CHAPTER 13Stock Market Analysis

1 An investor is convinced that the stock market will experience a substantial increase next year because corporate earnings are expected to rise by at least 12 percent. Do you agree or disagree? Why or why not?Although corporate earnings may rise by 12 percent next year, that information by itself is not sufficient to forecast an increase in the stock market. The market level is a product of both corporate earnings and the earnings multiple. The earnings multiple must likewise be projected since it is not stable over time

3 To arrive at an estimate of the net profit margin, why would you spend time estimating the operating profit margin and work down?The investor can improve his net profit margin estimate by working from the gross margin down to the net profit margin. By this procedure, the investor explicitly considers each major component that affects the net profit margin. This level of analysis provides insights into the components which do not behave consistently over time. Also, the gross profit margin should be easier to estimate since it has the lowest level of relative variability.

4 You are convinced that capacity utilization next year will decline from 82 percent to about 79 percent. Explain what effect this change will have on the operating profit margin. The effect of a decline in capacity utilization should be a decline in the aggregate profit margin, all else the same, because it will mean greater overhead and depreciation per unit of output. Also more fixed financial charges per unit.

5 You see an estimate that hourly wage rates will increase by 6 percent next year. How does this affect your estimate of the operating profit margin? What other information do you need to determine the effect of this wage rate increase and why do you need it?The increase in hourly wages of 6 percent will, all else held equal, cause the operating margin to decrease. In addition to the estimate of the changes in the hourly wage rate, an estimate of the productivity rate change is also needed to forecast the unit labor cost change. The relationship is:

% Hourly Wages - % Productivity = % Unit Labor Cost

6 It is estimated that next year hourly wage rates will increase by 7 percent and

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productivity will increase by 5 percent. What would you expect to happen to until labor cost? Discuss how this unit labor cost estimate would influence your estimate of the operating profit margin. 7.0- 5.0 = 2.0% increase in the unit labor cost. The unit labor cost is negatively related to the profit margin. This increase would, holding other factors constant, decrease the aggregate profit margin. Because it is a low rate of increase, the effect on the profit margin should be small.

7(a) The return on equity increases.7(b) The aggregate debt-equity ratio declines.7(c) Overall productivity of capital increases.7(d) The dividend-payout ratio declines.

An increase in the ROE with no other changes should cause an increase in the multiple because it would imply a higher growth rate. An important question is, how was the increase in ROE accomplished? If it was due to operating factors (higher asset turnover or profit margin) it is positive. If it was due to an increase in financial leverage, there could be some offset due to an increase in the required rate of return (k).

Increase, because this will increase earnings growth by raising equity turnover. It could also cause a decrease because it will increase the financial risk and, thus, the required k.

Decrease, because this will increase growth and therefore raise the real RFR. It could also reduce inflation, which would decrease the nominal RFR, causing the multiplier to rise.

Increase, because a decrease in the dividend payout rate increases the retention rate, raising the growth rate. It could also cause a decrease because it reduces the next period's dividends.

8 Briefly discuss the two factors that must be considered (estimated) whether you are employing the present value of cash flow approaches or the relative valuation ratio approaches. Both the present value of cash flow approaches and the relative valuation ratios approach require two factors be estimated: (1) required rate of return on the stock, because this rate becomes the discount rate or is a major component of the discount rate, and (2) growth rate of the variable used in the valuation techniques, such as, dividends, earnings, cash flows or sales.

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9 Discuss the difference between the constant growth DDM and the two stage growth model. In your discussion, explain when you would use each of these models. The DDM assumes that (1) dividends grow at a constant rate, (2) the constant growth rate will continue for an infinite period, and (3) the required rate of return (k) is greater than the infinite growth rate (g). Therefore, the infinite period DDM cannot be applied to the valuation of stock for growth companies because the high growth of earnings for the growth company is inconsistent with the assumptions of the infinite period constant growth DDM model. A company cannot permanently maintain a growth rate higher than its required rate of return, because competition will eventually enter this apparently lucrative business, which will reduce the firm’s profit margins and therefore its ROE and growth rate. Therefore, after a few years of exceptional growth (a period of temporary supernormal growth) a firm’s growth rate is expected to decline. Eventually its growth rate is expected to stabilize at a constant level consistent with the assumptions of the infinite period DDM.

10 Based upon that data contained in exhibit 13.27, what would be your estimate of nominal GDP growth for the united kingdom versus Japan in 2003?Nominal GDP growth is equal to real GDP growth plus the rate of inflation. From Exhibit 13.27, we find nominal GDP for the United Kingdom for 2003 can be estimated as 2.8% (real GDP) + 2.6% (inflation) = 5.4%. For Japan, the estimate is 1.0% + (-0.7%) = 0.3%.

11 Based upon the data in exhibits 13.27, and 13.29, what is the main reason for the current interest rate in the United States versus Japan?The nominal rate of interest is approximately the expected real rate of interest plus the expected rate of inflation. Further, the real rate of interest can be approximated by the expected real growth rate in GDP. From the numbers in Exhibits 13.27 and 13.29, we see that the United States has a higher real growth rate, both currently and forecasted, as well as a higher expected rate of inflation than Japan. Both factors help explain the higher current interest rate in the U.S. relative to Japan.

