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Equity ASSEt VAluAtion Workbook



CFA Institute is the premier association for investment professionals around the world, with over 130,000 members in 151 countries and territories. Since 1963 the organization has developed and administered the renowned Chartered Financial Analyst® Program. With a rich history of leading the investment profession, CFA institute has set the highest standards in ethics, education, and professional excellence within the global investment community, and is the foremost authority on investment profession conduct and practice. Each book in the CFA institute investment Series is geared toward industry practitioners along with graduate-level finance students and covers the most important topics in the industry. The authors of these cutting-edge books are themselves industry professionals and academics and bring their wealth of knowledge and expertise to this series.


Equity ASSEt VAluAtion Workbook

Third Edition

Jerald E. Pinto, CFA

Elaine Henry, CFA

Thomas r. robinson, CFA

John D. Stowe, CFA


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v

ContentS

Part I Learning Objectives, Summary Overview, and Problems 1

ChaPter 1equity Valuation: applications and Processes 3Learning outcomes 3Summary overview 3Problems 5

ChaPter 2return Concepts 9Learning outcomes 9Summary overview 9Problems 11

ChaPter 3Introduction to Industry and Company analysis 17Learning outcomes 17Summary overview 18Problems 20

ChaPter 4Industry and Company analysis 25Learning outcomes 25Summary overview 26Problems 26

ChaPter 5Discounted Dividend Valuation 33Learning outcomes 33Summary overview 34Problems 36


vi Contents

ChaPter 6Free Cash Flow Valuation 45Learning outcomes 45Summary overview 46Problems 48

ChaPter 7Market-Based Valuation: Price and enterprise Value Multiples 61Learning outcomes 61Summary overview 62Problems 65

ChaPter 8residual Income Valuation 75Learning outcomes 75Summary overview 76Problems 77

ChaPter 9Private Company Valuation 85Learning outcomes 85Summary overview 86Problems 87

Part IISolutions 95

ChaPter 1equity Valuation: applications and Processes 97Solutions 97

ChaPter 2return Concepts 101Solutions 101

ChaPter 3Introduction to Industry and Company analysis 107Solutions 107

ChaPter 4Industry and Company analysis 109Solutions 109



Contents vii

ChaPter 5Discounted Dividend Valuation 113Solutions 113

ChaPter 6Free Cash Flow Valuation 123Solutions 123

ChaPter 7Market-Based Valuation: Price and enterprise Value Multiples 137Solutions 137

ChaPter 8residual Income Valuation 145Solutions 145

ChaPter 9Private Company Valuation 157Solutions 157

about the CFa Program 161


Equity AssEt VAluAtion Workbook


1

PArt ILeArnIng ObjectIves, suMMAry OvervIew,

And PrObLeMs


3

chAPter 1equIty vALuAtIOn:

APPLIcAtIOns And PrOcesses

LeArnIng OutcOMes

After completing this chapter, you will be able to do the following:

• define valuation and intrinsic value and explain sources of perceived mispricing;• explain the going concern assumption and contrast a going concern value to a liquidation

value; • describe definitions of value and justify which definition of value is most relevant to public

company valuation;• describe applications of equity valuation;• describe questions that should be addressed in conducting an industry and competitive

analysis;• contrast absolute and relative valuation models and describe examples of each type of model;• describe sum-of-the-parts valuation and conglomerate discounts;• explain broad criteria for choosing an appropriate approach for valuing a given company.

suMMAry OvervIew

In this reading, we have discussed the scope of equity valuation, outlined the valuation process, introduced valuation concepts and models, discussed the analyst’s role and responsibilities in conducting valuation, and described the elements of an effective research report in which ana-lysts communicate their valuation analysis.

• valuation is the estimation of an asset’s value based on variables perceived to be related to future investment returns, or based on comparisons with closely similar assets.


4 Part I: Learning Objectives, summary Overview, and Problems

• The intrinsic value of an asset is its value given a hypothetically complete understanding of the asset’s investment characteristics.

• The assumption that the market price of a security can diverge from its intrinsic value—as suggested by the rational efficient markets formulation of efficient market theory—underpins active investing.

• Intrinsic value incorporates the going-concern assumption, that is, the assumption that a company will continue operating for the foreseeable future. In contrast, liquidation value is the company’s value if it were dissolved and its assets sold individually.

• Fair value is the price at which an asset (or liability) would change hands if neither buyer nor sell-er were under compulsion to buy/sell and both were informed about material underlying facts.

• In addition to stock selection by active traders, valuation is also used for:• inferring (extracting) market expectations;• evaluating corporate events;• issuing fairness opinions;• evaluating business strategies and models; and• appraising private businesses.

• The valuation process has five steps:1. understanding the business.2. Forecasting company performance.3. selecting the appropriate valuation model.4. converting forecasts to a valuation.5. Applying the analytical results in the form of recommendations and conclusions.

• understanding the business includes evaluating industry prospects, competitive position, and corporate strategies, all of which contribute to making more accurate forecasts. un-derstanding the business also involves analysis of financial reports, including evaluating the quality of a company’s earnings.

• In forecasting company performance, a top-down forecasting approach moves from macro-economic forecasts to industry forecasts and then to individual company and asset forecasts. A bottom-up forecasting approach aggregates individual company forecasts to industry fore-casts, which in turn may be aggregated to macroeconomic forecasts.

• selecting the appropriate valuation approach means choosing an approach that is:• consistent with the characteristics of the company being valued;• appropriate given the availability and quality of the data; and• consistent with the analyst’s valuation purpose and perspective.

• two broad categories of valuation models are absolute valuation models and relative valua-tion models.• Absolute valuation models specify an asset’s intrinsic value, supplying a point estimate of

value that can be compared with market price. Present value models of common stock (also called discounted cash flow models) are the most important type of absolute valuation model.

• relative valuation models specify an asset’s value relative to the value of another asset. As applied to equity valuation, relative valuation is also known as the method of compara-bles, which involves comparison of a stock’s price multiple to a benchmark price multiple. The benchmark price multiple can be based on a similar stock or on the average price multiple of some group of stocks.

• two important aspects of converting forecasts to valuation are sensitivity analysis and situ-ational adjustments.• sensitivity analysis is an analysis to determine how changes in an assumed input would

affect the outcome of an analysis.


Chapter 1 Equity Valuation: Applications and Processes 5

• situational adjustments include control premiums (premiums for a controlling interest in the company), discounts for lack of marketability (discounts reflecting the lack of a public market for the company’s shares), and illiquidity discounts (discounts reflecting the lack of a liquid market for the company’s shares).

• Applying valuation conclusions depends on the purpose of the valuation.• In performing valuations, analysts must hold themselves accountable to both standards of

competence and standards of conduct.• An effective research report:• contains timely information;• is written in clear, incisive language;• is objective and well researched, with key assumptions clearly identified;• distinguishes clearly between facts and opinions;• contains analysis, forecasts, valuation, and a recommendation that are internally consistent;• presents sufficient information that the reader can critique the valuation;• states the risk factors for an investment in the company; and• discloses any potential conflicts of interests faced by the analyst.

• Analysts have an obligation to provide substantive and meaningful content. cFA Institute members have an additional overriding responsibility to adhere to the cFA Institute code of ethics and relevant specific standards of Professional conduct.

PrObLeMs

1. critique the statement: “no equity investor needs to understand valuation models be-cause real-time market prices for equities are easy to obtain online.”

2. The reading defined intrinsic value as “the value of an asset given a hypothetically complete understanding of the asset’s investment characteristics.” discuss why “hypothetically” is included in the definition and the practical implication(s).

3. A. explain why liquidation value is generally not relevant to estimating intrinsic value for profitable companies.

b. explain whether making a going-concern assumption would affect the value placed on a company’s inventory.

