EF4314 Self-study Exercise 3

Question 1
Conceptual Questions

a. Information indicates that a firm will earn a return on common equity above its cost of
equity capital in all years in the future, but its shares trade below book value. Those
shares must be mispriced. True or false?
b. An advocate of discounted cash flow analysis says, "Residual earnings valuation does
not work well for companies like Coca-Cola, Cisco Systems, or Nike, which have
substantial assets, like brands, R&D assets, and entrepreneurial know-how off the
books. A low book value must give you a low valuation." True or false?

Question 2
ROCE and Residual Earnings Valuation

The following are ROCE forecasts made for a firm at the end of 2010.

ROCE is expected to continue at the same level after 2013. The firm reported book value of
common equity of $3.2 billion at the end of 2010, with 500 million shares outstanding. If the
required equity return is 12 percent, what is the per-share value of these shares?

Question 3
Residual Earnings Valuation and Target Prices

The following forecasts of earnings per share (EPS) and dividend per share (DPS) were made
at the end of 2012 for a firm with a book value per share of $22.00:
The firm has an equity cost of capital of 12 percent per annum.
a. Calculate the residual earnings that are forecast for each year, 2013 to 2017.
b. What is the per-share value of the equity at the end of 2012 based on the residual earnings
valuation model?
c. What is the forecasted per-share value of the equity at the end of the year 2017?
d. What is the expected P/B ratio in 2017?

Question 4
Residual Earnings Valuation: Black Hills Corp

Black Hills Corporation is a diversified energy corporation and a public utility holding
company. The following gives the firm's earnings per share and dividends per share for the
years 2000-2004.

Suppose these numbers were given to you at the end of 1999, as forecasts, when the book value
per share was $9.96, as indicated. Use a required return of 11 percent for calculations below.
a. Calculate residual earnings and return of common equity (ROCE) for each year, 2000-
2004.
b. Value the firm at the end of 1999 under the assumption that the ROCE in 2004 will
continue at the same level subsequently.

Question 5
Valuing Dell, Inc.

In September 2008, the shares of Dell, Inc., the computer maker, traded at $20.50 each. In its
last annual report, Dell had reported book value of $3,735 million with 2,060 million shares
outstanding. Analysts were forecasting earnings per share of $1.47 for fiscal year 2009 and
$1.77 for 2010. Dell pays no dividends. Calculate the per-share value of Dell in 2008 based on
the analysts' forecasts, with an additional forecast that residual earnings will grow at the
anticipated GDP growth rate of 4 percent per year after 2010. Use a required return of 10
percent.

Question 6
Valuing: General Electric Co.

General Electric Co. reported a per-share book value of $10.47 in its balance sheet on
December 31, 2004. In early 2005, analysts were forecasting consensus earnings per share of
$1.71for 2005 and $1.96 for 2006. The required return for equity is 10 percent. The dividend
payout ratio is expected to be 50 percent of earnings. Calculate the value per share in early
2005 with a forecast that residual earnings will grow at a long-term growth rate of 4 percent,
the average GDP growth rate, after 2006.

Question 7
Converting Analysts' Forecasts to a Valuation: Nike, Inc.

Nike reported book value per share of $15.93 at the end of its 2008 fiscal year. The annual EPS
and dividend per share in 2008 were $3.80 and $0.88, respectively. Analysts were forecasting
earnings of $3.90 per share for 2009 and $4.45 for 2010, and were also forecasting a five-year
growth rate in EPS of 13 percent per year. Convert these forecasts to a valuation with the added
forecast that residual earnings will grow at the GDP growth rate of 4 percent per year after
2013. Use a required return of 10 percent in your calculations and assume a fixed payout ratio
during the forecast horizon. Nike traded at $60 per share at the time. Based on your calculations,
do you think Nike is reasonably priced? What does your analysis tell you about the long-run
growth rate that the market is forecasting for Nike?