Equity: Concepts and Techniques

■ A global industry analysis should examine return potential evidenced by

demand analysis, value creation, industry life cycle, competition structure,
competitive advantage, competitive strategies, co-opetition and the value net,
and sector rotation. The analysis also should examine risk elements evidenced
by market competition, value chain competition, government participation,
and cash flow covariance.
■ Global financial analysis involves comparing company ratios with global industry
averages. In this context, DuPont analysis uses various combinations of the tax
retention, debt burden, operating margin, asset turnover, and leverage ratios.
■ The role of market efficiency in individual asset valuation is to equate funda-
mental value with asset valuation so that the analyst searches for mispricing or
market inefficiency.
■ Franchise value is the present value of growth opportunities divided by next year’s
earnings. The intrinsic P0/E1 ratio equals 1/r plus the franchise value, where r is
the nominal required return on the stock. The franchise value is further divided
into a franchise factor (FF) and a growth factor (G) to give P0/E1 = 1/r + FF * G.
■ To analyze the effects of inflation for valuation purposes, the analyst must
recognize the distorting effects of historical inventory and borrowing costs
on reported earnings, as well as recognize the inflation tax reflected in capital
gains taxes. Further, the analyst must estimate the degree of inflation flow-
through, l.
■ With earnings that are constant except for inflation, I as the inflation rate, r as
the required nominal return on the stock, and r as the required real return on
the stock, the P/E ratio can be estimated as P0/E1 = 1/(r + (1 - l)I).
■ Multifactor models can be used in the analysis of the risk profile of portfolios.
The exposure of a portfolio to the various factors is the weighted average of the
exposures of the stocks making up the portfolio.

Problems
1. Explain why a corporation can have a stock market price well above its accounting
book value.

2. The accounting and fiscal standards of countries allow corporations to build general
provisions (or “hidden reserves”) in anticipation of foreseen or unpredictable expenses.
How would this practice affect the book value of a corporation and its ratio of market
price to book value?

3. Discuss some of the reasons the earnings of German firms tend to be understated
compared with the earnings of U.S. firms.

4. Consider a firm that has given stock options on 20,000 shares to its senior executives.
These call options can be exercised at a price of $22 anytime during the next three

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years. The firm has a total of 500,000 shares outstanding, and the current price is $20
per share. The firm’s net income before taxes is $2 million.
a. What would be the firm’s pretax earnings per share if the options are not expensed?
b. Under certain assumptions, the Black–Scholes model valued the options given by
the firm to its executives at $4 per share option. What would be the firm’s pretax
earnings per share if the options are expensed accordingly?
c. Under somewhat different assumptions, the Black-Scholes model valued the options
at $5.25 per share option. What would be the firm’s pretax earnings per share if the
options are expensed based on this valuation?

5. Japanese companies tend to belong to groups (keiretsu) and to hold shares of one
another. Because these cross-holdings are minority interest, they tend not to be consoli-
dated in published financial statements. To study the impact of this tradition on
published earnings, consider the following simplified example:
Company A owns 10 percent of Company B; the initial investment was 10 million
yen. Company B owns 20 percent of Company A; the initial investment was also 10 mil-
lion yen. Both companies value their minority interests at historical cost. The annual net
income of Company A was 10 million yen. The annual net income of Company B was 30
million yen. Assume that the two companies do not pay any dividends. The current stock
market values are 200 million yen for Company A and 450 million yen for Company B.
a. Restate the earnings of the two companies, using the equity method of consolida-
tion. Remember that the share of the minority-interest earning is consolidated on a
one-line basis, proportionate to the share of equity owned by the parent.
b. Calculate the P/E ratios, based on nonconsolidated and consolidated earnings. How
does the nonconsolidation of earnings affect the P/E ratios?