CHAPTER 13

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Answers to Problems1. You are told that nominal GDP will increase by about 10% next year.Using

Exhibit 13.10 and the regression equation,what increase would you expect in corporate sales?How would this estmate change if you gave more weight to recent observations in Exhibit 13.11?

1. Using only the graph and drawing a line over from ten percent to the line of best fit and down to the horizontal percent change indicates an estimate of slightly under 10% for the S & P series. Alternatively, if you apply the following regression equation:

% S&P Industrials Sales = -.024 + 1.16 (% in Nominal GDP) = -.024 + 1.16 (0.10) = -.024 + .116 = .092 or 9.2%

Exhibit 13.10 was based upon an analysis that encompassed the period: 1975-2000. The overall average GDP percentage change was 7.4%, with 6.3% change in S&P Industrials. During the 1990s, the percentage change in GDP was lower than the average over the period (approximately 5.5%) and lower than the 10% proposed in the problem. Therefore, one could argue that based upon recent observations, the percentage change in S&P 400 Sales should also be lower:

% S&P Industrials Sales = -.024 + 1.16x.055= -.024 + .0638= 3.98%

2. currently ,the dividend payout ratio(d/e) for the aggregate market is 60%,the required return (k) is 11% and the expected growth rate for dividends (g) is 5%

(a) Compute the current earnings multiplier.

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(b) You expect the D/E ratio to decline to 50%,but you assume there will be no other changes.What will be the P/E?

(c) Starting with the initial conditions,you expect the dividend payout ratio to be constant,the rate of inflation to increase by 3% and the growth rate to increase by 2%.Compute the expected P/E.

(d) Starting with the initial conditions,you expect the dividend payout ratio to be constant,the rate of inflation to decline by 3% and the growth rate to decline by 1%.Compute the expected P/E.

2(a) .60 P/E = = .60/.06 = 10x

.13 - .07

2(b). .50P/E = = .50/.06 = 8.3x

.13 - .07

2(c) .60 P/E = = .60/.07 = 8.57x .16 - .09

2(d) .60P/E = = .60/.04 = 15x

.10 - .06

3. A U.s pension plan hired two off-shore firms to manage the non-U.S equity portion of its total portfolio.Each firm was free to own stocks in any country included in Capital International’s Europe,Australia and Far East Index(EAFE) and to use any form of dollar and/ or nondollar cash or bonds as an equity substitute or reserve.After

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three years had elapsed,the records of the managers and the EAFE Index were as follows :

SUMMERY: CONTRIBUTIONS TO RETURN# Currency Country

SelectionStock selection

Cash/Bond Allocation

Total Return Recorded

1. Manager A (9.0%) 19.7% 3.1% 0.6% 14.4%2. Manager B (7.4%) 14.2% 6.0% 2.8% 15.6%3. Composite of A & B (8.2%) 16.9% 4.5% 1.7% 15.0%4. EAFE Index (12.9%) 19.9% --------- --------- 7.0%

You are a member of the plan sponsor’s pension committeewhich will soon meet with plan’s consultant to review manager performance.Inprepartaion for this meeting,you go through the following analysis :a.Briefly describe the strengths & weaknesses of each manager,relative to the EAFE Index data.b.Briefly explain the meaning of the data in the “Currency” column.

3. CFA Examination I (1985)

3(a). Overall, both managers added value by mitigating the currency effects present in the Index. Both exhibited an ability to “pick stocks” in the markets they chose to be in (Manager B in particular). Manager B used his opportunities not to be in stocks quite effectively (via the cash/bond contribution to return), but neither of them matched the passive index in picking the country markets in which to be invested (Manger B, in particular).

MANAGER A MANAGER BSTRENGTHS Currency Management Currency Management

Stock Selection Use of Cash/Bond Flexibility

WEAKNESSES Country Selection Country Selection(to a limited degree)

3(b). The column reveals the effect on performance in local currency terms after adjustment for movements in the U.S. dollar and, therefore, the effect on the portfolio. Currency gains/losses arise from translating changes in currency exchange rates versus the U.S. dollar over the measuring period (3 years in this case) into U.S. dollars for the U.S. pension plan. The Index mix lost 12.9% to the dollar, reducing what would otherwise have been a very favorable return from the various country markets of 19.9% to a net return of only 7.0%.

4. As an analyst for Middle,Diddle and O’Leary,you are forecasting the market P/E ratio using the dividend discount model.Because the economy has been expanding for 9 years,you expect the dividend–payout ratio will be at its low of 40% and that long-term government bond rates will rise to 7%.Because investors are becoming less risk averse,the equity risk premium will decline to 3%.As a result,investors will require a 10% return and the return on

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equity will be 12%.a. What is the expected growth rate?b. What is your expectation of the market P/E ratio?c. What will be the value for the market index if the expectation is for earnings per

share of $53.00?d. What will be your rate of return if you acquired the index at a value of 950,you sold

the index at the value computed in part c and dividends during the year were $30.00?