4. explain how the procedure for using a valuation model to infer market expectations about a company’s future growth differs from using the same model to obtain an independent estimate of value.

5. example 1, based on a study of Intel corporation that used a present value model (cornell 2001), examined what future revenue growth rates were consistent with Intel’s stock price of $61.50 just prior to its earnings announcement, and $43.31 only five days later. The example states, “using a conservatively low discount rate, cornell estimated that Intel’s price before the announcement, $61.50, was consistent with a forecasted growth rate of 20 percent a year for the subsequent 10 years and then 6 percent per year thereafter.” discuss the implications of using a higher discount rate than cornell did.

6. discuss how understanding a company’s business (the first step in equity valuation) might be useful in performing a sensitivity analysis related to a valuation of the company.

Practice Problems and solutions: Equity Asset Valuation, second edition, by jerald e. Pinto, cFA, elaine henry, cFA, Thomas r. robinson, cFA, and john d. stowe, cFA. copyright © 2009 by cFA Institute.



7. In a research note on the ordinary shares of the Milan Fashion group (MFg) dated early july 2007 when a recent price was €7.73 and projected annual dividends were €0.05, an analyst stated a target price of €9.20. The research note did not discuss how the target price was obtained or how it should be interpreted. Assume the target price represents the expected price of MFg. what further specific pieces of information would you need to form an opinion on whether MFg was fairly valued, overvalued, or undervalued?

8. you are researching XMI corporation (XMI). XMI has shown steady earnings per share growth (18 percent a year during the last seven years) and trades at a very high multiple to earnings (its P/e is currently 40 percent above the average P/e for a group of the most comparable stocks). XMI has generally grown through acquisition, by using XMI stock to purchase other companies whose stock traded at lower P/es. In investigating the financial disclosures of these acquired companies and talking to industry contacts, you conclude that XMI has been forcing the companies it acquires to accelerate the payment of expenses before the acquisition deals are closed. As one example, XMI asks acquired companies to immediately pay all pending accounts payable, whether or not they are due. subsequent to the acquisition, XMI reinstitutes normal expense payment patterns.A. what are the effects of XMI’s pre-acquisition expensing policies?b. The statement is made that XMI’s “P/e is currently 40 percent above the average P/e

for a group of the most comparable stocks.” what type of valuation model is implicit in that statement?

The following information relates to Questions 9–16guardian capital is a rapidly growing us investment firm. The guardian capital research team is responsible for identifying undervalued and overvalued publicly traded equities that have a market capitalization greater than $500 million.

due to the rapid growth of assets under management, guardian capital recently hired a new analyst, jack richardson, to support the research process. At the new analyst orientation meeting, the director of research made the following statements about equity valuation at guardian:

statement 1 “Analysts at guardian capital seek to identify mispricing, relying on price eventually converging to intrinsic value. however, convergence of the market price to an analyst’s estimate of intrinsic value may not happen within the portfolio manager’s investment time horizon. so, besides evi-dence of mispricing, analysts should look for the presence of a particular market or corporate event,—that is, a catalyst—that will cause the mar-ketplace to re-evaluate the subject firm’s prospects.”

statement 2 “An active investment manager attempts to capture positive alpha. but mispricing of assets is not directly observable. It is therefore important that you understand the possible sources of perceived mispricing.”

statement 3 “For its distressed securities fund, guardian capital screens its investable universe of securities for companies in financial distress.”

statement 4 “For its core equity fund, guardian capital selects financially sound companies that are expected to generate significant positive free cash flow from core business operations within a multiyear forecast horizon.”

statement 5 “guardian capital’s research process requires analysts to evaluate the rea-sonableness of the expectations implied by the market price by comparing the market’s implied expectations to his or her own expectations.”



Chapter 1 Equity Valuation: Applications and Processes 7

After the orientation meeting, the director of research asks richardson to evaluate three companies that are retailers of men’s clothing: diamond co., renaissance clothing, and de-luxe Men’s wear.

richardson starts his analysis by evaluating the characteristics of the men’s retail clothing industry. he finds few barriers to new retail entrants, high intra-industry rivalry among retailers, low product substitution costs for customers, and a large number of wholesale clothing suppliers.

while conducting his analysis, richardson discovers that renaissance clothing included three non-recurring items in their most recent earnings release: a positive litigation settlement, a one-time tax credit, and the gain on the sale of a non-operating asset.

to estimate each firm’s intrinsic value, richardson applies appropriate discount rates to each firm’s estimated free cash flows over a ten-year time horizon and to the estimated value of the firm at the end of the ten-year horizon.

Michelle Lee, a junior technology analyst at guardian, asks the director of research for advice as to which valuation model to use for vegA, a fast growing semiconductor company that is rapidly gaining market share.

The director of research states that “the valuation model selected must be consistent with the characteristics of the company being valued.”

Lee tells the director of research that vegA is not expected to be profitable for several more years. According to management guidance, when the company turns profitable, it will invest in new product development; as a result, it does not expect to initiate a dividend for an extended period of time. Lee also notes that she expects that certain larger competitors will become interested in acquiring vegA because of its excellent growth prospects. The director of research advises Lee to consider that in her valuation.

9. based on statement 2, which of the following sources of perceived mispricing do active investment managers attempt to identify? The difference between:A. intrinsic value and market price. b. estimated intrinsic value and market price.c. intrinsic value and estimated intrinsic value.

10. with respect to statements 3 and 4, which of the following measures of value would the distressed securities fund’s analyst consider that a core equity fund analyst might ignore? A. Fair value b. Liquidation value c. Fair market value

11. with respect to statement 4, which measure of value is most relevant for the analyst of the fund described? A. Liquidation valueb. Investment value c. going-concern value

12. According to statement 5, analysts are expected to use valuation concepts and models to: A. value private businesses.b. render fairness opinions. c. extract market expectations.

13. based on richardson’s industry analysis, which of the following characteristics of men’s retail clothing retailing would positively affect its profitability? That industry’s:A. entry costs.b. substitution costs. c. number of suppliers.



14. which of the following statements about the reported earnings of renaissance clothing is most accurate? relative to sustainable earnings, reported earnings are likely:A. unbiased. b. upward biased. c. downward biased.

15. which valuation model is richardson applying in his analysis of the retailers? A. relative valueb. Absolute valuec. sum-of-the-parts

16. which valuation model would the director of research most likely recommend Lee use to estimate the value of vegA?A. Free cash flow b. dividend discount c. P/e relative valuation


9

ChaPter 2return ConCePtS

Learning outCoMeS


• distinguish among realized holding period return, expected holding period return, required return, return from convergence of price to intrinsic value, discount rate, and internal rate of return;

• calculate and interpret an equity risk premium using historical and forward-looking estima-tion approaches;

• estimate the required return on an equity investment using the capital asset pricing model, the Fama–French model, the Pastor–Stambaugh model, macroeconomic multifactor mod-els, and the build-up method (e.g., bond yield plus risk premium);

• explain beta estimation for public companies, thinly traded public companies, and nonpub-lic companies;

• describe strengths and weaknesses of methods used to estimate the required return on an equity investment;

• explain international considerations in required return estimation;• explain and calculate the weighted average cost of capital for a company;• evaluate the appropriateness of using a particular rate of return as a discount rate, given a

description of the cash flow to be discounted and other relevant facts.

SuMMary overview

in this reading we introduced several important return concepts. required returns are impor-tant because they are used as discount rates in determining the present value of expected future cash flows. when an investor’s intrinsic value estimate for an asset differs from its market price, the investor generally expects to earn the required return plus a return from the convergence of price to value. when an asset’s intrinsic value equals price, however, the investor only expects to earn the required return.


