FINC311/ FINC614

Week 11 Tutorial

Dr. Huong Dieu Dang

huong.dang@canterbury.ac.nz
Rm 432 Meremere Building
 Short case: Beachwood (past exam)
• Beachwood Builders merged with Country Point Homes in December 31, 1992. Both companies were
builders of mid-scale and luxury homes in their respective markets. On December 31, 2002, because
of tax considerations and the need to segment the businesses between mid-scale and luxury homes,
Beachwood decided to spin-off Country Point, its luxury home subsidiary, to its common
shareholders. Beachwood retained Bernheim Securities to value the spin-off of Country Point to its
shareholders. The following information is available to Bernheim’s investment bankers:
• Country Point’s allocated common equity was $55.6 million as of December 31, 2002.
• Beachwood paid no dividends and has no preferred shareholders.
• Country Point’s free cash flow is expected to grow 7 percent after 2006.
• The current risk-free rate is 6 percent. The market risk premium is 11 percent.
• Beachwood Builders had 5 million common shares as of December 31, 2002.
• Country Point’s cost of capital is equal to its return on equity at year-end (round to nearest
percentage point).
• Country Point did not have any long-term debt allocated from Beachwood.
• The following table for Country Point is also available for analysis
$ (in millions) 2002 2003 2004 2005 2006
Net Income 10 15 20 25 30
Depreciation 5 6 5 6 5
Capital Expenditures 7 8 9 10 12

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Case study Beachwood (past exam)
• a. Bernheim’s investment bankers have determined that the value of
Country Point to be $162.6 million and to effect the spin-off, it was
appropriate for Beachwood to issue its common shareholders two shares
in Country Point for each share that its current shareholders held. The
appropriate initial offering price per share for the spin-off to Beachwood’s
shareholders should be

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Case study Beachwood (past exam)
• b. Immediately after the spin-off, Country
Point’s book value per share would
be

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Case study Beachwood (past exam)
• c. Based on the initial offering price of the spin-off, the
estimated price-to-book ratio is

• d. Based on Bernheim’s careful analysis, comparable

firms to Country Point trade at a price-to-book ratio of
3.5 times. The expected price per share of the spin-off
assuming a liquid and efficient market for Country
Point’s common shares would be

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Price multiples CFA question (past exam)
• Analysts and portfolio managers at Big Picture Investments (Big Picture) are having
their weekly investment meeting. CEO Bob Powell, CFA, believes the firm’s portfolios
are too heavily weighted toward growth stocks. “I expect value to make a comeback
over the next 12 months. We need to get more value stocks in the Big Picture’s
portfolios”. Four of Powell’s analysts, all of whom hold the CFA charter, were at the
meeting – Laura Barnes, Chester Lincoln, Thaddeus Bosley, and Zelda Marks. Powell
suggested Big Picture should start selecting stocks with the lowest price/earnings
(P/E) multiples. Here are the analysts’ comments:
• Barnes said numerous academic studies have shown that low P/E stocks tend to
outperform those with high P/E. She uses the P/E ratio as the basis of most of her
valuation analysis. “I prefer to use the justified P/E ratio because it is inversely
related to the required rate of return.”
• Lincoln warned against using P/E ratios to value technology stocks. He suggests using
price/ book ratios instead, because they are useful for explaining long term stock
returns. “Book value is a good measure of value for companies with a lot of liquid
assets, and it is easier to calculate than the P/E because you rarely have to adjust
book value.”
• Bosley prefers the price/ sales (P/S) ratio and the earnings yield. “The P/S ratio is
particularly useful for valuing companies in cyclical industries because it is not
affected by sharp changes in profitability caused by economic cycles.”
• Marks acknowledges that the P/E ratio is a useful valuation measurement. However,
she prefers using the price/ free cash flow ratio. “Free cash flow is more difficult to
manipulate than earnings and it has proven value as a predictor of stock returns.”
• Comment on the accuracy of each analyst’s quote.
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 Price multiples question (cont)
• Barnes said numerous academic studies have shown that low P/E stocks tend to outperform
those with high P/E. She uses the P/E ratio as the basis of most of her valuation analysis. “I
prefer to use the justified P/E ratio because it is inversely related to the required rate of return.”
• Lincoln warned against using P/E ratios to value technology stocks. He suggests using price/ book
ratios instead, because they are useful for explaining long term stock returns. “Book value is a
good measure of value for companies with a lot of liquid assets, and it is easier to calculate than
the P/E because you rarely have to adjust book value.”
• Bosley prefers the price/ sales (P/S) ratio and the earnings yield. “The P/S ratio is particularly
useful for valuing companies in cyclical industries because it is not affected by sharp changes in
profitability caused by economic cycles.”
• Marks acknowledges that the P/E ratio is a useful valuation measurement. However, she prefers
using the price/ free cash flow ratio. “Free cash flow is more difficult to manipulate than
earnings and it has proven value as a predictor of stock returns.”
• Based on the responses to Powell, which of the analysts is most likely concerned about earnings
volatility? Explain your answer.