6. The annual revenues (in billion dollars) in financial year 2001 for the top five players in
the global media and entertainment industry are given in the following table. The top
five corporations in this industry include three U.S.-based corporations (AOL Time
Warner, Walt Disney, and Viacom), one French corporation (Vivendi Universal), and
one Australian corporation (News Corporation). The revenue indicated for Vivendi
Universal does not include the revenue from its environmental business. Assume that
the total worldwide revenue of all firms in this industry was $250 billion.
Company Revenue
AOL Time Warner 38
Walt Disney 25
Vivendi Universal 25
Viacom 23
News Corporation 13

a. Compute the three-firm and five-firm concentration ratios.

b. Compute the three-firm and five-firm Herfindahl indexes.
c. Make a simplistic assumption that in addition to the five corporations mentioned in
the table, there are 40 other companies in this industry with an equal share of the
remaining market. Compute the Herfindahl index for the overall industry.
d. Suppose there were not 40, but only 10 other companies in the industry with an equal
share of the remaining market. Compute the Herfindahl index for the overall industry.
e. Interpret your answers to parts (c) and (d) in terms of the competition structure of
the industry.

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7. News Corporation is headquartered in Australia, and its main activities include

television entertainment, films, cable, and publishing.
a. Collect any relevant information that you may need, and discuss whether an
analyst should do the valuation of News Corporation primarily relative to the
global media and entertainment industry or relative to other companies based in
Australia.
b. One of the competitors of News Corporation is Vivendi Universal, a firm headquar-
tered in France. Should an analyst be concerned in comparing financial ratios of
News Corporation with those of Vivendi Universal?

8. You are given the following data about Walt Disney and News Corporation, two of the
major corporations in the media and entertainment industry. The data are for the end
of the financial year 1999, and are in US$ millions. Though News Corporation is based
in Australia, it also trades on the NYSE, and its data in the following table, like those for
Walt Disney, are according to the U.S. GAAP.

Walt Disney News Corporation

Sales 23,402 14,395
EBIT 3,035 1,819
EBT 2,314 1,212
NI 1,300 719
Assets 43,679 35,681
Equity 20,975 16,374

a. Compute the ROE for Walt Disney and News Corporation.

b. Use the DuPont model to analyze the difference in ROE between the two compa-
nies, identifying the elements that primarily cause this difference.

9. In the past 20 years, the best-performing stock markets have been found in countries
with the highest economic growth rates. Should the current growth rate guide you in
choosing stock markets if the world capital market is efficient?

10. Consider a French company that pays out 70 percent of its earnings. Its next annual
earnings are expected to be :4 per share. The required return for the company is 12
percent. In the past, the company’s compound annual growth rate (CAGR) has been
1.25 times the world’s GDP growth rate. It is expected that the world’s GDP growth rate
will be 2.8 percent p.a. in the future. Assuming that the firm’s earnings will continue to
grow forever at 1.25 times the world’s projected growth rate, compute the intrinsic value
of the company’s stock and its intrinsic P/E ratio.

11. Consider a company that pays out all its earnings. The required return for the firm is
13 percent.
a. Compute the intrinsic P/E value of the company if its ROE is 15 percent.
b. Compute the intrinsic P/E value of the company if its ROE is 20 percent.
c. Discuss why your answers to parts (a) and (b) differ or do not differ from one
another.
d. Suppose that the company’s ROE is 13 percent. Compute its intrinsic P/E value.
e. Would the answer to part (d) change if the company retained half of its earnings
instead of paying all of them out? Discuss why or why not.

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12. Consider a firm with a ROE of 12 percent. The earnings next year are projected at $50
million, and the firm’s earnings retention ratio is 0.70. The required return for the firm
is 10 percent. Compute the following for the firm:
i. Franchise factor
ii. Growth factor
iii. Franchise P/E value
iv. Tangible P/E value
v. Intrinsic P/E value

13. Consider a firm for which the nominal required rate of return is 8 percent. The rate of
inflation is 3 percent. Compute the P/E ratio of the firm under the following situations:
i. The firm has a full inflation flow-through.
ii. The firm can pass only 40 percent of inflation through its earnings.
iii. The firm cannot pass any inflation through its earnings.
What pattern do you observe from your answers to items (i) through (iii)?

14. Company B and Company U are in the same line of business. Company B is based in Brazil,
where inflation during the past few years has averaged about 9 percent. Company U is based
in the United States, where the inflation during the past few years has averaged about
2.5 percent. The real rate of return required by global investors for investing in stocks such
as B and U is 8 percent. Neither B nor U has any real growth in earnings, and both of them
can pass only 60 percent of inflation through their earnings. What should be the P/E of the
two companies? What can you say based on a comparison of the P/E for the two companies?

