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Tutorial 8

# Tutorial 8

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06/15/2009

Tutorial 8: Company analysis - Forecasting Earnings & Valuation
6. Refer to data & answers from question 2 of Tutorial 6,Estimate 20x3 EPS, using the Dupont model, and based on the following judgemental adjustmentsfollowing an interview with management:-A new inventory management system is projected to improve total asset turnover to 8.7x-Cheap&Good intend to change its merchandise mix towards more house brands, building onits successful marketing campaign using the theme ‘value-for-money’ supermarket.Management expects the strategy to improve operating margin by 0.25% points (from 4% to4.25%).-Conservatively estimate the end 20x3 Equity at the 20x2 Equity level. (The actual levelshould be higher resulting from profits in 20x3).Answer:
ROE=(1 - taxrate)x[(EBITxNet Sales)-InterestExpense]x Totalassets[(NetSalesTotal Assets)Total assets]EquityROE=(1 - 0.20)x[(0.04x7.95)-0.02]x1.66=0.04(20x2)or39.60%ROE=(1 - 0.20)x[(0.0425x8.70)-0.02]x1.66=0.46or46.40%Equity=Equity (20x2 actual)=\$3,030,000Netprofit=ROExEquity=0.46x\$3,030,000 =\$1,407,338(20x3 estimate)EPS=Netprofit/Numberof =\$1,407,338/2,000,000=\$0.70

shares
7. U.S. Steel has averaged about 27% over the 4 year period (2000 - 2004) for its payout ratio. Itsactual payout ratio was 30% and 25% for the last of these years (equal to a DPS of \$2 in both years),although it paid 26% in 2000. The next year's (2005) EPS is expected to be \$7.25. Today is the 1 Jan2005.a)Forecast the dividend payable next year.Answer:Using the EPS of \$7.25, one arrives at a forecast of \$1.81 (i.e. 25% of \$7.25) to \$2.18 (i.e. 30% x\$7.25) for the next year’s dividend. Using the average payout of 27%, a possible forecast is \$1.96 (i.e.27% x \$7.25).Empirical evidence suggests firms are reluctant to cut the absolute dollar amount of dividends.Cutting DPS from \$2 to \$1.96 is only a small cut but may be interpreted by investors as the companynot having sufficient cash resources to maintain dividends.Therefore, a good forecast is that the previous year’s level of \$2.00 per share is likely to bemaintained, rather than a small cut which might be more damaging for investors’ confidence. b)If U.S. Steel ‘normal’ PE is 4.5, what will be expected share price by end 05?Answer:Projected intrinsic value (Expected share price at the end of 05)= Forecast EPS x ‘normal’ P/E= \$7.25 x 4.5= \$32.63The expected price is \$32.63 (i.e. 4.5 x \$7.25)c)Compute the holding period yield one year from today assuming yesterday's closing for U.S. Steelis \$19.38.Answer:

The forecast of a one-year holding period yield for U.S. Steel can be made using the projecteddividend of \$2.00, projected PE of 4.5 and the projected price of \$32.63.Yesterday’s price was \$19.38, implying that a holding period yield would equal 78.7%, i.e.HPY = (32.63 + 2.00 – 19.38) / 19.38 = 78.7%d)If you change your assumptions to a period of supernormal growth (20% p.a. growth in dividendsfor the next three years) before reverting to a long-term sustainable growth in dividends of 5% p.a. from the fourth year, and you require a return of 15% p.a., what is the stock’s intrinsic valuecurrently?Answer:D
0
= \$2.00D
1
= \$2.00 x 1.20 = \$2.40D
2
= \$2.40 x 1.20 = \$2.88D
3
= \$2.88 x 1.20 = \$3.46D
4
= \$3.46 x 1.05 = \$3.63Using the Constant-Growth formulae,Fair value, P
3
= D
4
/ (k-g)= \$3.63 / (0.15 – 0.05)= \$36.30Using the 2-stage Growth formulae,Fair value, P
0
= D
1
x PVIF(k, 1) + D
2
x PVIF(k, 2) + (D
3
+ P
3
) x PVIF(k, 3)= \$2.40 x PVIF(15%, 1) + \$2.88 x PVIF(15%, 2) + (\$3.46 + \$36.30) x PVIF(15%, 3)= \$2.40 x 0.870 + \$2.88 x 0.756 + \$39.76 x 0.658= \$30.43 (\$30.21 if calculated directly without tables)8. Lion Airways Ltd is a loss-making airline that does not intend to pay any dividends. Your assessment is that the losses are temporary and the company will become profitable within the nexttwo years. You have been tasked to do a valuation of Lion Airways shares.a)Is the DDM an appropriate valuation tool to use? Why?