EF4314 Solution to Self-study Exercise 3

Question 1
Conceptual Questions
a. True. A firm with positive expected residual earnings (produced by an ROCE above
the cost of capital) must be valued at a premium.
b. False. Book value may be low relative to total value, but the residual earnings methods
estimate the missing value in the balance sheet to add to book value. It does so by
forecasting the earnings that will be added to book value in the future. Those earnings
include earnings from assets that are not on the balance sheet, like brands and
knowledge assets: Even though value is missing from the balance sheet, it can be
calculated from earnings that will come through the income statement.

Question 2
ROCE and Residual Earnings Valuation

Given that ROCE is equal to the required return, expected residual earnings are zero. So the
shares are worth their book value per share.

Book value per share = $3,200/500 = $6.40.

So price per share is $6.40.

Question 3
Residual Earnings Valuation and Target Prices
Develop the pro forma as follows:

2012 2013 2014 2015 2016 2017

EPS 3.90 3.70 3.31 3.59 3.90
DPS 1.00 1.00 1.00 1.00 1.00
BPS 22.00 24.90 27.60 29.91 32.50 35.40

(a) RE (0.12) 1.26 .71 0 0 0

Discount rate 1.12 1.2544

PV 1.125 .57
 Total PV 1.70

(b) Intrinsic Value at 2012 = 22+1.70 = 23.70

(c) As residual earnings are expected to be zero after 2017, the equity is expected to be

worth its book value of $35.40 at that point.

(d) The expected P/B ratio at 2017 is one because subsequent residual earnings is

expected to be zero.

Question 4
Residual Earnings Valuation: Black Hills Corp

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

Question 5
Valuing Dell, Inc.

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
1.442  1.04
Continuing value 24.99
1.10  1.04
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.

Question 6
Valuing: General Electric Co.

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:

. . . ∗ .
𝑉𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 10.47 ∗
. . . . .
= 23.62

Question 7
Converting Analysts' Forecasts to a Valuation: Nike, Inc.
Nike appears to be reasonably priced at $60 per share.
If you accept the analysts’ forecasts up to 2013 (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.