questions

C1.1. Fundamental risk arises from the inherent risk in the business from sales revenue falling
or expenses rising unexpectedly, for example. Price risk is the risk of prices deviating from
fundamental value. Prices are subject to fundamental risk, but can move away from fundamental
value, irrespective of outcomes in the fundamentals. When an investor buys a stock, she takes on
fundamental risk the stock price could drop because the firms operations dont meet
expectations but she also runs the (price) risk of buying a stock that is overpriced or selling a
stock that is underpriced. Chapter 19 elaborates and Figure 19.5 (in Chapter 19) gives a display.

C1.3. This statement is based on a statistical average from the historical data: The return on
stocks in the U.S. and many other countries during the twentieth century was higher than that for
bonds, even though there were periods when bonds performed better than stocks. So, the
argument goes, if one holds stocks long enough, one earns the higher return. However, it is
dangerous making predictions from historical averages when risky investment is involved.
Averages from the past are not guaranteed in the future. After all, the equity premium is a reward
for risk, and risk means that the investor can get hit (with no guarantee of always getting a higher
return). The investor who holds stocks (for retirement, for example) may well find that her stocks
have fallen when she comes to liquidate them. Indeed, for the past 5-year period, the past 10-
year period, and the past 25-year period up to 2010, bonds outperformed stocksnot very



3
pleasant for the post war baby-boomer at retirement age at that point who had held stocks for
the long run. Waiting for the long-run may take a lot of time (and in the long run we are all
dead).
The historical average return for equities is based on buying stocks at different times, and
averages out buying high and buying low (and selling high and selling low). An investor
who buys when prices are high (or is forced to sell when prices are low) may not receive the
typical average return. Consider investors who purchased shares during the stock market bubble
in the 1990s: They lost considerable amount of their retirement nest egg over the next few
years. See Box 1.1.

C1.5. This is not an easy question at this stage. It will be answered in full as the book proceeds.
But one way to think about it is as follows: If an investor expects to earn 10% on her investment
in a stock, then earnings/price should be 10% and price/earnings should be 10. Any return above
this would be considered high and any return below it low. So a P/E of 33 (an E/P yield of
3.03%) would be considered high and a P/E of 8 (an E/P yield of 12.5%) would be considered
low. But we would have to also consider how accounting rules measure earnings: If accounting
measures result in lower earnings (through high depreciation charges or the expensing of
research and development expenditure, for example) then a normal P/E ratio might be higher
than 10. And one also has to consider growth: If earnings are expected to be higher in the future
than current earnings, the E/P ratio should be lower than this 10% benchmark (and the
corresponding P/E higher). In early 2012, the S&P 500 P/E ratio stood at 14.4.

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C1.7. Yes. Stocks would be efficiently priced at the agreed fundamental value and the market
price would impound all the information that investors are using. Stock prices would change as
new information arrived that revised the fundamental value. But that new information would be
unpredictable beforehand. So changes in prices would also be unpredictable: stock prices would
follow a random walk.

C1.9. a. If the market price, P, is efficient (in pricing intrinsic value) and V is a good measure
of intrinsic value, the P/V ratio should be 1.0. The graph does show than the P/V ratio oscillates
around 1.0 (at least up to the bubble years). However, there are deviations from 1.0. These
deviations must either be mispricing (in P) that ultimately gets corrected so the ratio returns to
1.0, or a poor measure of V.
b. Yes, you would have done well up to 1995 if P/V is an indication of mispricing. When
the P/V ratio drops below 1.0, prices increase (as the market returns to fundamental value), and
when the P/V ratio rises above 1.0, prices decrease (as the market returns to fundamental value).
A long position in the first case and a short position in the latter case would earned positive
returns. Of course, this strategy is only as good as the V measure used to estimate intrinsic value.
c. Clearly, shorting Dow stocks during this period would have been very painful, even
though the P/V ratio rose to well above 1.0. Up to 1999, the P/V ratio failed to revert back to 1.0
even though it deviated significantly from 1.0. This illustrates price risk in investing (see
question C1.1 and Box 1.1). Clearly, buying stocks when the P/V ratio was at 1.2 would clearly
involved a lot of price risk: The P/V ratio says stocks are too expensive and youd be paying too
much. But selling short at a P/V ratio of 1.2 in 1997 would also have borne considerable price
risk, for the P/V ratio increase even further subsequently. In bubbles or periods of momentum
investing, overpriced stocks get more overpriced, so taking a position in the hope that prices will



5
return to fundamental value is risky. Only after the year 2000 did prices finally turn down, and
the P/V ratio fell back towards 1.0.
Chapter 5 covers the calculation of P/V ratios here.

6
Exercises
Drill Exercises
E1.1. Calculating Enterprise Value
This exercise tests the understanding of the basic value relation:
Enterprise Value = Value of Debt + Value of Equity
Enterprise Value = $600 + $1,200 million
= $1,800 million
(Enterprise value is also referred to as the value of the firm, and sometimes as the value
of the operations.)
E1.3 Buy or Sell?
Value = $850 + $675
= $1,525 million
Value per share = $1,525/25 = $61
Market price = $45
Therefore, BUY!

Applications
E1.5. Enterprise Market Value: General Mills and Hewlett-Packard
(a) General Mills

Market value of the equity = $36.50 644.8 million shares
=

$23,535,2 million
Book value of total (short-term and long-term) debt = 6,885.1
Enterprise value $30,420.3 million




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Note three points:
(i) Total market value of equity = Price per share Shares outstanding.
(ii) The book value of debt is typically assumed to equal its market value, but
financial statement footnotes give market value of debt to confirm this.
(iii) The book value of equity is not a good indicator of its market value. The price-to-
book ratio for the equity can be calculated from the numbers given:
$23,535.2/$6,616.2 = 3.56.
(b) This question provokes the issue of whether debt held as assets is part of enterprise value
(a part of operations) or effectively a reduction of the net debt claim on the firm. The issue arises
in the financial statement analysis in Part II of the book: Are debt assets part of operations or part
of financing activities? Debt is part of financing activities if it is held to absorb excess cash
rather than used as a business asset. The excess cash could be applied to buying back the firms
debt rather than buying the debt of others, so the net debt claim on enterprise value is what is
important. Put another way, HP is not in the business of trading debt, so the debt asset is not part
of enterprise operations. The calculation of enterprise value is as follows:
Market value of equity = $41 2,126 million shares = $ 87,166 million
Book value of net debt claims:
Short-term borrowing $ 8,406 million
Long-term debt 14,512
Total debt $22,918 million
Debt assets 12,700 10,218
Enterprise value 97,384 million

The $10,218 million is referred to as net debt.


8
Minicases
M1.1 Critique of an Equity Analysis: America Online, Inc.
I ntroduction
This case can be used to outline how the analyst goes about a valuation and, specifically,
to introduce pro forma analysis. It can also be used to stress the importance of strategy in
valuation. The case involves suspect analysis, so is pertinent to the question (that will be
answered as the book proceeds): What does a credible equity research report look like?
The case can be introduced with the Apple example is Box 1.6. The case anticipates some
of the material in Chapter 3 that lays out how to approach fundamental analsis You may wish to
introduce that material with this case by putting Figures 3.1 and 3.2 in front of the students, for
example.
You may wish to recover the original Wall Street Journal (April 26, 1999) piece on
which this case is based and hand it out to students. It is available from Dow Jones News
Retrieval. With the piece in front of them, students can see that it has three elements that are
important to valuation scenarios about the future (including the future for the internet, as seen
at the time), a pro forma analysis that translates the scenario into numbers, and a valuation that
follows from the pro forma analysis. So the idea emphasized in Chapter 3 -- that pro forma
analysis is at the heart of the analysis is introduced, but also the idea that pro forma analysis must
be done with an appreciation for strategy and scenarios that can develop under the strategy.



9

To value a stock, an analyst forecasts (based on a scenario), and then converts the
forecast to a valuation. An analysis can thus be criticized on the basis of the forecasts that are
made or on the way that value is inferred from the forecast. Students will question Alger's
forecasts, but the point of the case is to question the way he inferred the value of AOL from his
forecasts.
10
Working the Case
A. Calculation of price of AOL with a P/E of 24 in 2004
Earnings in 2004 for a profit margin of 26% of sales:
$16.000 0.26

$4.160 billion
Market value in 2004 with a P/E ratio of 24 $99.840
Present value in 1999 (at a discount rate of 10%, say) $61.993
Shares outstanding in 1999 1.100
Value per share, 1999

(Students might quibble about the discount rate; the
sensitivity of the value to different discount rates can
be looked at.)

$56.36
B. Market value of equity in 1999: 105 1.10 billion
shares

$115.50 billion
Future value in 2004 (at 10%) $186.014
Forecasted earnings, 2004 $4.160 billion
Forecasted P/E ratio 44.7


So, if AOL is expected to have a P/E of 50 in 2004, it is a BUY.



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C. Use Box 1.6 as background for this part. There are two problems with the analysis:

1. The valuation is circular: the current price is based on an assumption about what the
future price will be. That future price is justified by an almost arbitrary forecast of a
P/E ratio. The valuation cannot be made without a calculation of what the P/E ratio
should be. Fundamental analysis is needed to break the circularity.
Alger justified a P/E ratio of 50, based on
- Continuing earnings growth of 30% per year after 2000
- Consistency of earnings growth
- An "excitement factor" for the stock.
Is his a good theory of the P/E ratio? Discussion might ask how the P/E ratio is related to
earnings growth (Chapter 6) and whether 30% perpetual earnings growth is really
possible.
What is "consistency" of earnings growth?
What is an "excitement factor"?
How does one determine an intrinsic P/E ratio?

2. The valuation is done under one business strategy--that of AOL as a stand-alone,
internet portal firm. The analysis did not anticipate the Time Warner merger or any
other alternative paths for the business. (See box 1.4 in the text). To value an
internet stock in 1999, one needed a well-articulated story of how the "Internet
revolution" would resolve itself, and what sort of company AOL would look like in
the end.