10 Part i: Learning objectives, Summary overview, and Problems

For two important approaches to estimating a company’s required return, the CaPM and the build-up model, the analyst needs an estimate of the equity risk premium. This reading examined realized equity risk premia for a group of major world equity markets and also ex-plained forward-looking estimation methods. For determining the required return on equity, the analyst may choose from the CaPM and various multifactor models such as the Fama–French model and its extensions, examining regression fit statistics to assess the reliability of these methods. For private companies, the analyst can adapt public equity valuation models for required return using public company comparables, or use a build-up model, which starts with the risk-free rate and the estimated equity risk premium and adds additional appropriate risk premia.

when the analyst approaches the valuation of equity indirectly, by first valuing the total firm as the present value of expected future cash flows to all sources of capital, the appropriate discount rate is a weighted average cost of capital based on all sources of capital. Discount rates must be on a nominal (real) basis if cash flows are on a nominal (real) basis.

among the reading’s major points are the following:

• The return from investing in an asset over a specified time period is called the holding period return. Realized return refers to a return achieved in the past, and expected return refers to an anticipated return over a future time period. a required return is the minimum level of expected return that an investor requires to invest in the asset over a specified time period, given the asset’s riskiness. The (market) required return, a required rate of return on an asset that is inferred using market prices or returns, is typically used as the discount rate in finding the present values of expected future cash flows. if an asset is perceived (is not perceived) as fairly priced in the marketplace, the required return should (should not) equal the investor’s expected return. when an asset is believed to be mispriced, investors should earn a return from convergence of price to intrinsic value.

• an estimate of the equity risk premium—the incremental return that investors require for holding equities rather than a risk-free asset—is used in the CaPM and in the build-up approach to required return estimation.

• approaches to equity risk premium estimation include historical, adjusted historical, and forward-looking approaches.

• in historical estimation, the analyst must decide whether to use a short-term or a long-term government bond rate to represent the risk-free rate and whether to calculate a geometric or arithmetic mean for the equity risk premium estimate. Forward-looking estimates include gordon growth model estimates, supply-side models, and survey estimates. adjusted his-torical estimates can involve an adjustment for biases in data series and an adjustment to incorporate an independent estimate of the equity risk premium.

• The CaPM is a widely used model for required return estimation that uses beta relative to a market portfolio proxy to adjust for risk. The Fama–French model (FFM) is a three factor model that incorporates the market factor, a size factor, and a value factor. The Pastor-Stambaugh extension to the FFM adds a liquidity factor. The bond yield plus risk premium approach finds a required return estimate as the sum of the ytM of the subject company’s debt plus a subjective risk premium (often 3 percent to 4 percent).

• when a stock is thinly traded or not publicly traded, its beta may be estimated on the basis of a peer company’s beta. The procedure involves unlevering the peer company’s beta and then re-levering it to reflect the subject company’s use of financial leverage. The procedure adjusts for the effect of differences of financial leverage between the peer and subject company.


Chapter 2 Return Concepts 11

• emerging markets pose special challenges to required return estimation. The country spread model estimates the equity risk premium as the equity risk premium for a developed market plus a country premium. The country risk rating model approach uses risk ratings for devel-oped markets to infer risk ratings and equity risk premiums for emerging markets.

• The weighted average cost of capital is used when valuing the total firm and is generally understood as the nominal after-tax weighted average cost of capital, which is used in dis-counting nominal cash flows to the firm in later readings. The nominal required return on equity is used in discounting cash flows to equity.

ProbLeMS

1. a Canada-based investor buys shares of toronto-Dominion bank (toronto: tD.to) for C$72.08 on 15 october 2007 with the intent of holding them for a year. The dividend rate was C$2.11 per year. The investor actually sells the shares on 5 november 2007 for C$69.52. The investor notes the following additional facts:• no dividends were paid between 15 october and 5 november.• The required return on tD.to equity was 8.7 percent on an annual basis and 0.161

percent on a weekly basis.a. State the lengths of the expected and actual holding-periods.b. given that tD.to was fairly priced, calculate the price appreciation return (capital

gains yield) anticipated by the investor given his initial expectations and initial expect-ed holding period.

C. Calculate the investor’s realized return.D. Calculate the realized alpha.

2. The estimated betas for aoL time warner (nySe: aoL), J.P. Morgan Chase & Com-pany (nySe: JPM), and The boeing Company (nySe: ba) are 2.50, 1.50, and 0.80, respectively. The risk-free rate of return is 4.35 percent, and the equity risk premium is 8.04 percent. Calculate the required rates of return for these three stocks using the CaPM.

3. The estimated factor sensitivities of terranova energy to Fama–French factors and the risk premia associated with those factors are given in the table below:

Factor Sensitivity risk Premium (%)

Market factor 1.20 4.5

Size factor −0.50 2.7

value factor −0.15 4.3

a. based on the Fama–French model, calculate the required return for terranova energy using these estimates. assume that the treasury bill rate is 4.7 percent.

b. Describe the expected style characteristics of terranova based on its factor sensitivities.

4. newmont Mining (nySe: neM) has an estimated beta of –0.2. The risk-free rate of return is 4.5 percent, and the equity risk premium is estimated to be 7.5 percent. using the CaPM, calculate the required rate of return for investors in neM.

Copyright © 2011 CFa institute



5. an analyst wants to account for financial distress and market-capitalization as well as market risk in his cost of equity estimate for a particular traded company. which of the following models is most appropriate for achieving that objective?a. The capital asset pricing model (CaPM).b. The Fama–French model.C. a macroeconomic factor model.

6. The following facts describe Larsen & toubro Ltd’s component costs of capital and capital structure. based on the information given, calculate Larsen & toubro’s waCC.

Component Costs of Capital (%)

Cost of equity based on the CaPM: 15.6

Pretax cost of debt: 8.28

tax rate: 30

target weight in capital structure: equity 80, Debt 20

The following information relates to Questions 7–12an equity index is established in 2001 for a country that has relatively recently established a market economy. The index vendor constructed returns for the five years prior to 2001 based on the initial group of companies constituting the index in 2001. over 2004 to 2006, a series of military confrontations concerning a disputed border disrupted the economy and financial markets. The dispute is conclusively arbitrated at the end of 2006. in total, ten years of equity market return history is available as of the beginning of 2007. The geometric mean return relative to 10-year government bond returns over 10 years is 2 percent per year. The forward dividend yield on the index is 1 percent. Stock returns over 2004 to 2006 reflect the setbacks, but economists predict the country will be on a path of a 4 percent real gDP growth rate by 2009. earnings in the public corporate sector are expected to grow at a 5 percent per year real growth rate. Consistent with that, the market P/e ratio is expected to grow at 1 percent per year. although inflation is currently high at 6 percent per year, the long-term forecast is for an inflation rate of 4 percent per year. although the yield curve has usually been upward sloping, currently the government yield curve is inverted; at the short-end, yields are 9 percent, and at 10-year maturities yields are 7 percent.

7. The inclusion of index returns prior to 2001 would be expected to: a. bias the historical equity risk premium estimate upwards.b. bias the historical equity risk premium estimate downwards.C. have no effect on the historical equity risk premium estimate.

8. The events of 2004 to 2006 would be expected to:a. bias the historical equity risk premium estimate upwards.b. bias the historical equity risk premium estimate downwards.C. have no effect on the historical equity risk premium estimate.

9. in the current interest rate environment, using a required return estimate based on the short-term government bond rate and a historical equity risk premium defined in terms of a short-term government bond rate would be expected to:a. bias long-term required return on equity estimates upwards.b. bias long-term required return on equity estimates downwards.C. have no effect on long-term required return on equity estimates.



10. a supply side estimate of the equity risk premium as presented by The ibbotson–Chen earnings model is closest to:a. 3.2 percent.b. 4.0 percent.C. 4.3 percent.