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 Price multiples question (cont)
• Barnes said numerous academic studies have shown that low P/E stocks tend to outperform
those with high P/E. She uses the P/E ratio as the basis of most of her valuation analysis. “I
prefer to use the justified P/E ratio because it is inversely related to the required rate of return.”
• Lincoln warned against using P/E ratios to value technology stocks. He suggests using price/ book
ratios instead, because they are useful for explaining long term stock returns. “Book value is a
good measure of value for companies with a lot of liquid assets, and it is easier to calculate than
the P/E because you rarely have to adjust book value.”
• Bosley prefers the price/ sales (P/S) ratio and the earnings yield. “The P/S ratio is particularly
useful for valuing companies in cyclical industries because it is not affected by sharp changes in
profitability caused by economic cycles.”
• Marks acknowledges that the P/E ratio is a useful valuation measurement. However, she prefers
using the price/ free cash flow ratio. “Free cash flow is more difficult to manipulate than than
earnings and it has proven value as a predictor of stock returns.”
• Based on the responses to Powell, which of the analysts has proposed a method that has the
best chance to work for determining the relative value of start-up companies? Explain your
answer.

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 Price multiples question (cont)
• Powell has provided Barnes with a group of large cap stocks to analyse. The stocks
come from a variety of different sectors and have widely different financial structures
and growth profiles. She has been asked to determine which of these stocks represent
attractive values. She is considering four possible methods for the job:
• The PEG ratio, because it corrects for risk if the stocks have similar expected returns
• Comparing P/E ratios to the average stock in the S&P500 index, because the
benchmark should serve as a good proxy for the average large cap stock valuation.
• Comparing P/E ratios to the median stock in the S&P500 Index, because outliers can
skew the average upward
• The P/S ratio because it works well for companies in different stages of the business
cycle.
• For which method does Barnes provide the weakest justification? Explain your answer.

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 Price multiples question (cont)
• Barnes is contemplating the use of a price/ earnings ratio to value a start-
up medical technology firm. Which of the following is the most compelling
reason not to use the P/E ratio? Explain your answer.
• Earnings per share are not a good determinant of investment value for
medical-technology companies.
• Clients who receive a report on the company may not understand what
the P/E ratio means.
• The company is likely to be unprofitable.
• P/E ratios for medical-technology firms with different specialities are not
comparable.

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Short answer past exam question
Comment on the following statement:
“The P/E multiple of a cyclical firm normally peaks at the depths of a recession and
bottoms out at the peak of an economic boom”
Short answer past exam question (2)
Mary Wong, a value-oriented portfolio manager, has an important client who wants to alter the composition of
her equity portfolio, which is currently a diversified portfolio of 60 global common stocks. Because of concerns
about the economy and based on the assumption that the consumer staples sector will be less hurt than others
in a recession, the client wants to add a group of stocks from the consumer staples sector and still maintain a
diversified portfolio. In addition, the client wants the stocks to meet the following criteria:
Stocks must have a large market capitalisation
Stocks must have a dividend yield of at least 4 percent
Stocks must have a forward PE no greater than 15
The following table shows how many stocks satisfied each screen, which was run in July 2008:

Screen Number satisfying

Consumer stable sector 277
Large cap (>9.7 billion in this database) 446
Dividend yield of at least 4% 1609
Forward PE less than 15 2994
All four screens 6

The stocks satisfying all screens were Altria Group, Inc.; British American Tobacco (The company’s ADR),
Reynolds American, Inc.; Tesco PLC (The ADR); Unilever N.V. (the ADR); and Unilever PLC (the ADR).

Wong recommends Reynolds American, Inc. (RA) as RA has a low PE in light of the potential earnings in the
coming years. State if the base for Wong’s recommendation is consistent with her value investment
orientation. Explain clearly.
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Short answer past exam question (3)
Mavis Borchard, principal of Borchard Investments, is discussing portfolio strategy with Wilford
Tupper, a potential client who walked into her office in the hopes of finding a shrewd way to invest
$800,000. Tupper is an experienced investor with other stock holdings, but he does not have the
time to manage additional investment.
After listening to Tupper's investment goals, Borchard suggests a policy of active management, listing
several of its benefits.
• "The potential returns of this strategy are higher than those of passive-management strategies, yet
the risk-reward trade-off is appealing. The information ratio for active management is higher than
the ratio for passive management."
• "To ensure that my portfolios deliver the best performance and that I don't deviate from my
original investment style, I regress my returns against three indexes, a large-cap, a mid-cap, and
small-cap."
• "I use a bottom-up approach to select stocks, focusing entirely on macro-economic and industry
conditions."
Tupper is not satisfied with Borchard's strategies and asks about other types of investments.
Historically, Tupper has not been successful at beating the market with his large-cap stock choices,
but he is a firm believer in reversion to the mean.
Which of Borchard's statements is likely to be most effective at convincing Tupper to let her actively
manage his money? Explain clearly.

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 Review: The Information Ratio
The Sharpe ratio of an optimally constructed risky
portfolio will exceed that of the index portfolio (the
passive strategy)
2
 A 
s P = s M +   (eA ) 
2 2

The contribution of the active portfolio depends on the

ratio of its alpha to its residual standard deviation
The information ratio measures the extra return we can
obtain from security analysis (i.e. active management)
compared to the firm-specific risk we incur when we
overweight or underweight securities relative to the
passive market index 14