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Further Discussion Points
Circular valuations are not uncommon in the press and in equity research reports: the analyst
specifies a future P/E ratio without much justification, and this drives the valuation. Tenet 11
in Box 1.6 is violated.
The ability of AOL to make acquisitions like its recent takeover of Netscape (at the time) will
contribute to growth -- and Alger argued this. But, if AOL pays a fair price for these
acquisitions, it will just earn a normal return. What if it pays too much for an overvalued
internet firm?
What if it can buy assets (like those of Time Warner) cheaply because its stock is overpriced?
This might justify buying AOL at a seemingly high price. Introduce the discussion on
creating value by issuing shares in Chapter 3.
The value of AOLs brand and its ability to attract and retain subscribers are crucial.
The competitive landscape must be evaluated. Some argue that entry into internet commerce
is easy and that competition will drive prices down. Consumers will benefit tremendously
from the internet revolution, but producers will earn just a normal return. A 26% profit
margin has to be questioned. The 1999 net profit margin was 16%.
A thorough analysis would identify the main drivers of profitability and the growth.
- analysis of the firms strategy
- analysis of brand name attraction
- analysis of churn rates in subscriptions
- analysis of potential competition
- analysis of prospective mergers and takeovers and synergies that might be available
- analysis of margins.



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Postscript

David Alger, president of Fred Alger Management Inc., perished in the September 11, 2001
attack on the World Trade Center in New York, along with many of his staff. The Alger Spectra
fund was one of the top performing diversified stock funds of the 1990s.






























14
CHAPTER TWO

Introduction to the Financial Statements

Concept Questions
C2.2. False. Cash can also be paid out through share repurchases.
C2.4. For one of two reasons:

1. The firm is mispriced in the market.
2. The firm is carrying assets on its balance sheet at less than market value, or is
omitting other assets like brand assets and knowledge assets. Historical cost
accounting and the immediate expensing of R&D and expenditures on brand
creation produce balance sheets that are likely to be below market value.
C2.6. Some examples:
- Expensing research and development expenditures.
- Using short estimated lives for depreciable assets resulting is high depreciation
charges.
- Expensing store opening costs before revenue is received.
- Not recognizing the cost of stock options.
- Expensing advertising and brand creation costs.
- Underestimating bad debts
- Not recognizing contingent warranty liabilities from sales of products.
See Box 2.4.

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C2.8. Dividends are distributions of the value created in a firm; they are not a loss in generating
value. So accountants calculate the value added (earnings), add it to equity, and then treat
dividends as a distribution of the value added (by charging dividends against equity in the
balance sheet).

C2.10. Like depreciation of plant, amortization of intangibles recognizes a loss of value. Patents
expire, and so the value of the original investment is lost. So, just as the cost of plant is expensed
against the revenue the plant produces, the cost of patents is expensed against the revenue that
the patent produces.

C2.12. The fundamental analyst wants to anchor on what we know so not to mix what we
know with speculation. So he tells the accountants: Tell me what you know, dont speculate;
leave the speculation to me, the analyst. The reliability criterion enforces this request.

























16
Exercises
Drill Exercises
E2.2. Applying Accounting Relations: Cash Flow Statement

Change in cash = CFO Cash investment Cash paid out in financing activities
$130 = $400 - ? - $75
? = $195 million


E2.4. Preparing an Income Statement and Statement of Shareholders Equity
Income statement:
Sales $4,458
Cost of good sold 3,348
Gross margin 1,110
Selling expenses (1,230)
Research and development (450)
Operating income (570)
Income taxes 200
Net loss (370)

Note that research and developments expenses are expensed as incurred.

Equity statement:

Beginning equity, 2012 $3,270

Net loss $(370)
Other comprehensive income 76 (294) ($76 is unrealized gain on securities)
Share issues 680
Common dividends (140)

Ending equity, 2012 $3,516

Comprehensive income (a loss of $294 million) is given in the equity statement. Unrealized
gains and losses on securities on securities available for sale are treated as other comprehensive
income under GAAP.

Net payout = Dividends + share repurchases share issues

= 140 + 0 680

= - 540
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That is, there was a net cash flow from shareholders into the firm of $540 million.

Taxes are negative (that is, the effect on income is positive) because income is negative (a loss).
A loss yields a tax benefit that he firm can carry forward to reduce future taxes.


E2.5. Classifying Accounting Items

a. Current asset
b. Net revenue in the income statement: a deduction from revenue
c. Net accounts receivable, a current asset: a deduction from gross receivables
d. An expense in the income statement. But R&D is usually not a loss to shareholders; it
is an investment in an asset.
e. An expense in the income statement, part of operating income (and rarely an
extraordinary item). If the restructuring charge is estimated, a liability is also
recorded, usually lumped with other liabilities.
f. Part of property, plan and equipment. As the lease is for the entire life of the asset, it
is a capital lease. Corresponding to the lease asset, a lease liability is recorded to
indicate the obligations under the lease.
g. In the income statement
h. Part of dirty-surplus income in other comprehensive income. The accounting would
be cleaner if these items were in the income statement.
i. A liability
j. Under GAAP, in the statement of owners equity. However from the shareholders
point of view, preferred stock is a liability
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k. Under GAAP, an expense. However from the shareholders point of view, preferred
dividends are an expense. Preferred dividends are deducted in calculating net income
available to common and for earnings in earnings per share.
l. As an expense in the income statement.

E2.7. Using Accounting Relations to Check Errors
Ending shareholders equity can be derived in two ways:

1. Shareholders equity = assets liabilities

2. Shareholders equity = Beginning equity + comprehensive income net dividends
So, if the two calculations do not agree, there is an error somewhere. First make the calculations
for comprehensive income and net dividends:
Comprehensive income = net income + other comprehensive income
= revenues expenses + other comprehensive income
= 2,300 1,750 90
= 460
Net dividend = dividends + share repurchases share issues
= 400 +150 900
= - 350
Now back to the two calculations:
1. Shareholders equity = 4,340 1,380
= 2,960
2, Shareholders equity = 19,140 + 460 (-350)
= 19,950
The two numbers do not agree. There is an error somewhere.
19

Applications
E2.9. Testing Accounting Relations: General Mills Inc.
This exercise tests some basic accounting relations.
(a) Total liabilities = Total assets stockholders equity
= 17,679 5,648
= 12,031
(b) Total Equity (end) = Total Equity (beginning) + Comprehensive
Income Net Payout to Common Shareholders
5,648 = 5,417 + ? 737
? = 968
Net payout to common = cash dividends + stock purchases share issues
= 648 + 692 - 603
= 737

E2.10. Testing Accounting Relations: Genetech Inc.
(a)
Revenue = Net income + Net expenses (including taxes)
= $784.8 + 3,836.4
= $4,621.2 million
(b) ebit = Net income + Interest + Taxes
= $784.8 - 82.6 + 434.6
= $1,136.8 million
(Note: net interest is interest income minus interest expense)
(c) ebitda = Net income + interest + taxes + depreciation and amortization
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= Ebit + depreciation + amortization
= $1,136.8 + 353.2
= $1,490.0 million
Depreciation and amortization is reported as an add-back to net income to get cash flow from
operations in the cash flow statement.
(a) Long-term assets = Total assets Current assets
= $9,403.4 3,422.8
= $5,980.6 million
Total Liabilities = Total assets shareholders equity
= $9,403.4 6,782.2
= $2,621.2 million
Short-term Liabilities = Total liabilities Long-term Liabilities
= $2,621.2 - 1,377.9
= $1,243.3 million
(b) Change in cash and cash equivalents = Cash flow from operations Cash used in investing
activities + Cash from financing activities
Change in cash and cash equivalents is given by the changes in the amount is the balance sheet
= $270.1 372.2 = -$102.1
So, -$102.1 = $1,195.8 - $451.6 + ?
So ? = -$846.3 million
That is, there was a cash outflow of $846.3 million for financing activities.


21

E2.12. Find the Missing Numbers in Financial Statements: General Motors
a.
Total Equity (end) = Total Equity (beginning) + Comprehensive
Income Net Payout to Common Shareholders

-56,990 = -37,094 + ? 283
? = -19,613 (a loss)

b.

Comprehensive income = Net income + Other comprehensive income
-19,613 = -18,722 + ?
? = - 891

c.
Net income = Revenue expenses and losses
-18,722 = ? 60,895
? = 42,173

d.
June 30, 2008 December 31, 2007

Assets 136,046 148,883
Liabilities ? = 193,036 ? = 185,977
Equity -56,990 -37,094

E2.14. Calculating Stock Returns: Nike, Inc.
The stock return is the change in price plus the dividend received. So, Nikes stock return
for fiscal year 2010 is
Stock return = $73.38 - $57.83 + $1.06 = $16.61
The rate-of-return is the return divided by the beginning-of-period price: $16.61/57.83 = 28.72%.





p. 22 Solutions Manual to accompany Financial Statement Analysis and Security Valuation
CHAPTER THREE

How Financial Statements are Used in Valuation


Concept Questions
C3.1. Investors are interested in profits from sales, not sales. So price-to-sales ratios vary
according to the profitability of sales, that is, the profit margin on sales. Investors are also
interested in future sales (and the profitability of future sales) not just current sales. So a firm
will have a higher price-to-sales ratio, the higher the expected growth in sales and the higher the
expected future profit margin on sales. See Box 3.4.
Note that the price-to-sales ratio should be calculated on an unlevered basis. See Box 3.2
C3.3.
Merits:
The price-to-ebitda ratio has the same merits as the price-to-ebit ratio. But,
by adding back depreciation and amortization to ebit, it rids the calculation of an accounting
measurement that can vary over firms and, for a given firm, is sometimes seen as suspect. It thus
can make firms more comparable.
Problems:
This multiple suffers from the same problems as the price-to-ebit ratio.
In addition it ignores the fact that depreciation and amortization are real costs. Factories
depreciate (lose value) and this is a cost of operations, just as labor costs are. Copyrights and
patents expire. And goodwill on a purchase of another firm is a cost of the purchase that has
to be amortized against the benefits (income) from the purchase, just as depreciation
amortizes the cost of physical assets acquired. The accounting measures of these economic
23
costs may be doubtful, but costs they are. Price-to-ebitda for a firm that is capital intensive
(with a lot of plant and depreciation on plant) is different from that of a labor intensive firm
where labor costs are substituted for plant depreciation costs. So adding back depreciation
and amortization may reduce comparability.
During the telecom bubble, analysts priced firms based on ebitda. The telecoms over-invested
in networks, producing excess capacity. The cost of this excess capacity does not affect ebitda,
so is not counted.