11. Common stock issues in the above market with average systematic risk are most likely to have required rates of return:a. between 2 percent and 7 percent.b. between 7 and 9 percent.C. 9 percent or greater.

12. which of the following statements is most accurate? if two equity issues have the same market risk but the first issue has higher leverage, greater liquidity, and a higher required return, the higher required return is most likely the result of the first issue’s:a. greater liquidity.b. higher leverage.C. higher leverage and greater liquidity.

Questions 13 through 19 relate to Horizon Asset ManagementJudy Chen is the primary portfolio manager of the global equities portfolio at horizon asset Management. Lars Johansson, a recently hired equity analyst, has been assigned to Chen to assist her with the portfolio.

Chen recently sold shares of novo-gemini, inc. from the portfolio. Chen tasks Johans-son with assessing the return performance of novo-gemini, with specific trade information provided in exhibit 1.

exhibit 1 novo-gemini, inc. trade Details

1. novo-gemini shares were purchased for $20.75 per share.2. at the time of purchase, research by Chen suggested that novo-gemini shares were expected to sell

for $29.00 per share at the end of a 3-year holding period.3. at the time of purchase, the required return for novo-gemini based upon the capital asset pricing

model (CaPM) was estimated to be 12.6% on an annual basis.4. exactly 3 years after the purchase date, the shares were sold for $30.05 per share.5. no dividends were paid by novo-gemini over the 3-year holding period.

Chen explains to Johansson that, at the time of purchase, the CaPM used to estimate a required return for novo-gemini incorporated an unadjusted historical equity risk premium estimate for the uS equity market. Chen notes that the uS equities market has experienced a meaningful string of favorable inflation and productivity surprises in the past. She asks Johans-son whether the historical equity risk premium should have been adjusted before estimating the required return for novo-gemini.

For another perspective on the reward to bearing risk, Chen asks Johansson to calculate a forward-looking equity risk premium for the uS equity market using data on the S&P 500 index in exhibit 2.

exhibit 2 S&P 500 index Data

Dividend yield, based on year-ahead aggregate forecasted dividends 1.2%Consensus long-term earnings growth rate 4%20-year uS government bond yield 3%



Chen is now considering adding shares of bezak, inc. to the portfolio. Chen asks Johans-son to calculate bezak’s weighted average cost of capital using the CaPM with the information provided in exhibit 3.

exhibit 3 bezak, inc.

Pretax cost of debt 4.9%

Long-term debt as a percent of total capital, at market value 25%

Marginal tax rate 30%

bezak, inc. beta 2.00

estimated equity risk premium 5.5%

risk-free rate 3.0%

Lastly, Chen asks Johansson to evaluate twin industries, a privately owned uS company that may initiate a public stock offering. Johansson decides to adapt CaPM to estimate the required return on equity for twin industries. using the MSCi / Standard & Poor’s global industry Classification Standard (giCS), Johansson identifies a publicly traded peer company with an estimated beta of 1.09 that is much larger but otherwise similar to twin industries. twin industries is funded 49% by debt, while the publicly traded peer company is funded 60% by debt.

13. based upon exhibit 1, the expected three-year holding period return for novo-gemini inc. at the time of purchase was closest to: a. 39.76%.b. 42.76%.C. 44.82%.

14. based upon exhibit 1, the realized three-year holding period return for novo-gemini inc. was closest to: a. 39.76%.b. 42.76%.C. 44.82%.

15. based on the historical record of surprises in inflation and productivity, the historical equity risk premium for the uS equity market, if it is used as an estimate of the for-ward-looking equity risk premium, should most likely be:a. left unchanged.b. adjusted upward.C. adjusted downward.

16. based on exhibit 2, the forward-looking estimate for the uS equity risk premium is closest to:a. 2.2%.b. 5.8%. C. 8.2%.

17. based on exhibit 3, and assuming interest on debt is tax-deductible, the weighted average cost of capital (waCC) for bezak, inc. is closest to: a. 10.87%.b. 11.36%.C. 13.61%.



18. The estimate of beta for twin industries is closest to:a. 0.44.b. 0.85.C. 0.89.

19. a potential weakness of Johansson’s approach to estimating the required return on equity for twin industries is that the return estimate:a. does not include a size premium.b. may overstate potential returns over the long term.C. does not consider systematic risk arising from the economics of the industry.


17

ChAPter 3IntroduCtIon

to Industry And CoMPAny AnAlysIs

leArnIng outCoMes


• explain uses of industry analysis and the relation of industry analysis to company analysis;• compare methods by which companies can be grouped, current industry classification sys-

tems, and classify a company, given a description of its activities and the classification system;• explain the factors that affect the sensitivity of a company to the business cycle and the uses

and limitations of industry and company descriptors such as “growth,” “defensive,” and “cyclical”;

• explain how a company’s industry classification can be used to identify a potential “peer group” for equity valuation;

• describe the elements that need to be covered in a thorough industry analysis;• describe the principles of strategic analysis of an industry;• explain the effects of barriers to entry, industry concentration, industry capacity, and market

share stability on pricing power and price competition;• describe industry life cycle models, classify an industry as to life cycle stage, and describe

limitations of the life-cycle concept in forecasting industry performance;• compare characteristics of representative industries from the various economic sectors;• describe macroeconomic, technological, demographic, governmental, and social influences

on industry growth, profitability, and risk;• describe the elements that should be covered in a thorough company analysis.


18 Part I: learning objectives, summary overview, and Problems

suMMAry overvIew

In this reading, we have provided an overview of industry analysis and illustrated approaches that are widely used by analysts to examine an industry.

• Company analysis and industry analysis are closely interrelated. Company and industry anal-ysis together can provide insight into sources of industry revenue growth and competitors’ market shares and thus the future of an individual company’s top-line growth and bot-tom-line profitability.

• Industry analysis is useful for:• understanding a company’s business and business environment;• identifying active equity investment opportunities;• formulating an industry or sector rotation strategy; and• portfolio performance attribution.

• The three main approaches to classifying companies are:• products and/or services supplied;• business-cycle sensitivities; and• statistical similarities.

• Commercial industry classification systems include:• global Industry Classification standard;• russell global sectors; and• Industry Classification Benchmark.

• governmental industry classification systems include:• International standard Industrial Classification of All economic Activities;• statistical Classification of economic Activities in the european Community;• Australian and new Zealand standard Industrial Classification; and• north American Industry Classification system.

• A limitation of current classification systems is that the narrowest classification unit assigned to a company generally cannot be assumed to constitute its peer group for the purposes of detailed fundamental comparisons or valuation.

• A peer group is a group of companies engaged in similar business activities whose economics and valuation are influenced by closely related factors.

• steps in constructing a preliminary list of peer companies:• examine commercial classification systems if available. These systems often provide a use-

ful starting point for identifying companies operating in the same industry.• review the subject company’s annual report for a discussion of the competitive environ-

ment. Companies frequently cite specific competitors.• review competitors’ annual reports to identify other potential comparables.• review industry trade publications to identify additional peer companies.• Confirm that each comparable or peer company derives a significant portion of its reve-

nue and operating profit from a similar business activity as the subject company.• not all industries are created equal. some are highly competitive, with many companies

struggling to earn returns in excess of their cost of capital, and other industries have attractive characteristics that enable a majority of industry participants to generate healthy profits.

• differing competitive environments are determined by the structural attributes of the indus-try. For this important reason, industry analysis is a vital complement to company analysis. The analyst needs to understand the context in which a company operates to fully under-stand the opportunities and threats that a company faces.