15. Omega, Inc., is based in Brazil, and most of its operations are domestic. During the
period 1995–99, the firm has not had any real growth in earnings. The annual inflation
in Brazil during this period is given in the following table:

Year Inflation (%)

1995 22.0
1996 9.1
1997 4.3
1998 2.5
1999 8.4
Source : International Monetary Fund.

The real rate of return required by global investors for investing in stocks such as
Omega, Inc., is 7 percent.
a. Compute the P/E for Omega in each of the years if it can completely pass inflation
through its earnings.
b. Compute the P/E for Omega in each of the years if it can pass only 50 percent of
inflation through its earnings.
c. What conclusion can you draw about the effect of inflation on the stock price?

16. Consider a French company that exports French goods to the United States. What effect
will a sudden appreciation of the euro relative to the dollar have on the P/E ratio of the
French company? Discuss the effect under both the possibilities—the company being
able to completely pass through the euro appreciation to its customers and the company
being unable to completely pass through the euro appreciation to its customers.

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17. Using the five macroeconomic factors described in the text, you outline the factor
exposures of two stocks as follows:
Factor Stock A Stock B
Confidence 0.2 0.6
Time horizon 0.6 0.8
Inflation -0.1 -0.5
Business cycle 4.0 2.0
Market timing 1.0 0.7

a. What would be the factor exposures of a portfolio invested half in stock A and half
in stock B?
b. Contrary to general forecasts, you expect strong economic growth with a slight
increase in inflation. Which stock should you overweigh in your portfolio?
18. Here is some return information on firms of various sizes and their price-to-book
(value) ratios. Based on this information, what can you tell about the size and value style
factors?
Stock Size P/BV Return (%)
A Huge High 4
B Huge Low 6
C Medium High 9
D Medium Low 12
E Small High 13
F Small Low 15

19. You are analyzing whether the difference in returns on stocks of a particular country
can be explained by two common factors, with a linear-factor model. Your candidates
for the two factors are changes in interest rates and changes in the approval rating of
the country’s president, as measured by polls. The following table gives the interest rate,
the percentage of people approving the president’s performance, and the prices of
three stocks (A, B, and C) for the past 10 periods.
Interest Approval Price of Stock
Period Rate (%) (%) A B C
1 7.3 47 22.57 24.43 25.02
2 5.2 52 19.90 12.53 13.81
3 5.5 51 15.46 17.42 19.17
4 7.2 49 21.62 24.70 23.24
5 5.4 68 14.51 16.43 18.79
6 5.2 49 12.16 11.56 14.66
7 7.5 72 25.54 24.73 28.68
8 7.6 45 25.83 28.12 21.47
9 5.3 47 13.04 14.71 16.43
10 5.1 67 11.18 12.44 12.50

Try to assess whether the two factors have an influence on stock returns. To do so,
estimate the factor exposures for each of the three stocks by doing a time-series regres-
sion for the return on each stock against the changes in the two factors.

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20. You are a U.S. investor considering investing in Switzerland. The world market risk
premium is estimated at 5 percent, the Swiss franc offers a 1 percent risk premium, and the
current risk-free rates are equal to 4 percent in dollars and 3 percent in francs. In other
words, you expect the Swiss franc to appreciate against the dollar by an amount equal to the
interest rate differential plus the currency risk premium, or a total of 2 percent. You believe
that the following equilibrium model (ICAPM) is appropriate for your investment analysis:
E(Ri) = Rf + b 1 * RPw + b 2 * RPSFr
where all returns are measured in dollars, R Pw is the risk premium on the world index,
and R PSFr is the risk premium on the Swiss franc. Your broker provides you with the
following estimates and forecasted returns.
Stock A Stock B Stock C Stock D
Forecasted return (in francs) 0.08 0.09 0.11 0.07
World beta (b1) 1 1 1.2 1.4
Dollar currency exposure (b2) 1 0 0.5 -0.5

a. What should be the expected dollar returns on the four stocks, according to the ICAPM?
b. Which stocks would you recommend buying or selling?

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