C3.5.
72 . 0 06 . 0 12
S
E
E
P
S / P = = =

C3.7. Traders refer to firms with high P/E and/or high P/B ratios as growth stocks, for they see
these firms as yielding a lot of earnings growth. They see prices increasing in the future as the
growth materializes. The name, value stocks is reserved for firms with low multiples, for low
multiples are seen as indicating that price is low relative to value. A glamour stock is one that is
very popular due to high sales and earnings growth (and usually trades at high P/S and P/E
ratios). A contrarian stock is once that is said to be out of favor and trades at a low multiple.


p. 24 Solutions Manual to accompany Financial Statement Analysis and Security Valuation
C3.9. Yes. The value of a bond depends on the coupon rate because the value of the bond is the
present value of the cash flows (including coupon payments) that the bond pays. But the yield is
the rate at which the cash flows are discounted and this depends on the riskiness of the bond, not
the coupon rate. Consider a zero coupon bond it has no coupon payment, but a yield that
depends on the risk of not receiving payment of principal.

C3.11. No. Dividends reduce the price of a firm (and the per-share price). But shareholder
wealth is not changed (at least before the taxes they might have to pay on the dividends) because
they have the dividend in hand to compensate them for the drop in the share price. In a stock
repurchase, total equity value drops by the amount of the share repurchase, as with the dividend.
Shareholders who tender shares in the repurchase are just as well off (as with a dividend)
because they get the cash value of their shares. The wealth of shareholders who did not
participate in the repurchase is also not affected: share repurchases at market price do not affect
the per-share price. So share repurchases do not create value for any shareholders.
Subsequent eps are higher with a stock repurchase than with a dividend (as explained in
the answer to question C3.10). Shareholders who tendered their shares in the repurchase earn
from reinvesting the cash received, as they would had they received a dividend. Shareholders
who did not tender have lower earnings (because assets are taken out of the firm) but higher
earnings per share to compensate them from not getting the dividend to reinvest.








25
Exercises
Drill Exercises
E3.1. Calculating a Price from Comparables

P/E for the comparable firm = 100/5 = 20
P/B for the comparable firm = 100/50 = 2

Price for target, from earnings = $2.50 20 = $50 per share
Price for target, form book value = $30 2 = $60 per share

Average of the two prices = $55 per share


E3.3 Unlevered (Enterprise) Multiples

Market price of equity = 80 $7 = $560 million
Market value of debt 140 (assumes book value market value)
Market value of enterprise $700 million

Book value of shareholders equity = $250 - 140 = $110million

a. P/B = 560/110 = 5.09
b. Unlevered P/S = 700/560 = 1.25
c. Enterprise P/B = 700/250 = 2.8


E3.5. Valuing Bonds

For this question, first calculate discount factors for each of five years ahead. You can also get
them from present value tables where the discount factor is given as 1/1.05
t
. At a 5% required
return, the discount factors are:

Year Ahead (t) Discount factor (1.05
t
)
1 1.05
2 1.1025
3 1.1576
4 1.2155
5 1.2763

a. The only cash flow is the $1,000 at maturity

Present value (PV) of $1,000 five years hence = $1,000/1.2763
= $783.51
p. 26 Solutions Manual to accompany Financial Statement Analysis and Security Valuation

b. This is easy. If the coupon rate is the required rate of return, the bond is worth its face
value, $1,000. You can show this by working the problem as in part b, but with an annual
coupon of $50.


c. The yearly cash flows and their present value are:

Year Ahead (t) Discount factor (1.05
t
) Cash Flow PV
1 1.05 40 38.10
2 1.1025 40 36.28
3 1.1576 40 34.55
4 1.2155 40 32.91
5 1.2763 1, 040 814.86

Total Present Value $956.70

(Your answers might differ by a couple of cents if you use discount factors to 5 or 6 decimal
places.)


Applications
E3.7 The Method of Comparables: Dell, Inc.

First calculate the multiples for the comparable firms from the price and accounting numbers:





Sales

Earnings
Book
Value
Market
Value
Hewlett-Packard Co. $84,229 $ 7,264 $38,526 $115,700
Lenovo Group Ltd. 14,560 161 1,134 6,381


HP:

Price/Sales = 1.37
P/E = 15.93
P/B = 3.00

Lenovo:

Price/Sales = 0.44
P/E = 39.63
P/B = 5.63
27

Now apply the multiples to Dell:

Average Multiples Dells Dells
for Comparable Number Valuation

Sales 0.91 x 61,133 = $55,631 million
Earnings 27.78 x 2,947 = 81,868
Book value 4.32 x 3,735 = 16,135
Average of valuations 51,211


With 2,060 million shares outstanding, the estimated value per share
= $51,211/2,060 = $24.86
Difficulties:
- The comparables are not exactly like Dell. They have different
aspects in operationsHP has a big printer business, for example. One
firm may be a dominant firm in an industry, and thus not a comparable
for others.
- The calculation assumes the market prices for the comps are
efficient
- Not sure how to weight the three valuation based on sales, earnings
and book values; the valuations differ considerably, depending on the
multiple used

E3.9. Measuring Value Added
(a) Buying a stock:


Value of a share =
12 . 0
2
=

$ 16.67
Price of a share 19.00
Value lost per share $ 2.33

(b) Value of the investments:

Present value of net cash flow of
$1M per year for five years (at 9%)

$ 3.890 million
Initial costs 2.000
Value added $ 1.890 million

p. 28 Solutions Manual to accompany Financial Statement Analysis and Security Valuation
E3.11. Share Issues and Market Prices: Is Value Generated or Lost By Share Issues?
This exercise tests understanding of a conceptual issue: do share issues affect
shareholder value per share? The understanding is that issuing shares at market price does not
affect the wealth of the existing shareholders if the share market is efficient: New shareholders
are paying the fair price for their share. However, if the shares are issued at less than market
price, the old shareholders lose value.
(a) Total value of equity prior to issue = 158 million $55 = $ 8.69B
Value of share issue = 30 million $55 = 1.65B
Total value of equity after share issue 10.34B
Shares outstanding after share issue = 188 million

Price per share after issue = $55

Like a share repurchase, a share issue does not affect per share value as long as the shares
are issued at the market price. Old shareholders cant be damaged or gain a benefit from
the issue. Of course, if the market believes that the issue indicates how insiders view the
value of the firm, the price may change. But this is an informational effect, not a result of
the issue. Old shareholders would benefit if the market were inefficient, however. If
shares are issued when they are overvalued in the market, the new shareholders pay too
much and the old shareholders gain.
The idea that share issues don't generate value (if at market prices) is the same idea that
dividends don't generate value. Share issues are just dividends in reverse.

29
(b) Total value of equity prior to exercise = 188 million 62 = $11.66B
Value of share issue through exercise = 12 million 30 = 0.36B
Total value of equity after exercise 12.02B
Shares outstanding after exercise 200 million

Price per share $60.10
The (old) shareholders lost $1.90 per share through the issue: issue of shares at less than
market causes dilution of shareholder value.
E3.13. Betas, the Market Risk Premium, and the Equity Cost of Capital: Oracle
Corporation

a) The CAPM equity cost of capital is given by
Cost of capital = Risk-free rate + (Beta Market risk premium)
= 4.0% + (1.20 ?)
Market Risk
Premium
Cost of
Capital
4.5% 9.4%
6.0% 11.2%
7.5% 13.0%
9.0% 14.8%

b)
Market Risk
Premium
Beta Cost of Capital
4.5% 0.9
1.4
8.05%
10.30%
6.0% 0.9
1.4
9.40%
12.40%
p. 30 Solutions Manual to accompany Financial Statement Analysis and Security Valuation
7.5% 0.9
1.4
10.75%
14.5%
9.0% 0.9
1.4
12.10%
16.60%


c) Lowest cost of capital: 8.05%
Highest cost of capital: 16.60%
Forecasted price in May 2012 = $2.17 20 = $43.40
Forecasted price, cum-dividend (total payoff) = $43.40 + 0.24 = $43.64
Present value at 8.05 % = $43.64 = $40.389
1.0805
Present value at 16.60% discount rate = $43.64 = $37.427
1.1660

Note that the current value is the present value of the total payoff one year hence, that is, the
cum-dividend price one year hence. Put is another way, $37.427 in vesting in May 2011 is
expected to yield a payoff of $43.64 (including dividends) one year hence if the required return
is 16.60%.



31
CHAPTER FOUR
Cash Accounting, Accrual Accounting, and Discounted Cash Flow Valuation

Concept Questions

C4.1. The first sentence is true: dividends are the payoff to equity investing. The second sentence
is true in theory but not in practice. Equity value is the present value of the infinite stream of
expected dividends that a going concern generates. But, in practice, one cant forecast to infinity.
Dividends paid over practical, finite forecast horizons are not relevant to value: the dividends
firm pay up to the liquidating dividend can be any amount but that amount does not affect its
present value. Consider the case of a firm that pays no dividend (in the short run), for example.
Apple Inc., is a case in point: Apple pays no dividends (as of 2012). Cisco paid no dividends for
many years, nor did Microsoft. Dell pays no dividends. Yet these are companies that have
considerable value. This is this dividend conundrum: Value is based on expected dividends, but
forecasting dividends is not relevant to value as a practical matter.

C4.3. Not necessarily. A firm can generate higher free cash flow by liquidating its investments.
A highly profitable (and highly valuable) firm can have low (or even negative) free cash flows
because it is investing heavily to capitalize on its investment opportunities. Again, see the GE
and Starbuck examples in Exhibit 4.2.