Chapter 3 Introduction to Industry and Company Analysis 19

• The framework for strategic analysis known as “Porter’s five forces” can provide a useful start-ing point. Porter maintains that the profitability of companies in an industry is determined by five forces: 1) The threat of new entrants, which in turn is determined by economies of scale, brand loyalty, absolute cost advantages, customer switching costs, and government regulation; 2) the bargaining power of suppliers, which is a function of the feasibility of product substitution, the concentration of the buyer and supplier groups, and switching costs and entry costs in each case; 3) the bargaining power of buyers, which is a function of switching costs among customers and the ability of customers to produce their own product; 4)the threat of substitutes; and 5) the intensity of rivalry among existing competitors, which in turn is a function of industry competitive structure, demand conditions, cost conditions, and the height of exit barriers.

• The concept of barriers to entry refers to the ease with which new competitors can challenge incumbents and can be an important factor in determining the competitive environment of an industry. If new competitors can easily enter the industry, the industry is likely to be highly competitive because incumbents that attempt to raise prices will be undercut by newcomers. As a result, industries with low barriers to entry tend to have low pricing power. Conversely, if incumbents are protected by barriers to entry, they may enjoy a more benign competitive environment that gives them greater pricing power over their customers because they do not have to worry about being undercut by upstarts.

• Industry concentration is often, although not always, a sign that an industry may have pricing power and rational competition. Industry fragmentation is a much stronger signal, however, that the industry is competitive and pricing power is limited.

• The effect of industry capacity on pricing is clear: tight capacity gives participants more pricing power because demand for products or services exceeds supply; overcapacity leads to price cutting and a highly competitive environment as excess supply chases demand. The analyst should think about not only current capacity conditions but also future changes in capacity levels—how long it takes for supply and demand to come into balance and what effect that process has on industry pricing power and returns.

• examining the market share stability of an industry over time is similar to thinking about barriers to entry and the frequency with which new players enter an industry. stable market shares typically indicate less competitive industries, whereas unstable market shares often indicate highly competitive industries with limited pricing power.

• An industry’s position in its life cycle often has a large impact on its competitive dynamics, so it is important to keep this positioning in mind when performing strategic analysis of an industry. Industries, like individual companies, tend to evolve over time and usually experi-ence significant changes in the rate of growth and levels of profitability along the way. Just as an investment in an individual company requires careful monitoring, industry analysis is a continuous process that must be repeated over time to identify changes that may be occurring.

• A useful framework for analyzing the evolution of an industry is an industry life-cycle model, which identifies the sequential stages that an industry typically goes through. The five stages of an industry life cycle according to the hill and Jones model are:• embryonic;• growth;• shakeout;• mature; and• decline.

• Price competition and thinking like a customer are important factors that are often over-looked when analyzing an industry. whatever factors most influence customer purchasing



decisions are also likely to be the focus of competitive rivalry in the industry. Broadly, in-dustries for which price is a large factor in customer purchase decisions tend to be more competitive than industries in which customers value other attributes more highly.

• external influences on industry growth, profitability, and risk include:• technology;• demographics;• government; and• social factors.

• Company analysis takes place after the analyst has gained an understanding of the compa-ny’s external environment and includes answering questions about how the company will respond to the threats and opportunities presented by the external environment. This in-tended response is the individual company’s competitive strategy. The analyst should seek to determine whether the strategy is primarily defensive or offensive in its nature and how the company intends to implement it.

• Porter identifies two chief competitive strategies:• A low-cost strategy (cost leadership) is one in which companies strive to become the low-

cost producers and to gain market share by offering their products and services at lower prices than their competition, while still making a profit margin sufficient to generate a superior rate of return based on the higher revenues achieved.

• A product/service differentiation strategy is one in which companies attempt to establish themselves as the suppliers or producers of products and services that are unique either in quality, type, or means of distribution. to be successful, the companies’ price premiums must be above their costs of differentiation, and the differentiation must be appealing to customers and sustainable over time.

• A checklist for company analysis includes a thorough investigation of:• corporate profile;• industry characteristics;• demand for products/services;• supply of products/services;• pricing; and• financial ratios.

• spreadsheet modeling of financial statements to analyze and forecast revenues, operating and net income, and cash flows has become one of the most widely used tools in company analysis. spreadsheet modeling can be used to quantify the effects of the changes in certain swing factors on the various financial statements. The analyst should be aware that the output of the model will depend significantly on the assumptions that are made.

ProBleMs

1. which of the following is least likely to involve industry analysis?A. sector rotation strategy.B. top-down fundamental investing.C. tactical asset allocation strategy.

Copyright © 2011 CFA Institute.



2. A sector rotation strategy involves investing in a sector by:A. making regular investments in it.B. investing in a pre-selected group of sectors on a rotating basis.C. timing investment to take advantage of business-cycle conditions.

3. which of the following information about a company would most likely depend on an industry analysis? The company’s:A. dividend policy.B. competitive environment.C. trends in corporate expenses.

4. which industry classification system uses a three-tier classification system?A. russell global sectors.B. Industry Classification Benchmark.C. global Industry Classification standard.

5. In which sector would a manufacturer of personal care products be classified?A. health care.B. Consumer staples.C. Consumer discretionary.

6. which of the following statements about commercial and government industry classifica-tion systems is most accurate?A. Many commercial classification systems include private for-profit companies.B. Both commercial and government classification systems exclude not-for-profit

companies.C. Commercial classification systems are generally updated more frequently than govern-

ment classification systems. 7. which of the following is not a limitation of the cyclical/non-cyclical descriptive approach

to classifying companies?A. A cyclical company may have a growth component in it.B. Business-cycle sensitivity is a discrete phenomenon rather than a continuous spectrum.C. A global company can experience economic expansion in one part of the world while

experiencing recession in another part. 8. A company that is sensitive to the business cycle would most likely:

A. not have growth opportunities.B. experience below-average fluctuation in demand.C. sell products that the customer can purchase at a later date if necessary.

9. which of the following factors would most likely be a limitation of applying business-cycle analysis to global industry analysis?A. some industries are relatively insensitive to the business cycle.B. Correlations of security returns between different world markets are relatively low.C. one region or country of the world may experience recession while another region

experiences expansion.10. which of the following statements about peer groups is most accurate?

A. Constructing a peer group for a company follows a standardized process.B. Commercial industry classification systems often provide a starting point for con-

structing a peer group.C. A peer group is generally composed of all the companies in the most narrowly defined

category used by the commercial industry classification system.




11. with regard to forming a company’s peer group, which of the following statements is not correct?A. Comments from the management of the company about competitors are generally

not used when selecting the peer group.B. The higher the proportion of revenue and operating profit of the peer company de-

rived from business activities similar to the subject company, the more meaningful the comparison.

C. Comparing the company’s performance measures with those for a potential peer-group company is of limited value when the companies are exposed to different stages of the business cycle.

12. when selecting companies for inclusion in a peer group, a company operating in three different business segments would:A. be in only one peer group.B. possibly be in more than one peer group.C. not be included in any peer group.

13. An industry that most likely has both high barriers to entry and high barriers to exit is the:A. restaurant industry.B. advertising industry.C. automobile industry.

14. which factor is most likely associated with stable market share?A. low switching costs.B. low barriers to entry.C. slow pace of product innovation.

15. which of the following companies most likely has the greatest ability to quickly increase its capacity?A. restaurant.B. steel producer.C. legal services provider.

16. A population that is rapidly aging would most likely cause the growth rate of the industry producing eye glasses and contact lenses to:A. decrease.B. increase.C. not change.

17. If over a long period of time a country’s average level of educational accomplishment in-creases, this development would most likely lead to the country’s amount of income spent on consumer discretionary goods to:A. decrease.B. increase.C. not change.

18. If the technology for an industry involves high fixed capital investment, then one way to seek higher profit growth is by pursuing:A. economies of scale.B. diseconomies of scale.C. removal of features that differentiate the product or service provided.