4(a). Growth = .60 x .12 = .072 = 7.2%

4(b). .40P/E = = 14.29x

.10 - .072

4(c). The market price will rise to: Price = 14.29 x $53 = $757.37

757.14 - 950 + 304(d). Rate of Return = = -17.14% 950

5. You are given the following estimated per share data related to the S& P Industrials Index for the year 2004 :# Description Amount in $

1. Sales 1020.002. Depreciation 45.003. Interest expense 18.00

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You are also informed that the estimating operating profit margin is 0.152 and the tax rate is 32%.

a. Compute the estimated EPS for 2004.b. Assume that a member of the research committee for your firm feels that it is

important to consider a range of operating profit margin(OPM) estimates.Therefore you are asked to derive both optimistic and pessimistic EPS estimates using 0.149 and 0.155 for the OPM and holding everything aelse constant.

5(a). $850 x .152 = $129.20 (operating profit margin)$129.20 - $38 = $ 91.20 (depreciation)$91.20 - $16 = $ 75.20 (interest)$75.20 x (1-.32) = $ 51.14 (Estimated EPS)

5(b). Optimistic:$850 x .155 = $131.75 (operating profit margin)$131.75 - $38 = $ 93.75 (depreciation)$93.75 - $16 = $ 77.75 (interest)$77.75x (1 -.32) = $ 52.87 (Estimated EPS)

Pessimistic:$850 x .149 = $126.65 (operating profit margin)$126.65 - $38 = $ 88.65 (depreciation)$88.65 - $16 = $ 72.65 (interest)$72.65 x (1 - .32) = $ 49.40 (Estimated EPS)

6. Given the EPS estimates in Problem 5,you are also given the following estimates related to the market earnings multiple :# Description Pessimistic Consensus optimistic

1. D/E 0.65 0.55 0.452. Nominal RFR 0.10 0.09 0.083. Risk Premium 0.05 0.04 0.034. ROE 0.10 0.13 0.16

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a. Based on the three EPS and P/E estimates,compute the high,low and consensus intrinsic market value for the S& P Industries Index in 2004.

b. Assuming that the S & P Industrial Index at the begining of the year was priced at 1600,compute your estimated rate of return under the three scenarios from Part a.Assuming your required rate of return is equal to the consensus,how would you weight the S & P Industrials Index inyour global portfolio?

6(a). Growth Rates: Required return:High = (1 - 0.45) x 0.16 = .088 High = 0.08 + 0.03 = 0.11Low = (1 - 0.65) x 0.10 = .035 Low = 0.10 + 0.05 = 0.15Consensus = (1 - 0.55) x 0.13 = .0585 Consensus = 0.09 + 0.04 = 0.13

P/E Ratios:High = 0.45/(0.11 – 0.088) = 0.45/.022 = 20.4545Low = 0.65/(0.15 – 0.035) = 0.65/.115 = 5.6522Consensus = 0.55/(0.13 – 0.0585) = 0.55/.0715 = 7.6923

Price:High = 52.87 x 20.4545 = $ 1081.43Low = 49.40 x 5.6522 = $ 279.22Consensus = 51.14 x 7.6923 = $ 393.38

6(b). High = (1081.43/1600) –1 = -.3241Low = (279.22/1600) –1 = -.8255Consensus = (393.38/1600) –1 = -.7541

Given that large losses are expected, one should underweight the U.S. stocks in a global portfolio.

7. you are analyzing the u.s equity market based upon the s & p industrials index and using the present value of free cash flow to equity technique.your inputs are as follows:

beginning fcfe: $40.00, k = 0.09

# year growth rates1. 1-3 9%2. 4-6 8%3. 7 & beyond 7%

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a. Assuming that the current value for the S & P Industrials Index is 1600,would you underweight,overweight or marketweight the U.S equity market?

b. Assume that there is a 1% increase in the inflation-what would be the market’s value and how would you weight the U.S market?State your assumptions.

7.7(a). FCFE0 = $40

FCFE1 = $40x(1.09) = $43.60FCFE2 = $40x(1.09)2 = $47.52FCFE3 = $40x(1.09)3 = $51.80FCFE4 = $51.80x(1.08) = $55.94FCFE5 = $51.80x(1.08)2 = $60.42FCFE6 = $51.80x(1.08)3 = $65.25FCFE7 = $65.25x(1.07) = $69.82Value at time t = 0:

If the current value of the Index were 1,600, one would overweight the U.S. equity market in the portfolio.

7(b). A one percent increase in the rate of inflation would have two possible effects: One, the required return would increase from 9% to 10%, decreasing the value; and two, the nominal cash flow growth rates would increase for all time periods by one percentage point. If both effects are at work, they would cancel each other out, as the increase in free cash flow is discounted back at an equivalently higher discount rate.

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