C4.5. The answer is (b). Matching cash received from sales with cash spent on inventory does
not match value received with value given up to earn the cash, because it recognizes the cost of
unsold goods against the receipts from goods sold. Accrual accounting accomplishes the
matching because only the cost of goods sold is recognized against the revenue from goods sold.
p. 32 Solutions Manual to accompany Financial Statement Analysis and Security Valuation

C4.7. Free cash flow is earnings (before after-tax interest) minus operating accruals minus cash
investment in operations:
C I (free cash flow) = Earnings + net interest payments accruals cash investment
Or, as in equation 4.11 and Box 4.7,
Earnings = C I - net interest payments + accruals + cash investment
C4.9. Statement b is much more likely to be true. Indeed, very profitable companies (with
significant investment opportunities) are likely to invest a lot and so generate negative free cash
flow.
Exercises
Drill Exercises
E4.1. A Discounted Cash Flow Valuation

2012 2013 2014 2015

Cash flow from operations $1,450 1,576 1,718
Cash investment $1,020 1,124 1,200
Free cash flow $ 430 452 518

Discount rate (1.10)
t
1.10 1.21 1.331
PV of cash flows 391 374 389
Total PV to 2015 $1,154
Continuing value* 8,979
PV of CV 6,746
a. Enterprise value $7,900 million
Net debt 759
b. Value of equity $7,141 million


* Continuing value = =

04 . 1 10 . 1
04 . 1 518
8,989
E4.3. Valuation with Negative Free Cash Flows

Calculate free cash flow from the forecasts of cash flow from operations and cash investments.
Your will see that free cash flow is negative in all years except 2013:
33

2013 2014 2015 2016

Cash flow from operations 730 932 1,234 1,592
Cash investments 673 1,023 1,352 1,745
Free cash flow 57 ( 91) ( 118) ( 153)

If you calculate the present value of these free cash flows (with any discount rate), youll get a
negative price. Prices cant be negative (with limited liability). The continuing value must be
greater than 100% of the price, but we have no way to calculate it. The free cash flows are
increasingly negative because, while cash flow from operations are positive and increasing, the
firm is investing more.


E4.5. Reconciling Accrual and Cash Flow Numbers
a. Accruals = Earnings Cash flow from operations
= $735 - $1,623
= -$888 million
(Accruals are negative, as they are often, because depreciation is a big number)
b. As there is no net debt (and thus no net interest), the reported cash flow from operations
is the correct number
Free cash flow = Cash flow from operations cash investment
= $4,219 -$2,612
= $ 1,607 million

Earnings = Cash flow from operations + accruals
= $4,219 1,389
= $2,830
As the firm added accruals to earnings to get to the cash flow the accruals are negative.

c. Cash from revenues = Accrual revenues + beginning accounts receivable ending
accounts receivable
= $623 +281 - 312
= $592 million
d. Tax expense = Cash paid for taxes taxes payable at the beginning of the year +
taxes payable at the end of the year
p. 34 Solutions Manual to accompany Financial Statement Analysis and Security Valuation

= $128 67 + 23
= $84 million
Applications

E4.7. Calculating Cash Flow from Operations and Cash Investment for Coca-Cola

Cash flow from operations:

Reported cash flow from operations $7,150
Interest paid $405
Interest received 236
Net interest paid 169
Tax deduction (at 36%) 61 108
Cash from operations $7,258 million

Cash investment:

Reported cash investment $6,719
Sale of investments $ 448
Purchase of investments (99) 349
Cash investment in operations $7,068

Cokes free cash flow was $7,258 7,068 = $190.

E4.9. Cash Flow and Earnings: Kimberly-Clark Corporation
Part a.

Adjust cash flow from operations for after-tax net interest payments and cash investment for net
investments in interest-bearing assets:

Cash flow from operations reported $2,969.6
Interest paid $175.3
Interest income (17.9)
Net interest 157.4
Tax on net interest (at 35.6%) 56.0 101.4
Cash flow from operations $3,071.0

Cash flow from investing reported $(495.4)
Net investment in debt securities (38) + 11.5 ( 26.5)
Net investment in time deposits 22.9 (499.0)

35
Free cash flow $2,572.0

Note: As cash interest receipts are not reported (as is usual), use interest income from the income
statement.

Part b.

Accruals = Net income Cash flow from operations
= $1,800.2 2,969.6
= $(1,169.4)

E4.10. A Discounted Cash Flow Valuation: General Mills, Inc.

a. The exercise involves calculating free cash flows, discounting them to present value, then
adding the present value of a continuing value. For part (a) of the question, the continuing value
has no growth:

2005 2006 2007 2008 2009
Cash flow from operations 2,014 2,057 2,095 2,107
Cash investment in operations 300 380 442 470
Free cash flow (FCF) 1,714 1,677 1,653 1,637
Discount rate 1.09 1.1881 1.2950 1.4116
Present value of FCF 1,572 1,411 1,276 1,160
Total of PV to 2009 5,419
Continuing value (CV) 18,189
PV of CV 12,885
Enterprise value 18,304
Net debt 6,192
Equity value 12,112

Value per share on 369 million shares = $32.82

CV (no growth) = 189 , 18
09 . 0
637 , 1
=
PV of CV = 885 , 12
4116 . 1
189 , 18
=

b. With growth of 3% after 2009, the continuing value is:
102 , 28 $
03 . 1 09 . 1
03 . 1 637 , 1
=

= CV
The present value of the continuing value is $28,102/1.4116 = $19,908.
p. 36 Solutions Manual to accompany Financial Statement Analysis and Security Valuation
Do the valuation is as follows:

Total of PV to 2009 5,419
Continuing value (CV) 28,102
PV of CV 19,908
Enterprise value 25,327
Net debt 6,192
Equity value 19,135

Value per share on 369 million shares = $51.86.

E4.11. Free Cash Flow for General Motors

Appropriate free cash flow calculation:

2005 2004
Cash flow from operations reported $3,676 $12,108
Net interest $4,059 $3,010
Tax at 36% 1,461 2,589 1,084 1,926
$6,274 $14,034

Cash investment reported $(179) (24,209)
Net investment in debt securities (1,618) (1,797) ( 592) (24,801)

Free cash flow $4,477 $(10,767)

Mistakes by analyst:

1. Includes net sales of marketable (debt) securities as cash investment in operations
rather than sales of these securities to satisfy a cash shortfall. In both years, there is
more sales (liquidations) of these securities than purchases, reducing reported cash
investment.

2. Treats the liquidation of investments in companies (of
$
1,367 million in 2005) as
good news because it increases free cash flow. Selling off investments increases
current cash flow but reduces future free cash flows.

3. Treats increased sales of finance receivables (of
$
27,802 million in 2005) as
increasing free cash flow (and thus as good news). Sales of finance receivables
merely speed the receipt of cash. Booking the receivables from customers is what
adds value.

4. Treats the decrease in bookings of finance receivables (from a
$
31,731 million
increase in 2004 to a
$
15,843 million increase in 2005) as good news.

37
E4.12. Cash Flows for Wal-Mart Stores

a. Wal-Mart is an expanding company with opportunities to invest in new stores throughout
the world. While it generates considerable cash flow from operations, cash investments
routinely exceed cash from operations. So free cash flow is negative. This is a firm like
General Electric in Exhibit 4.2. DCF analysis will not work for this firm.
b. The difference between earnings and cash from operations is due net interest (after-tax)
and accruals.
The difference between earnings and free cash flows is due to net interest (after
tax), accruals and investments in operations.
c. DCF will not work. Negative free cash flows yield negative values.


E4.14. An Examination of Revenues: Microsoft Corp.

Cash revenue = Revenue reported Change in Accounts
Receivable + Change in Unearned Revenue
= $62.484 1.822 + 0.546
= $61,208 billion
Minicase
M4.1 Discounted Cash Flow Valuation: Coca Cola Company
Price: $62
Trailing P/E: 23.9
P/B: 6.6
P/Sales: 5.0

Annual sales: $28.9 billion
Market cap: $143.7 billion

p. 38 Solutions Manual to accompany Financial Statement Analysis and Security Valuation
A. Calculating free cash flow for 2008-2010
As GAAP confuses operating and financing cash flows, the cash flow statement numbers
must be adjusted. Equations 4.9 and 4.10 show how the adjustment are made and Box 4.5
demonstrates with Nike, Inc. Here are the adjustments for Coke:

2010 2009 2008

Reported cash flow from ops 9,532 8,186 7,571
Interest payments 733 355 438
Interest receipts 317 249 333
Net interest payments 416 106 105
Taxes (35.6%) 148 268 38 68 37 68
Cash flow from operations 9,800 8,254 7,639

Reported cash investment 4,405 4,149 2,363
Purchase of S/T investments (4,579) (2,130) -
Sale of S/T investments 4,032 3,858 - 2,019 - 2,363

Free cash flow 5,942 6,235 5,276

Note that interest receipts are usually not reported, so interest income (that may include some
accrued interest) is taken as an approximation.

B. Valuation using DCF
Following the template in Exhibit 4.1, the valuation proceeds as follows:



2007 2008 2009 2010
Fee cash flow 5,276 6,235 5,942
Discount rate (1.09
t
) 1.09 1.1881 1.2950
PV of FCF 4,840 5,248 4,588
Total PV of FCF to 2010 14,676
Continuing value (CV)
594 , 123
04 . 1 09 . 1
04 . 1 942 , 5
=

123,594

PV of CV =
295 . 1
594 , 123
95,439
39

Enterprise value 110,115
Net debt 12,235 (23,417 11,182)
Value of equity 97,880
Value per share on 2,318 shares outstanding: $42.23
The continuing value here is based on FCF growing at the GDP growth rate of 4%. As the
market price is $62, it is clear that the market sees higher growth rate if it agrees with the FCF
forecasts. One might expect a higher growth rate for Coke than the average GDP rate, given that
Coke has competitive advantage due to its brand positioning. Setting the growth rate at 5% (as in
Exhibit 4.1), yields a continuing value of $155,978 million and an equity value of $122,887
million or $53.01 per share.