19. which of the following life-cycle phases is typically characterized by high prices?A. Mature.B. growth.C. embryonic.



20. In which of the following life-cycle phases are price wars most likely to be absent?A. Mature.B. decline.C. growth.

21. when graphically depicting the life-cycle model for an industry as a curve, the variables on the axes are:A. price and time.B. demand and time.C. demand and stage of the life cycle.

22. which of the following is most likely a characteristic of a concentrated industry?A. Infrequent, tacit coordination.B. difficulty in monitoring other industry members.C. Industry members attempting to avoid competition on price.

23. which of the following industry characteristics is generally least likely to produce high returns on capital?A. high barriers to entryB. high degree of concentrationC. short lead time to build new plants

24. An industry with high barriers to entry and weak pricing power most likely has:A. high barriers to exit.B. stable market shares.C. significant numbers of issued patents.

25. economic value is created for an industry’s shareholders when the industry earns a return:A. below the cost of capital.B. equal to the cost of capital.C. above the cost of capital.

26. which of the following industries is most likely to be characterized as concentrated with strong pricing power?A. Asset management.B. Alcoholic beverages.C. household and personal products.

27. which of the following industries is most likely to be considered to have the lowest barriers to entry?A. oil services.B. Confections and candy.C. Branded pharmaceuticals.

28. with respect to competitive strategy, a company with a successful cost leadership strategy is most likely characterized by:A. a low cost of capital.B. reduced market share.C. the ability to offer products at higher prices than competitors.

29. when conducting a company analysis, the analysis of demand for a company’s product is least likely to consider the:A. company’s cost structure.B. motivations of the customer base.C. product’s differentiating characteristics.



30. which of the following statements about company analysis is most accurate?A. The complexity of spreadsheet modeling ensures precise forecasts of financial

statements.B. The interpretation of financial ratios should focus on comparing the company’s results

over time but not with competitors.C. The corporate profile would include a description of the company’s business, invest-

ment activities, governance, and strengths and weaknesses.


25

chAPter 4Industry And

coMPAny AnAlysIs

leArnIng outcoMes


• compare top-down, bottom-up, and hybrid approaches for developing inputs to equity valuation models;

• compare “growth relative to gdP growth” and “market growth and market share” approaches to forecasting revenue;

• evaluate whether economies of scale are present in an industry by analyzing operating margins and sales levels;

• forecast the following costs: cost of goods sold, selling general and administrative costs, financing costs, and income taxes;

• describe approaches to balance sheet modeling;• describe the relationship between return on invested capital and competitive advantage;• explain how competitive factors affect prices and costs;• judge the competitive position of a company based on a Porter’s five forces analysis;• explain how to forecast industry and company sales and costs when they are subject to price

inflation or deflation;• evaluate the effects of technological developments on demand, selling prices, costs, and

margins;• explain considerations in the choice of an explicit forecast horizon;• explain an analyst’s choices in developing projections beyond the short-term forecast

horizon;• demonstrate the development of a sales-based pro forma company model.



suMMAry overvIew

Industry and company analysis are essential tools of fundamental analysis. Among the points made in this reading, the key points include the following.

• Analysts can use a top-down, bottom-up, or a hybrid approach to forecasting income and expenses. top-down approaches usually begin at the level of the overall economy. Bottom-up approaches begin at the level of the individual company or unit within the company (e.g., business segment). time-series approaches are considered bottom-up, although time-series analysis can be a tool used in top-down approaches. hybrid approaches include elements of top-down and bottom-up approaches.

• In a “growth relative to gdP growth” approach to forecasting revenue, the analyst forecasts the growth rate of nominal gross domestic product and industry and company growth rel-ative to gdP growth.

• In a “market growth and market share” approach to forecasting revenue, the analyst com-bines forecasts of growth in particular markets with forecasts of a company’s market share in the individual markets.

• operating margins that are positively correlated with sales provide evidence of economies of scale in an industry.

• some balance sheet line items, such as retained earnings, flow directly from the income statement, whereas accounts receivable, accounts payable, and inventory are very closely linked to income statement projections.

• A common way to model working capital accounts is to use efficiency ratios.• return on invested capital (roIc), defined as net operating profit less adjusted taxes divid-

ed by the difference between operating assets and operating liabilities, is an after-tax measure of the profitability of investing in a company. high and persistent levels of roIc are often associated with having a competitive advantage.

• competitive factors affect a company’s ability to negotiate lower input prices with suppliers and to raise prices for products and services. Porter’s five forces framework can be used as a basis for identifying such factors.

• Inflation (deflation) affects pricing strategy depending on industry structure, competitive forces, and the nature of consumer demand.

• when a technological development results in a new product that threatens to cannibalize de-mand for an existing product, a unit forecast for the new product combined with an expect-ed cannibalization factor can be used to estimate the impact on future demand for the existing product.

• Factors influencing the choice of the explicit forecast horizon include the projected holding period, an investor’s average portfolio turnover, cyclicality of an industry, company specific factors, and employer preferences.

ProBleMs

The following information relates to Questions 1–6Angela green, an investment manager at horizon Investments, intends to hire a new invest-ment analyst. After conducting initial interviews, green has narrowed the pool to three can-didates. she plans to conduct second interviews to further assess the candidates’ knowledge of industry and company analysis.



Chapter 4 Industry and Company Analysis 27

Prior to the second interviews, green asks the candidates to analyze chrome network systems, a company that manufactures internet networking products. each candidate is pro-vided chrome’s financial information presented in exhibit 1.

exhIBIt 1 chrome network systems selected Financial Information (in millions of $)

year ended:

2010 2011 2012

net sales 46.8 50.5 53.9cost of sales 18.2 18.4 18.8gross profit 28.6 32.1 35.1selling, general, and administrative (sg&A) expenses 19.3 22.5 25.1operating income 9.3 9.6 10.0Interest expense 0.5 0.7 0.6Income before provision for income tax 8.8 8.9 9.4Provision for income taxes 2.8 2.8 3.1net income 6.0 6.1 6.3

green asks each candidate to forecast the 2013 income statement for chrome and to out-line the key assumptions used in their analysis. The job candidates are told to include horizon’s economic outlook for 2013 in their analysis, which assumes nominal gdP growth of 3.6%, based on expectations of real gdP growth of 1.6% and inflation of 2.0%.

green receives the models from each of the candidates and schedules second interviews. to pre-pare for the interviews, green compiles a summary of the candidates’ key assumptions in exhibit 2.

exhIBIt 2 summary of Key Assumptions used in candidates’ Models

Metric candidate A candidate B candidate c

net sales net sales will grow at the average annual growth rate in net sales over the 2010–2012 time period.

Industry sales will grow at the same rate as nominal gdP, but chrome will have a 2 percentage points decline in market share.

net sales will grow 50 basis points slower than nominal gdP.

cost of sales 2013 gross margin will be same as the average annual gross margin over the 2010–2012 time period.

2013 gross margin will decline as costs increase by expected inflation.

2013 gross margin will increase by 20 basis points from 2012.

selling, general, and administrative (sg&A) expenses

2013 sg&A/net sales ratio will be the same as the average ratio over the 2010–2012 time period.

2013 sg&A will grow at the rate of inflation.

2013 sg&A/net sales ratio will be the same as the 2012 ratio.

Interest expense 2013 interest expense assumes the effective interest rate will be the same as the 2012 rate.

2013 interest expense will be the same as the 2012 interest expense.

2013 interest expense will be the same as the average expense over the 2010–2012 time period.

Income taxes 2013 effective tax rate will be the same as the 2012 rate.

2013 effective tax rate will equal the blended statutory rate of 30%.

2013 effective tax rate will be the same as the average effective tax rate over the 2010–2012 time period.



