Solution To Practice Exercise Set 1: B8110, Fall 2009
Solution To Practice Exercise Set 1: B8110, Fall 2009
Solution To Practice Exercise Set 1: B8110, Fall 2009
Part a.
Adjust cash flow from operations for after-tax net interest payments and cash investment
for net investments in interest-bearing assets:
Note: As cash interest receipts are not reported (as is usual), use interest income from the
income statement.
Part b.
To develop the pro forma for the implied growth rate, first apply the forward P/E ratio to
get an earnings forecast for 2006, then convert the PEG ratio to an earnings forecast for
2007:
$1,271/Earnings2006 = 15
Forward P / E
PEG = Growth Rate for 2007 = 1.47
Thus, for a forward P/E of 15, the 2007 growth rate for 2007 earnings is 10.2%.
2003 2004
b. If cum-dividend earnings are expected to grow at the required rate of return, 10%, after
2006, the P/E should be normal:
1
P/E = = 10
0.10
c. Applying the abnormal earnings growth (AEG) pricing model with the long-term
growth rate for AEG of 4%:
1 2.455
V 84.73
0.10 1.10 1.04
= 1256
d. The S&P 500 index is appropriately priced (approximately) at 1271. This will not
always be the case. The estimated level can different from the actual level for a number
of reasons:
1. Analysts forecasts are too optimistic relative to how the rest of the market sees it.
2. The market agrees with analysts forecasts for 2006 and 2007, but sees the long-
term growth rate at less than 4%.
3. The market requires a higher or lower required return than 10%.
4. The market is mispriced.
With respect to point 1, sell-side analysts forecasts are often overly optimistic,
particularly two-year ahead forecasts on which the AEG is calculated.
This exercise is dangerous when both the market and analysts are too optimistic (as in the
bubble). Then you have to challenge the price with your own forecasts. Notice that the
next exercise works with actual earnings numbers, not analysts forecasts.
Exercise 3. Reverse Engineering the S&P 500 Index Using Book Rates of Return
(a)
With a P/B ratio is 2.5, investors are paying $2.50 for every dollar of book value in the
S&P 500 companies. With an ROCE of 18%, the current residual earnings on a dollar of
= 0.08
That is, 8 cents per dollar of book value. The value of an asset (with a constant growth
RE 0 g
V0 B0
g
(One always capitalizes the one-year-ahead amount, which is the current residual
earnings, RE0, growing one year at 10%.) So, for every dollar of book value worth $2.50,
0.08 g
2.50 1.0
1.10 g
Solving for g,
A good benchmark growth rate for the market as a whole is the GDP growth rate. This
has historically been an average of about 4.0%. So, if history is an indication of the
future, a 4.4 % implied growth rate suggests that the S&P 500 stocks, as a portfolio, are a
little overpriced.
What does a growth rate of 4.4% for residual earnings mean? If the S&P 500
firms can maintain an ROCE of 18%, then investment in net assets must grow by 4.4%.
Alternatively, if ROCE were to improve, a growth in residual earnings of 4.4% can be
maintained with a lower growth rate. Is a 4.4% growth rate for residual earnings
reasonable? What is the prospect for ROCE for the market as a whole? Is the market
appropriately priced?
(b)
See the last paragraph. With a constant ROCE, the growth in residual earnings is
determined by the growth in net assets (book value). Remember, residual earnings is
(c)
For all U.S. listed firms, the historical (arithmetic) average ROCE (since 1960) has been
10.3% and the median ROCE has been 12.5%. Since 1977, the average ROCE for the
S&P 500 (a weighted average of the 500 stocks in the index) has been about 17%, but it
(d)
See Figure 2.2 on page 44 of the text. Since 1977, the P/B ratio for the S&P 500 (a
weighted average of the 500 stocks in the index) has been about 2.8, but it was 1.2 in
a. Book value of shareholders equity (from the 2003 balance sheet) = $28,029
million
Shares outstanding = 6,998 million
Book value per share = $4.005
b. Prepare the pro forma and calculate residual earnings by charging prior book
value at 9%:
0.3220 g
0.2796 0.3220
V0E 4.005 1.09 g
1.09 1.1881 1.1881
E
Setting V 0 = $20.00, then g = 1.0713 ( a 7.13% growth rate)
0.023
1 0.0424 1.09 g
V E
0.64
0
0.09 1.09 1.09
g. Complete the pro forma above to include residual earnings (charging prior book
value at 9%):
h. From the pro forma in part e, eps growth rates for each year are:
a.
64.81 1.60
Trailing P/E 18.24
3.64
64.81
Forward P/E 17.01
3.81
1.089
Normal trailing P/E 12.24
0.089
1
Normal forward P/E 11.24
0.089
b.
1 0.1511
P 64.81 = 3.81 +
0.089
1.089 - g
Note: Normal earnings are the earnings in the prior year growing at 8.9%. So, for 2008,
normal earnings = $4.487 x 1.089 = 4.8863.
d.
The market was pricing approximately the same growth rates as forecasted by analysts.
Put another way, the market was pricing KMB based on consensus analysts forecasts.
e.
Yes, as analysts were forecasting the same growth rates as those implied in the market
price, they are saying that the market price is reasonable. The 2.6 rating a HOLD has
integrity.
(If you are following the Continuing Case in the text, some of this material will be
familiar to you.)