It is clear that, without some more analysis as to what the growth rate should be, we are a bit at
sea here (and the long-term growth rate has a big effect on the valuation). The only information
we have is the FCF growth from 2009-2010 and that is 18.18% in 2009 but -4.70% in 2010. Not
much help.

But therein lies the problem: FCF growth is not a good measure to base a continuing value on.
Indeed, FCF in 2010 is not a good base on which to apply a growth rate. The reason is that
investment (that is made to yield growth) reduces FCF and thus induces negative growth. For
Coke, we see increasing cash flow from operations over the years, 2008-2010, but we see FCF in
2010 has declined from 2009. The reason is, of course, the increased investment in 2010 in
acquisitions and PPE. Investment makes free cash flow look bad. All we could say here is that
we should have a higher growth rate on the low 2010 base, but what that growth rate should be is
largely speculation..and we would be left with a very speculative valuation.


Can we value Coke in 2004?
The problem is more severe in 2004:

________________________________________________________________________
2004 2005 2006 2007

Cash flow from operations 5,929 6,421 5,969 7,258
Cash investments 618 1,496 2,258 7,068
Free cash flow 5,311 4,925 3,711 190

Here the free cash flows are declining over the four years. If cash flows from operations and cash
investments were declining at about the same rate, we might conclude that the firm
indeed was in a state of decline: declining cash flows from the business lead to declining
investments. However, cash flows from operations are increasing and cash investment is
increasing at a faster rate: Coke is investing heavily. While free cash flow is declining
p. 40 Solutions Manual to accompany Financial Statement Analysis and Security Valuation
over these years, one would thus expect it to increase in future years as cash from the
rising investment here comes in. These cash flow are not a good indication of future free
cash flows (and nor is the $190 million of free cash flow in 2007 a good base to calculate
a continuing value.)

If you put yourself in the position of valuing Coke in early 2004 on the basis of these cash flows,
you would be in a stew, particularly in calculating a continuing value at the end of 2007
on the $190 million base. This is another example of why free cash flow does not work,
in principle: Investment (which is made to generate cash flows actually decreases free
cash flow. The cases of General Electric and Starbucks in Exhibit 4.2 are extremes where
FCF is actually negative due to investment.

Discussion

The chief discussion point of the case is the concept behind free cash flows. See that section in
the chapter. Free cash flow is a liquidation concept, so that a profitable firm, like Starbucks in
Exhibit 4.2, that invests heavily to take advantage of its profit opportunities, has negative free
cash flow. But a firm that liquidates its investments (possibly destroying value) increases free
cash flow. The measure is perverse. It does not capture value added.

Home Depot has negative free cash flow for many years, as did Wal-Mart, and free cash flows
turned positive only as these firms slowed their investment.

At this point, introduce accrual accounting and show how it deals with investment (as in the
text) and, in addition, attempts to correct the mismatching of value added and value surrendered
that is the problem with free cash flow. That will help set up the accrual accounting valuation of
the next two chapters.

Financial statements for presenting the case are below.


41










p. 42 Solutions Manual to accompany Financial Statement Analysis and Security Valuation
CHAPTER FIVE

Accrual Accounting and Valuation: Pricing Book Values


Concept Questions

C5.2. To trade at book value, as Jetform does (approximately), we must expect ROCE in the
future to be equal to the cost of capital, 10%. Thus we conclude that the market expects an
ROCE of 10% in the future. The current ROCE is not really relevant here, but it is somewhat
confirming: current ROCE is an indicator of future ROCE.
C5.4. No. If the firm is expected to earn an ROCE in excess of the required return, it should
sell at a premium over book value. Given the forecast, the firm is a BUY if it trades below book
value.
C5.6. Firms create residual earnings through ROCE and growth in net assets that earn at the
ROCE. The ROCE for GE are approximately level over the forecast years, but the book values
are increasing. With constant ROCE and growing book values, residual earnings increase.

C5.8. If the analyst does not forecast all sources of earnings (that is, comprehensive earnings)
then she will ignore some part of the payoff to shareholders, and will lose some value in her
calculation of a value from the forecast.





43
Exercises

Drill Exercises
E5.1. Forecasting Return on Common Equity and Residual Earnings

Set up the pro forma as follows:

2012 2013 2014 2015

Eps 3.00 3.60 4.10
Dps 0.25 0.25 0.30
Bps 20.00 22.75 26.10 29.90
ROCE 15.00% 15.83% 15.71%
RE (10% charge) 1.00 1.325 1.49

a. The answer to the question is in the last two lines of the pro forma

b. As forecasted residual earnings are positive, the shares of this firm are worth a premium
over book value.


E5.3. A Residual Earnings Valuation

This question asks you to convert a pro forma to a valuation using residual earnings methods.
First complete the pro forma by forecasting book values from earnings and dividends. Then
calculate residual earnings from the completed pro forma and value the firm.






2013E 2014E 2015E 2016E 2017E

Earnings 388.0 570.0 599.0 629.0 660.4
Dividends 115.0 160.0 349.0 367.0 385.4
Book value 4,583.0 4,993.0 5,243.0 5,505.0 5,780.0

ROCE 9.0% 12.4% 12.0% 12.0% 12.0%
Residual earnings -43.0 111.7 99.7 104.7 109.9
(10%)
p. 44 Solutions Manual to accompany Financial Statement Analysis and Security Valuation
Growth in RE -10.7% 5.0% 5.0%
Growth in Book value 8.9% 5.0% 5.0% 5.0%
Discount factor 1.110 1.210 1.331 1.464 1.611
PV of RE -39.1 92.3 74.9

a. Forecasted book values, ROCE, and residual earnings are given in the completed pro
forma above. Book value each year is the prior book value plus earnings and minus
dividends for the year. So, for 2011 for example,
Book value = 4583 +570 160 = 4,993.
The starting book value (in 2012) is 4,310. Residual earnings for each year is earnings
charged with the required return in book value. So, for 2014 for example,
RE is 570 (0.10 4,583) = 111.7.
b. Forecasted growth rates in book value and residual earnings are given above.
c. The growth rate in residual earnings is 5% after 2014. Assuming this growth rate will
continue into the future, the valuation is a Case 3 valuation with the continuing value
calculated at the end of 2014. That continuing value is the RE for 2015 of $99.7 growing
at 5% per year.
Book value, 2006 4,310.0
Total present value of RE to 2014 (-39.1 + 92.3) 53.20
Continuing value (CV), 2012: 0 . 994 , 1
05 . 1 10 . 1
7 . 99
=

Present value of CV: 1,994/1.210 1,647.93

Value of the equity, 2009 6,011.3

Per share value (on 1,380 million shares) 4.36

d. The premium is 6,011.3 4,310 = 1,701.3, or 1.23 on a per-share basis.
The P/B ratio is 6,011.3/4,310 = 1.39.

45
E5.5. Residual Earnings Valuation and Return on Common Equity

(a) Set the current year as Year 0.
Earnings, Year 1 = 15.60 0.15 = 2.34
Residual earnings, Year 1 = 2.34 (0.10 15.60)
= 0.78
This RE is a perpetuity, so

10 . 0
RE
B V
0
0 0
+ =

40 . 23
10 . 0
78 . 0
60 . 15 = + =

1.5 15.60 23.40 B P = =

(a) No effect: future payout does not affect current price (unless you have a tax story) and future
dividends dont affect current book value: P/B is still 1.5. But the issue is a little subtle. The
idea that dividend payout does not matter is premised on the assumption that dividends do
not affect investment activitythat is the assumption behind the famous Miller &
Modigliani dividend irrelevance notion. If the retained earnings were invested at the same
ROE of 15% (and thus affecting investments), then the value and P/B will change. For the
value to stay the same, it has to be that management (who make the dividend decision)
concludes that retained earnings cannot be invested at the same ROE of 15%. If they did not,
they should not be paying a dividend and destroying value! (Of course, they could pay a
dividend and borrow to replace the funds for investment).



p. 46 Solutions Manual to accompany Financial Statement Analysis and Security Valuation

E5.7. Using Accounting-Based Techniques to Measure Value Added for a Going Concern

(a)
Time line:
0 1 2 3 4 5 6 7
Investment
150 150 150 150 150 150 150 150
Depreciation
1
30 60 90 120 150 150 150
Book value
2
270 360 420 450 450 450 450
Revenue
52.5 100.5 144.0 183.0 217.5 217.5 217.5
Depreciation
30.0 60.0 90.0 120.0 150.0 150.0 150.0
Earnings (15%)
22.5 40.5 54.0 63.0 67.5 67.5 67.5
RE (0.12)
4.5 8.1 10.8 12.6 13.5 13.5 13.5
PV of RE
4.0 6.5 7.7 8.0
Total of PV of RE
26.2
112.5
PV of CV
71.5

Value
247.7
Lost
150
Value added
97.7
Continuing value
3


1. Depreciation is $30 million per year for each project in place
2. Book value (t) = Book value (t-1) + Investment (t) Depreciation (t)
3. CV =
12 . 0
5 . 13
= 112.5

The value of the firm is $247.7 million. The continuing value is based on a forecast of residual
earning of 13.5 in year 5 continuing perpetually with no growth. This is a Case 2 valuation.
(b) The value added is $97.7 million

47
(c) The value added is greater than 15% of the initial investment because there is growth in
investment: value is driven by the rate of return of 15% (relative to a cost of capital of 12%) but
also by growth.