1. Based on exhibit 1, which of the following provides the strongest evidence that chrome displays economies of scale?A. Increasing net salesB. Profit margins that are increasing with net salesc. gross profit margins that are increasing with net sales

2. Based on exhibit 2, the job candidate most likely to be using a bottom-up approach to model net sales is:A. candidate A.B. candidate B.c. candidate c.

3. Based on exhibit 2, the modeling approach used by candidate B to project future net sales is most accurately classified as a:A. hybrid approach.B. top-down approach.c. bottom-up approach.

4. Based on exhibits 1 and 2, candidate c’s forecast for cost of sales in 2013 is closest to:A. $18.3 million.B. $18.9 million.c. $19.3 million.

5. Based on exhibits 1 and 2, candidate A’s forecast for selling, general, and administrative expenses in 2013 is closest to:A. $23.8 million.B. $25.5 million.c. $27.4 million.

6. Based on exhibit 2, forecasted interest expense will reflect changes in chrome’s debt level under the forecast assumptions used by:A. candidate A.B. candidate B.c. candidate c.

The following information relates to Questions 7–12nigel French, an analyst at taurus Investment Management, is analyzing Archway technol-ogies, a manufacturer of luxury electronic auto equipment, at the request of his supervisor, lukas wright. French is asked to evaluate Archway’s profitability over the past five years rel-ative to its two main competitors, which are located in different countries with significantly different tax structures.

French begins by assessing Archway’s competitive position within the luxury electronic auto equipment industry using Porter’s five forces framework. A summary of French’s industry analysis is presented in exhibit 3.

exhIBIt 3 Analysis of luxury electronic Auto equipment Industry using Porter’s Five Forces Framework

Force Factors to consider

Threat of substitutes customer switching costs are high

rivalry Archway holds 60% of world market share; each of its two main competitors holds 15%



Force Factors to consider

Bargaining power of suppliers Primary inputs are considered basic commodities, and there are a large number of suppliers

Bargaining power of buyers luxury electronic auto equipment is very specialized (non-standardized)

Threat of new entrants high fixed costs to enter industry

French notes that for the year just ended (2014), Archway’s cost of goods sold was 30% of sales. to forecast Archway’s income statement for 2015, French assumes that all companies in the industry will experience an inflation rate of 8% on the cost of goods sold. exhibit 4 shows French’s forecasts relating to Archway’s price and volume changes.

exhIBIt 4 Archway’s 2015 Forecasted Price and volume changes

Average price increase per unit 5.00%

volume growth −3.00%

After putting together income statement projections for Archway, French forecasts Arch-way’s balance sheet items; he uses Archway’s historical efficiency ratios to forecast the compa-ny’s working capital accounts.

Based on his financial forecast for Archway, French estimates a terminal value using a valuation multiple based on the company’s average price-to-earnings multiple (P/e) over the past five years. wright discusses with French how the terminal value estimate is sensitive to key assumptions about the company’s future prospects. wright asks French:

“what change in the calculation of the terminal value would you make if a tech-nological development that would adversely affect Archway was forecast to occur sometime beyond your financial forecast horizon?”

7. which return metric should French use to assess Archway’s five-year historic performance relative to its competitors?A. return on equityB. return on invested capitalc. return on capital employed

8. Based on the current competitive landscape presented in exhibit 3, French should con-clude that Archway’s ability to:A. pass along price increases is high.B. demand lower input prices from suppliers is low.c. generate above-average returns on invested capital is low.

9. Based on the current competitive landscape presented in exhibit 3, Archway’s operating profit margins over the forecast horizon are least likely to:A. decrease.B. remain constant.c. increase.

exhIBIt 3 (continued)



10. Based on exhibit 4, Archway’s forecasted gross profit margin for 2015 is closest to:A. 62.7%.B. 67.0%.c. 69.1%.

11. French’s approach to forecasting Archway’s working capital accounts would be most likely classified as a:A. hybrid approach.B. top-down approach.c. bottom-up approach.

12. The most appropriate response to wright’s question about the technological development is to:A. increase the required return. B. decrease the price-to-earnings multiple.c. decrease the perpetual growth rate.

The following information relates to Questions 13–18gertrude Fromm is a transportation sector analyst at tucana Investments. she is conducting an analysis of omikroon, n.v., a publicly traded european transportation company that man-ufactures and sells scooters and commercial trucks.

omikroon’s petrol scooter division is the market leader in its sector and has two competi-tors. omikroon’s petrol scooters have a strong brand-name and a well-established distribution network. given the strong branding established by the market leaders, the cost of entering the industry is high. But Fromm anticipates that inexpensive imported small petrol-fueled motor-cycles may become substitutes for omikroon’s petrol scooters.

Fromm uses return on invested capital as the metric to assess omikroon’s performance. omikroon has just introduced the first electric scooter to the market at year-end 2014.

The company’s expectations are as follows:

• competing electric scooters will reach the market in 2016.• electric scooters will not be a substitute for petrol scooters. • The important research costs in 2015 and 2016 will lead to more efficient electric scooters.

Fromm decides to use a five-year forecast horizon for omikroon after considering the following factors:

Factor 1 The annual portfolio turnover at tucana investments is 30%.Factor 2 The electronic scooter industry is expected to grow rapidly over the next

10 years.Factor 3 omikroon has announced it would acquire a light truck manufacturer that

will be fully integrated to its truck division by 2016 and will add 2% to its total revenues.

Fromm uses the base case forecast for 2015 shown in exhibit 5 to perform the following sensitivity analysis:

• The price of an imported specialty metal used for engine parts increases by 20%.• This metal constitutes 4% of omikroon’s cost of sales. • omikroon will not be able to pass on the higher metal expense to its customers.



exhIBIt 5 omikroon’s selected Financial Forecasts for 2015 Base case (€ millions)

Petrol scooter division

commercial truck division

electric scooter division total

sales 99.05 45.71 7.62 152.38

cost of sales 105.38

gross profit 47.00

operating profit 9.20

omikroon will initially outsource its electric scooter parts. But manufacturing these parts in-house beginning in 2016 will imply changes to an existing factory. This factory cost €7 million three years ago and had an estimated useful life of 10 years. Fromm is evaluating two scenarios:

scenario 1 sell the existing factory for €5 million. Build a new factory costing €30 million with a useful life of 10 years.

scenario 2 refit the existing factory for €27 million.

13. using Porter’s five forces analysis, which of the following competitive factors is likely to have the greatest impact on omikroon’s petrol scooter pricing power?A. rivalryB. Threat of substitutesc. Threat of new entrants

14. The metric used by Fromm to assess omikroon’s performance takes into account:A. degree of financial leverage.B. operating liabilities relative to operating assets.c. competitiveness relative to companies in other tax regimes.

15. Based on omikroon’s expectations, the gross profit margin of omikroon’s electric scooter division in 2016 is most likely to be affected by: A. competition. B. research costs.c. cannibalization by petrol scooters.

16. which factor best justifies the five-year forecast horizon for omikroon selected by Fromm? A. Factor 1B. Factor 2c. Factor 3

17. Fromm’s sensitivity analysis will result in a decrease in the 2015 base case gross profit margin closest to:A. 0.55 percentage points.B. 0.80 percentage points.c. 3.32 percentage points.

18. Fromm’s estimate of growth capital expenditure included inomikroon’s property, plant, and equipment under scenario 2 should be: A. lower than under scenario 1. B. the same as under scenario 1. c. higher than under scenario 1.