Applications
E5.9. Residual Earnings Valuation: Black Hills Corp
The pro forma for the exercise is as follows:

Forecast Year
____________________________________
1999 2000 2001 2002 2003 2004

Eps 2.39 3.45 2.28 2.00 1.71
Dps 1.06 1.12 1.16 1.22 1.24
Bps 9.96 11.29 13.62 14.74 15.52 15.99

ROCE 24.0% 30.6% 16.7% 13.6% 11.0%
RE (11% charge) 1.294 2.208 0.782 0.379 0.003
Discount rate (1.11)
t
1.110 1.232 1.368 1.518 1.685
Present value of RE 1.166 1.792 0.572 0.250 0.002
Total present value of RE to 2004 3.78
Continuing value (CV) 0.0
Present value of CV 0.00
Value per share 13.74


a. ROCE and residual earnings are in the pro forma
b. If ROCE is to continue at 11% after 2004, then residual earnings are expected to be zero.
The continuing value is zero. The value is $13.74 per share a Case 1 valuation.
c. As the CV = 0, the target price is equal to forecasted bps of $15.99 at 2004.











p. 48 Solutions Manual to accompany Financial Statement Analysis and Security Valuation
E5.10. Valuing Dell, Inc.

a. The pro forma for 2009 and 2010 and the value it implies is as follows:

2008 2009 2010
EPS 1.47 1.77
DPS 0.00 0.00
BPS 1.813 3.283 5.053
RE (10%) 1.289 1.442
Discount rate 1.10 1.21
PV of RE 1.172 1.192
Total PV to 2010 2.364
Continuing value
04 . 1 10 . 1
04 . 1 442 . 1

24.99
PV of continuing value 20.66

Value per share 24.84

Note: BPS at the end of fiscal-year 2008 = $3,735/2,060 shares = $1.813.



E5.11. Valuing General Electric Co.

a. Here is the pro forma using a required return of 10%.

2004 2005 2006
EPS 1.71 1.96
DPS (dividend payout 50%) 0.86 0.98
BPS 10.47 11.32 12.30
RE (10%) 0.663 0.828

The value is calculated as follows, with a 4% growth rate in the continuing value:



04 . 1 10 . 1
828 . 0
10 . 1
1
10 . 1
663 . 0
47 . 10 $ 38 . 28 $

- + + =

= $23.62





49
E5.13. Converting Analysts Forecasts to a Valuation: Nike, Inc.
Here is a layout of the solution similar to Table 5.2:

Nike appears to be reasonably priced at $60 per share. If you accept the analysts forecasts up to
2012 (and you may well be skeptical). The calculation (with a value of $62.56) suggest that the
market is forecasting a 4% long-term growth rate.

E5.15. Impairment of Goodwill

(a) As the asset is at fair value (the acquisition price) on the balance sheet, it is expected to
earn at the required return on book value: Residual earnings is projected to be zero. (Fair
value in an acquisition always prices the acquisition to earn at the required rate of return.)
(b) The book value must be marked down to fair market value under FASB Statement No.
142. The book value at the end of 2011 before the write down, is 301 + 79 = 380 (the
depreciated amount of the tangible assets plus the good will).
p. 50 Solutions Manual to accompany Financial Statement Analysis and Security Valuation
Forecasted earnings for 2012 on this book value (at the forecasted ROCE of 9%) is
380 0.09 = 34.2
For a 10% required return, the book value that yields residual earnings in 2012 equal to zero
= 34.2 10 = 342:
RE
2012
= 34.2 (0.10 342) = 0
A book value of 342 is thus fair value.
Accordingly, the amount of impairment = 380 342 = 38.


Minicases

M5.3. Kimberly-Clark: Buy Its Paper?
Price 63.20
Book value (2007) $5,224
Shares outstanding 420.9 million
Bps $5,224 / 420.9 =
$
12.41


Parts A D and F of the case can be addressed with material from this chapter. Part E introduces the
reverse engineering of Chapter 7 which you may wish to delay until then, or use it to set up the ideas in
that chapter.


The Pro Forma










A. Forward P/E = $63.20 / $4.54
= 13.92

P/B = $63.20 / $12.41
=5.09

2007 2008 2009
Eps 4.13 4.54 4.96
Dps 2.32 2.53
Bps 12.41 14.63 17.06
RE (9%) 3.423 3.643
RE (8%) 3.547 3.790
RE (10%) 3.299 3.497
51
B.


C. Book value (2009) = 17.06
Continuing value = 75.77 (from part B)
Price (2009) 92.83

(The continuing value is the last term in Part B before discounting)

D. For a beta of 0.6, the required return = 5% + (0.6 x 5%)

= 8%

Repeat exercise in Part B:

V (with required return of 8%) = $103.42
V (with required return of 10%) = $68.39


E.



RE (2010) = RE (2009) x 1.02
=3.643 x 1.02 = 3.716

EPS (2010) = BV (2009) x .09 + RE
2010
=(17.06 X 0.09) + 3.716
= 5.251

EPS growth rate, 2010 =

Compare with 9.93% in 2008 and 8.95% in 2009. Either analysts forecasts for 2008 and
2009 are too high or the market sees lower growth after 2009.

F. Three points point to underpricing:

1. As the EPS growth forecast for 2010 by the market price is lower than the growth
rate forecasted by analysts for 2008 and 2009, the market price does look low.

2. Our valuation also indicates that the market price is below calculated value even
when we set a high required return of 10%. These valuations assume a standard
(average) 4% growth rate (the GDP growth rate).

3. With a 9% required return, the market is forecasting a 2% growth rate which is
low relative to the GDP growth rate.
p. 52 Solutions Manual to accompany Financial Statement Analysis and Security Valuation

Where does our uncertainty remain?

(i) Analysts forecasts may be biased.

(ii) We are unsure about the required return, although we have checked this
uncertainty by using different rates from 8% to 10%.

(iii) Growth: is 4%, a correct benchmark against which to compare the markets
growth rate of 2%?



CHAPTER SIX
Accrual Accounting and Valuation: Pricing Earnings

Concept Questions

C6.2. The historical 8.5% growth rate that is often quoted is the ex-dividend growth rate. It
ignores the fact that earnings were also earned by investors from reinvesting dividends (in the
S&P 500 stocks, for example) that were typically 40% of earnings. The cum-dividend rate is
about 13%. See Box 6.1.

C6.4. The trailing P/E is normal: 1.12/0.12 = 9.33. The forward P/E is also normal: 1/0.12 =
8.33. (The forecasted growth rate must be the cum-dividend growth rate.)

C6.6. Cum-dividend earnings growth incorporates earnings that are earned from the
reinvestment of dividends, and investors value those earnings. Ex-dividend growth rates are
affected by dividends: dividends reduce assets which then earn lower earnings. As cum-dividend
growth rates reflect the earnings from dividends, they are not affected by dividends. Cum-
dividend growth rates are effectively the rates that firms would have if they did not pay
dividends.
53

C6.8. Incorrect. As the normal (forward) P/E ratio is the inverse of the required return and the
required return for a bond is (usually) lower than that for a stock, the normal P/E ratio for a bond
is greater than that for a stock. But P/E also values abnormal earnings growth. A bond cannot
deliver abnormal earnings growth, so the P/E ratio for a growth stock might well be greater than
that for a bond.
C6.10. A PEG ratio is the ratio of the P/E to one-year-ahead expected earnings growth in
percentage terms. As the P/E anticipates earnings growth, the PEG ratio should be 1.0 if the
market is anticipating growth appropriately. However, more than one year of growth is involved
in assessing P/E ratios (and there are other clumsy aspects to itsee text), so the measure should
only be used as a first-pass check on the P/E ratio.

C6.12. Earnings-to-price ratios -- the inverse of price/earnings ratios -- are driven by three
things:
(1) The required equity return
(2) Expected growth
(3) Market inefficiency in pricing the required return and expected growth.

The argument assumes that factors (2) and (3) do not explain the change in the earnings-
to-price ratio. Were growth expectations higher in the 1990s than in the 1970s? Were S&P 500
stocks overpriced?

p. 54 Solutions Manual to accompany Financial Statement Analysis and Security Valuation
C6.14. Yes; eps growth can be increased with investment, but the investment may earn only the
required return, and thus not add value. A firm can also increase its expected earnings growth
through accounting methods, but not add value.


Exercises
Drill Exercises
E6.1 Forecasting Earnings Growth and Abnormal Earnings Growth

The calculations are as follows:

2011 2012 2013

Dps 0.25 0.25 0.30
Eps 3.00 3.60 4.10 (1)
Dps reinvested at 10% 0.025 0.025
Cum-div earnings 3.625 4.125 (2)
Normal earnings 3.300 3.960
AEG 0.325 0.165

(a)

Ex-div growth rate (from line 1) 20.0% 13.89%
Cum-div growth rate (from line 2) 20.83% 14.58%
- 3.625/3.00 for 2010
- 4.125/3.60 for 2011

(b) AEG is in pro forma above
(c) Normal forward P/E = 1/0.10 = 10.
(d) As AEG is forecasted to be greater than zero, then one would expect the forward P/E to
be greater than 10. Equivalently, as the cum-dividend earnings growth rate is expected to
be greater than the required return of 10%, the P/E should be greater than the normal P/E


E6.3. Valuation from Forecasting Abnormal Earnings Growth

This exercise complements Exercise 5.3 in Chapter 5, using the same forecasts. The question
asks you to convert a pro forma to a valuation using abnormal earnings growth methods. First
55
complete the pro forma by forecasting cum-dividend earnings and normal earnings. Then
calculate abnormal earnings growth and value the firm.



2013E 2014E 2015E 2016 2017

Earnings 388.0 570.0 599.0 629.0 660.45
Dividends 115.0 160.0 349.0 367.0 385.40
Reinvested dividends 11.5 16.0 34.9 36.70
Cum-div earnings 581.5 615.0 663.9 697.15
Normal earnings 426.8 627.0 658.9 691.90
Abnormal earn growth 154.7 -12.0 5.0 5.25

Growth rates:
Earnings growth 46.91% 5.09% 5.00% 5.00%
Cum-div earn growth (AEG) 49.87% 7.89% 10.83% 10.83%
Growth in AEG 5.0%

Discount rate 1.100 1.210
PV of AEG 140.64 -9.92

Note that the AEG for 2014 and 2015 are discounted back to the end of 2013.

a. Forecasted abnormal earnings growth (AEG) is given in the pro forma above.

AEG is the difference between cum-dividend earnings and normal earnings. So, for 2014,
AEG = 581.5 426.8 = 154.7.

Cum-dividend earnings is earnings plus prior years dividend reinvested at the
required rate of return. So, for 2014,
Cum-dividend earnings = 570.0 + (115 10%) = 581.5

Normal earnings is prior years earnings growing at the required rate. So, for 2014,
Normal earnings = 388 1.10 = 426.8

Abnormal earnings growth can also be calculated as

AEG = (cum-div growth rate required rate) prior years earnings
p. 56 Solutions Manual to accompany Financial Statement Analysis and Security Valuation
So, for 2014,
AEG = (0.4987 0.10) 388 = 154.7

b. The growth rates are given in the pro forma.
c. The growth rate of AEG after 2015 is 5%. Assuming this rate will continue into the
future, the valuation runs as follows:
Forward earnings, 2013 388.00
Total present value of AEG for 2014-2015 130.72
(140.64 9.92 = 130.72)
Continuing value (CV), 2015
05 . 1 10 . 1
5

= = 100.00

Present value of CV =
210 . 1
0 . 100
82.64
601.36

Capitalization rate 0.10

Value of the equity
10 . 0
36 . 601
= 6,013.6

Value per share on 1,380 million shares 4.36


This is a Case 2 valuation. If you worked exercise E5.3 using residual earnings methods,
compare you value calculation with the one here.
d. The forward P/E = 6,013.6/388 =15.5. The normal P/E is 1/0.10 = 10.


E6.4. Abnormal Earnings Growth Valuation and Target Prices

This exercise complements Exercise 5.4 in Chapter 5, using the same forecasts.
Develop the pro forma to forecast abnormal earnings growth (AEG) as follows:

2013 2014 2015 2016 2017

57
Eps 3.90 3.70 3.31 3.59 3.90
Dps 1.00 1.00 1.00 1.00 1.00
Reinvested dividends (12%) 0.12 0.12 0.12 0.12
Cum-dividend earnings 3.82 3.43 3.71 4.02
Normal earnings (12%) 4.368 4.144 3.707 4.021

Abnormal earnings growth -0.548 -0.714 0.003 -0.001

(a) See bottom line of pro forma for answer.

(b) As AEG is forecasted to be zero after 2015, the valuation is based on forecasted AEG up
to 2015:

(

+ =
2544 . 1
714 . 0
12 . 1
548 . 0
90 . 3
12 . 0
1
2012
E
V

= $23.68
Note that this is the same value as obtained using residual earnings methods in
Exercise 5.4.
(c) The expected trailing P/E for 2017 must be normal if abnormal earnings growth is
expected to continue to be zero after 2017. The normal trailing P/E for a required return
of 12% is 1.12/0.12 = 9.33.
(d) With a normal trailing P/E of 9.33,
2017
2017 2017
Eps
d V +
= 9.33
So, V + d = $3.90 x 9.33
= $36.387
As the dividend is expected to be $1.00, the 2017 value (ex-dividend) is $35.387.

E6.6. Normal P/E Ratios
The normal trailing P/E ratio is
return equity required
return equity required 1+

p. 58 Solutions Manual to accompany Financial Statement Analysis and Security Valuation
The normal forward P/E is the trailing P/E 1.0
The schedule for the trailing P/E is as follows. Subtract 1.0 to get the forward P/E.
8% 13.50
9% 12.11
10% 11.00
11% 10.09
12% 9.33
13% 8.69
14% 8.14
15% 7.67
16% 7.25

Applications

E6.8. Calculating Cum-dividend Earnings: General Mills





EPS


DPS

Earnings on prior
years reinvested
dividends
Cum-
dividend
EPS
2006 1.53 0.67
2007 1.65 0.72 0.0536 1.7036
2008 1.93 0.78 0.0576 1.9876
2009 1.96 0.86 0.0624 2.0224
2010 2.32 0.96 0.0688 2.3888


Cum-div EPS Normal
earnings
Abnormal
Earnings
Growth
(AEG)
59
2007 1.7036 1.6524 0.0512
2008 1.9876 1.7820 0.2056
2009 2.0224 2.0844 -0.0620
2010 2.3888 2.1168 0.2720
Normal earnings is prior years earnings multiplied by 1.08.


E6.9. Residual Earnings and Abnormal Earnings Growth: IBM
The pro forma for the forecast is as follows:
2010 2011 2012 2013 2014 2015
Eps 13.22 14.61 16.22 18.00 19.98
Dps 3.00 3.30 3.66 4.07 4.51
Bps 18.77 28.99 40.30 52.86 66.79 82.26

Reinvested dividends at 10% 0.300 0.330 0.366 0.407
Cum-dividend earnings 14.910 16.550 18.366 20.387
Normal earnings 14.542 16.071 17.842 19.800

Abnormal earnings growth 0.368 0.479 0.524 0.587

Residual earnings 11.343 11.711 12.190 12.714 13.301

Change in residual earnings 0.368 0.479 0.524 0.587
The answers to parts a, b and c of the question are in the last three lines of the pro forma.

E6.12. Valuation of Microsoft Corporation

The Pro Forma
2011 2012
Eps forecasted 2.60 2.77
Dps 0.40
Dps reinvested at 9% 0.036
Cum-dividend earnings 2.806
Normal earnings: 2.60 1.09 2.834
AEG -0.028


a. Normal forward P/E = 1/0.09 = 11.11
Traded forward P/E = $24.30/$2.60 = 9.346

p. 60 Solutions Manual to accompany Financial Statement Analysis and Security Valuation
b.
Valuation with no growth:


$28.60
1.09
0.028 -
2.60
0.09
1

2010
=
(

+ = V


Intrinsic P/E = $28.60/$2.60 =11.00

c.
The value without growth is higher than the market price. So, if you saw some
abnormal earnings growth ahead, the stock is definitely underpriced.
E6.14. Abnormal Earnings Growth and Accounting Methods
The revised pro forma is as follows:
2013E 2014E 2015E 2016E 2017E

Earnings 502.0 570.0 599.0 629.0 660.45
Dividends 115.0 160.0 349.0 367.0 385.40
Reinvested dividends 11.5 16.0 34.9 36.70
Cum-div earnings 581.5 615.0 663.9 697.15
Normal earnings 552.2 627.0 658.9 691.90
Abnormal earn growth 29.3 -12.0 5.0 5.25

Growth rates:
Earnings growth 13.55% 5.09% 5.00% 5.0%
Cum-div earn growth (AEG) 15.84% 7.89% 10.83% 10.83%
Growth in AEG 5.0%

Discount rate 1.100 1.210
PV of AEG 26.64 -9.92

(a) Forecasted earnings for 2013 increase by $114 million, to $502 million, because of the
lower cost of good sold. (This assumes that the write-down has no effect on forecasted
revenues on which forecasts for other years are based: it is often the case the an inventory
write-down means that the firm will have more trouble selling its inventory.)
(b) The valuation based on the revised pro forma is:

Forward earnings, 2013 502.00
61
Total present value of AEG for 2014-2015 16.72
(26.64 9.92 = 16.72)
Continuing value (CV), 2015
05 . 1 10 . 1
5

= = 100.00

Present value of CV =
210 . 1
0 . 100
82.64
601.36

Capitalization rate 0.10

Value of the equity
10 . 0
36 . 601
= 6,013.6

Value per share on 1,380 million shares 4.36


The valuation is the same at that in Exercise 6.3.
(c) As the additional earnings of $114 million in 2013 will incur a tax of $39.9 million, they
will be lower by that amount, that is $462.1 million. However, the lower earnings provide
a lower base for calculating AEG for 2014, so AEG in 2014 is higher than that in the pro
forma in (a). The net effect is to leave the valuation unchanged. (This assumes forecasts
for other years are already after tax.)

p. 62 Solutions Manual to accompany Financial Statement Analysis and Security Valuation
CHAPTER SEVEN

Valuation and Active Investing


Concept Questions

C7.1. The measure of the required return from the CAPM is imprecise. It involves an estimate of
a beta and the market risk premium. Betas are estimated with standard errors of about 0.25, so if
one estimated a beta of 1.2, say, it could actually be 0.95 or 1.45 with reasonable probability.
And the market risk premium is a big guess. See the appendix to Chapter 3. Fundamental
investors do not like to put speculation into a valuation, and the CAPM required return is
speculative.

C7.3. Investing is not a game against nature means that there is not a true intrinsic value to be
discovered (as if it existed in nature). So the onus is not on the investor to come up with an
intrinsic value. All the investor has to do is assess if the current market price is a reasonable one.
That price is set by other investors, based on their analysis, beliefs, fashions, and fads. The
question is: Are the forecasts in the market price justified? The game is against other investors
who set the price, not against nature.

C7.5. Growth refers to outcomes in the long-term, and the long-term is uncertain. Growth can be
competed away so that, unless the firm has protectionhas build a moat around its castleits
expected growth may not materialize. Buying growth is thus risky.

63
C7.7. See the answer to C7.6. Exceptional growth is usually maintained only in the short-term.
Eventually growth gets competed away, so that all firms look like the average firm in the
economy in the long-run.

C7.9. Yes, growth is risky, so a high P/E stock with a lot of growth built into its price is risky.
And, yes, P/E ratios are positively correlated with beta. Here are the average betas for 10
portfolios formed from a ranking on E/P (the inverse of P/E) for U.S. stocks from 1963-2006.
You can see that betas are higher for low E/P (high P/E) stocks. Note also that the returns from
buying stocks are lower for the E/P (high P/E) stocks: Buying growth is risky.

E/P
Portfolio
E/P
(%) Beta
Annual
Returns
(%)
1
(Low) -32.5 1.38 16.0
2 -3.3 1.32 10.3
3 2.0 1.28 11.4
4 4.5 1.22 12.8
5 6.1 1.14 14.8
6 7.4 1.06 15.2
7 8.6 1.01 17.9
8 10.0 0.97 18.1
9 11.8 0.96 20.8
10
(High) 16.3 0.99 25.3


C7.11. The market sees negative growth in the future.



p. 64 Solutions Manual to accompany Financial Statement Analysis and Security Valuation
Exercises
Drill Exercises
E7.1. Reverse Engineering Growth Rates
a. The pro forma:
2012 2013
EPS 2.60
BPS (for a P/B of 2.0) 13.00
Residual earnings (10%) 1.30

Set up the reverse engineering problem:

g - 1.10
1.30
13.00 $ $26 Price + = =

The solution for g = 1.0 (a growth rate of 0%). The market is giving this firm a no-growth
valuation.

b. The proforma:


2012 2013
EPS 4.11
BPS 27.40
Residual earnings (9%) 1.644

Set up the reverse engineering problem:

g - 1.09
1.644
27.40 $ $54 Price + = =

The solution for g = 1.0282 (a growth rate of 2.82%).

E7.2. Reverse Engineering Expected Returns

a. Use the weighted average expected return formula:

Book value = $13.00 (for a P/B of 2.0)
B/P = 0.5
Forwards ROCE = 2.60/13.00 = 20.0%
65

With no growth, the weighted average expected return is

ER = B/P ROCE
1

= 0.5 20%
= 10%

(You can also see this from the answer in part (a) of E7.1: the market price with a 10%
required return is a no-growth valuation, so a price with no growth yields 10%.

b. The weighted-average return formula now includes growth:

B/P = 27.40/54.00 = 0.507
ROCE
1
= 4.11/27.40 = 15.0%

ER = [B/P ROCE
1
] + [(1 B/P) (g-1)]

= [0.507 15.0%] + [0.493 4%]
= 9.577%

E7.3. Reverse Engineering Earnings Forecasts

The pro forma:

2012 2013
EPS 33.46
DPS 0.0
BPS 239.0 272.46
Residual earnings (9%) 11.95

a. Set up the reverse engineering problem:

Price = 2.6 $239.0 = $621.4 million

g - 1.09
11.95
239.0 $ $621.4 Price + = =

The solution for g = 1.0588 (a growth rate of 5.88%).







p. 66 Solutions Manual to accompany Financial Statement Analysis and Security Valuation
b. Reverse engineer the residual earnings calculation:

Earnings
2014
= (Book value
2013
0.09) + RE
2014

RE
2014
= RE
2013
RE growth rate
= $11.95 1.0588
= $12.653

Earnings
2014
= (Book value
2013
0.09) + RE
2014

= $(272.46 0.09) + 12.653
= $37.17


E7.4. Expected Returns for Different Growth Rates

Apply the weighted-average expected return formula to elicit the expected return in the market
price:

ER = [B/P ROCE
1
] + [(1 B/P) (g-1)]


B/P =1/2.2 = 0.455
ROCE
1
= 15.0%

Thus,

ER = [0.455 15.0%] + [0.545 (g-1)]

Here is the ER for different growth rates:

Growth Rate ER
3% 8.46%
4% 9.01%
6% 10.10%
Applications

E7.6. Reverse Engineering Growth Rates: Dell, Inc.

To answer this question, you have to specify your required return: a 10% rate is used here.

The pro forma is as follows:

2008 2009 2010
EPS 1.47 1.77
DPS 0.00 0.00
BPS 1.813 3.283 5.053
67
RE (10%) 1.289 1.442


The growth rate is calculated by reverse engineering:


) 10 . 1 ( 21 . 1
442 . 1
21 . 1
442 . 1
10 . 1
289 . 1
813 . 1 50 . 20 $
2008
g
g
P

+ + + = =

The solution for g = 1.025 (or a 2.5% growth rate).

The solution is the same with the following calculation:


) 10 . 1 ( 10 . 1
442 . 1
10 . 1
289 . 1
813 . 1 50 . 20 $
2008
g
P

+ + = =


E7.7. Building Blocks for a Valuation: General Electric

To answer this question, you have to specify your required return: a 10% rate is used here.

a. Here is the pro forma using a required return of 10%.

2004 2005 2006
EPS 1.71 1.96
DPS (dividend payout 50%) 0.86 0.98
BPS 10.47 11.32 12.30
RE (10%) 0.663 0.828

The value is calculated as follows, with a 4% growth rate in the continuing value:



04 . 1 10 . 1
828 . 0
10 . 1
1
10 . 1
663 . 0
47 . 10 $ 38 . 28 $

+ + =

= $23.62


b. The first building block is the book value = $10.47

The second component is the addition to book value if there is no growth, and is
calculated as:


(

+ =
10 . 0
828 . 0
10 . 1
1
10 . 1
663 . 0
12 . 11 $ = 8.13
p. 68 Solutions Manual to accompany Financial Statement Analysis and Security Valuation

The third (growth) component plugs to 17.40
the market price

Market price 36.00

The three components are diagramed as follows:




Book Value from Value from
Value Short-term Growth
Forecasts


c. Reverse engineer the model:


g
- + + =
10 . 1
828 . 0
10 . 1
1
10 . 1
663 . 0
47 . 10 $ 00 . 36 $

The solution is g = 1.0698, or approximately a 7% growth rate.


E7.9. The Markets Forecast of Nikes Growth Rate
The pro forma:

2010 2011 2012
69
EPS 4.29 4.78
DPS 1.16 1.29
BPS 20.15 23.28 26.77
RE (9%) 2.477 2.685

The dividend for 2012 is forecasted to be at the same payout ratio as in 2011: 0.270 4.78 =
1.29.

a. The growth rate is calculated by reverse engineering:


) 09 . 1 ( 09 . 1
685 . 2
09 . 1
477 . 2
15 . 20 74 $
2010
g
P

+ + = =

The solution for g = 1.0422 (or a 4.22% growth rate).

b. Reverse engineer the residual earnings calculation:

RE
2013
= RE
2012
Growth rate
= 2.685 1.0422
= 2.798

Earnings
2013
= (Book value
2012
0.09) + RE
2013

= $(26.77 0.09) + 2.798
= $5.207

RE
2014
= RE
2013
Growth rate
= 2.798 1.0422
= 2.916

BPS
2013
= 26.77 + 5.201 1.406
= 30.571 (dividend is at the payout ratio of 27%)


Earnings
2014
= (Book value
2013
0.09) + RE
2014

= $(30.571 0.09) + 2.916
= $5.667


E7.11. The Expected Return to Buying a Google Share

a. Price = $535
Book value = $143.92
B/P = 143.92/535 = 0.269
p. 70 Solutions Manual to accompany Financial Statement Analysis and Security Valuation
ROCE
1
= 33.94/143.92 = 23.58%

The weighted-average return formula:

Similarly, the ER for a growth rate of 5% = 10.00%, and ER for a 6% growth rate =
10.73%.

b. This is somewhat difficult. For this question, one has to apply the B/P ratio at the end of
2011and the ROCE for 2012:

Book value
2011
= 177.86 (from Exhibit 7.1)
Price
2011
= Price
2010
1.10 = 535 1.10 = 588.50
B/P (2011) = 0.302
ROCE
2012
= 39.55/177.86 = 22.24%

The price at the end of 2011 is the current price growing at the required return of 10% in
the exhibit. Note that one can solve the problem only by putting in a required return (that
was not necessary in part a), but the estimate (just for one year) will not affect the
calculation much.

ER = [B/P (2011) ROCE
2012
] + [(1 B/P) (g-1)]
= [0.302 22.24%] + [0.698 4%]
= 9.51%

Similarly, the ER for a growth rate of 5% = 10.21%, and ER for a 6% growth rate =
10.91%.

E7.13. Sellers Wants to Buy

a. The Pro forma:

2006 2007 2008
EPS 2.98 3.26
DPS 0.60 0.70
BPS 12.67 15.05 17.61

Residual earnings (10%) 1.713 1.755

The current book value per share = Book value/Shares outstanding
= $26,909/2,124
71
= $12.67

Reverse engineer Sellers price:

rate) growth % 5.55 (a 1.0555 g
g) - (1.10 x 1.10
1.755

1.10
1.713
12.67 $50
=
+ + =


A. Getting to EPS growth rates for 2009 and 2010:


2009 2010
RE growing at 5.55% 1.852 1.955 (1)
Prior BPS 17.61
Prior BPS x 0.10 1.761 (2)
EPS (1) + (2) 3.613
EPSgrowth rate

DPS (at 2008 payout ratio) 0.776
BPS 20.447
Prior BPS x 0.10 2.045 (3)
EPS (1) + (3) 4.00
EPS growth rate
E7.15. The Expected Return for the S&P 500


a. Book value on January 1, 2008 = 1,468 / 2.6
= 564.62
B/P = 564.62/1468 = 1/2.6 = 0.385

Forward ROCE for 2008 = 72.56 / 564.62
= 12.85%

b. The reverse engineering problem:


04 . 1 ?
) 62 . 564 (? 56 . 72
62 . 564 468 , 1

+ =

? = 1.07403, or a 7.403% expected return

The following formula solves for the expected return:

10.83%
%
10.71%
%
p. 72 Solutions Manual to accompany Financial Statement Analysis and Security Valuation
) 1 ( 1 ?
1

|
.
|

\
|
+
(

= g
P
B
ROCE
P
B


| | | | % 4 ) 385 . 0 1 ( % 85 . 12 385 . 0 + =


= 7.41%


c. Required return = 4% + 5% = 9%
Do not buy, for the expected return is less than the required return.


d. Although the level of the index is not given, one can still work the problem based on the
price-to-book of 5.4. For every $1 of book, the price is 5.4, so the reverse engineering
problem can be set up as:

04 . 0 ?
1 ?) 23 . 0 (
1 4 . 5

+ = ($1 of book value)
? = 7.52%
The weighted average expected return formula solves for the expected return:

) 1 )( 1 (
0
0
1
0
0
+ = g
P
B
ROCE
P
B
return Expected
= (0.185 0.23) + (0.815 4%)
= 4.255% + 3.26%
= 7.52%
If the required return is 9%, this expected return indicates that the S&P 500 stocks are
overvalued. All the more so when one appreciates that a 23% ROCE used as an input is quite
a bit above the historical ROCE of 17-18%. A 23% ROCE means a high residual earnings
base to apply a 4% growth rate to. If one entered a 17% ROCE, then the expected return
would be lower, at 6.41%. (Correspondingly, the forward ROCE for 2008 in part (a) is lower
73
than the historical average, and a higher return that the 7.41% there would be expected with a
higher forward ROCE.