33

ChAPter 5DisCounteD DiviDenD

vAluAtion

leArning outCoMes


• compare dividends, free cash flow, and residual income as inputs to discounted cash flow models and identify investment situations for which each measure is suitable;

• calculate and interpret the value of a common stock using the dividend discount model (DDM) for single and multiple holding periods;

• calculate the value of a common stock using the gordon growth model and explain the model’s underlying assumptions;

• calculate and interpret the implied growth rate of dividends using the gordon growth model and current stock price;

• calculate and interpret the present value of growth opportunities (Pvgo) and the compo-nent of the leading price-to-earnings ratio (P/e) related to Pvgo;

• calculate and interpret the justified leading and trailing P/es using the gordon growth model;

• calculate the value of noncallable fixed-rate perpetual preferred stock;• describe strengths and limitations of the gordon growth model and justify its selection to

value a company’s common shares;• explain the assumptions and justify the selection of the two-stage DDM, the h-model, the

three-stage DDM, or spreadsheet modeling to value a company’s common shares;• explain the growth phase, transitional phase, and maturity phase of a business;• describe terminal value and explain alternative approaches to determining the terminal value

in a DDM;• calculate and interpret the value of common shares using the two-stage DDM, the h-model,

and the three-stage DDM;• estimate a required return based on any DDM, including the gordon growth model and

the h-model;


34 Part i: learning objectives, summary overview, and Problems

suMMAry overview

This reading provided an overview of DCF models of valuation, discussed the estimation of a stock’s required rate of return, and presented in detail the dividend discount model.

• in DCF models, the value of any asset is the present value of its (expected) future cash flows

∑( )= +=CF

10 1V

rt

tt

n

where V0 is the value of the asset as of t = 0 (today), CFt is the (expected) cash flow at time t, and r is the discount rate or required rate of return. For infinitely lived assets such as com-mon stocks, n runs to infinity.

• several alternative streams of expected cash flows can be used to value equities, including dividends, free cash flow, and residual income. A discounted dividend approach is most suitable for dividend-paying stocks in which the company has a discernible dividend policy that has an understandable relationship to the company’s profitability, and the investor has a noncontrol (minority ownership) perspective.

• The free cash flow approach (FCFF or FCFe) might be appropriate when the company does not pay dividends, dividends differ substantially from FCFe, free cash flows align with profitability, or the investor takes a control (majority ownership) perspective.

• The residual income approach can be useful when the company does not pay dividends (as an alternative to a FCF approach) or free cash flow is negative.

• The DDM with a single holding period gives stock value as

P1 1 10

11

11

1 11V

Dr r

D Pr( ) ( ) ( )

=+

++

= ++

where D1 is the expected dividend at time 1 and V0 is the stock’s (expected) value at time 0. Assuming that V0 is equal to today’s market price, P0, the expected holding-period return is

=+

− = +−

11 10

1

0

1 0

0r

D PP

DP

P PP

• The expression for the DDM for any given finite holding period n and the general expression for the DDM are, respectively,

∑ ∑( ) ( ) ( )= + + + = += =∞

1 1and

10 10

1V

Dr

Pr

VD

rt

tt

nn

nt

tt

• explain the use of spreadsheet modeling to forecast dividends and to value common shares;

• calculate and interpret the sustainable growth rate of a company and demonstrate the use of DuPont analysis to estimate a company’s sustainable growth rate;

• evaluate whether a stock is overvalued, fairly valued, or undervalued by the market based on a DDM estimate of value.


Chapter 5 Discounted Dividend Valuation 35

• There are two main approaches to the problem of forecasting dividends. First, an analyst can assign the entire stream of expected future dividends to one of several stylized growth patterns. second, an analyst can forecast a finite number of dividends individually up to a terminal point and value the remaining dividends either by assigning them to a stylized growth pattern or by forecasting share price as of the terminal point of the dividend forecasts.

• The gordon growth model assumes that dividends grow at a constant rate g forever, so that Dt = Dt–1(1 + g). The dividend stream in the gordon growth model has a value of

( )=

+−

=−

>1

, or where00

01V

D gr g

VD

r gr g

• The value of noncallable fixed-rate perpetual preferred stock is V0 = D/r, where D is the stock’s (constant) annual dividend.

• Assuming that price equals value, the gordon growth model estimate of a stock’s expected rate of return is

( )=

++ = +

100

1

0r

D gP

gDP

g

• given an estimate of the next-period dividend and the stock’s required rate of return, the gordon growth model can be used to estimate the dividend growth rate implied by the current market price (making a constant growth rate assumption).

• The present value of growth opportunities (Pvgo) is the part of a stock’s total value, V0, that comes from profitable future growth opportunities in contrast to the value associated with assets already in place. The relationship is V0 = E1/r + Pvgo, where E1/r is defined as the no-growth value per share.

• The leading price-to-earnings ratio (P0/E1) and the trailing price-to-earnings ratio (P0/E0) can be expressed in terms of the gordon growth model as, respectively,

( ) ( )( )=

−=

−−

=+−

=− +

−1

and1 1 10

1

1 1 0

0

0 0PE

D Er g

br g

PE

D g Er g

b gr g

The above expressions give a stock’s justified price-to-earnings ratio based on forecasts of fundamentals (given that the gordon growth model is appropriate).

• The gordon growth model may be useful for valuing broad-based equity indices and the stock of businesses with earnings that are expected to grow at a stable rate comparable to or lower than the nominal growth rate of the economy.

• gordon growth model values are very sensitive to the assumed growth rate and required rate of return.

• For many companies, growth falls into phases. in the growth phase, a company enjoys an abnormally high growth rate in earnings per share, called supernormal growth. in the transition phase, earnings growth slows. in the mature phase, the company reaches an equi-librium in which such factors as earnings growth and the return on equity stabilize at levels that can be sustained long term. Analysts often apply multistage DCF models to value the stock of a company with multistage growth prospects.


36 Part i: learning objectives, summary overview, and Problems

• The two-stage dividend discount model assumes different growth rates in stage 1 and stage 2

∑ ( ) ( ) ( )( )( ) ( )=+

++

+ ++ −=

1

1

1 1

100

1

0VD g

r

D g g

r r gS

t

tt

nS

nL

nL

where gS is the expected dividend growth rate in the first period and gL is the expected growth rate in the second period.

• The terminal stock value, Vn, is sometimes found with the gordon growth model or with some other method, such as applying a P/e multiplier to forecasted ePs as of the terminal date.

• The h-model assumes that the dividend growth rate declines linearly from a high super-normal rate to the normal growth rate during stage 1, and then grows at a constant normal growth rate thereafter:

( ) ( )( ) ( )=

+−

+−

−=

+ + −−

1 10

0 0 0 0VD g

r gD H g g

r gD g D H g g

r gL

L

S L

L

L S L

L

• There are two basic three-stage models. in one version, the growth rate in the middle stage is constant. in the second version, the growth rate declines linearly in stage 2 and becomes constant and normal in stage 3.

• spreadsheet models are very flexible, providing the analyst with the ability to value any pattern of expected dividends.

• in addition to valuing equities, the irr of a DDM, assuming assets are correctly priced in the marketplace, has been used to estimate required returns. For simpler models (such as the one-period model, the gordon growth model, and the h-model), well-known formulas may be used to calculate these rates of return. For many dividend streams, however, the rate of return must be found by trial and error, producing a discount rate that equates the present value of the forecasted dividend stream to the current market price.

• Multistage DDM models can accommodate a wide variety of patterns of expected divi-dends. even though such models may use stylized assumptions about growth, they can provide useful approximations.

• Dividend growth rates can be obtained from analyst forecasts, statistical forecasting models, or company fundamentals. The sustainable growth rate depends on the roe and the earnings reten-tion rate, b: g = b × roe. This expression can be expanded further, using the DuPont formula, as

net income Dividendsnet income

net incomesales

salestotal assets

total assetsshareholders’ equity

g = − ×

× ×

Practice Problems and solutions: Equity Asset Valuation, second edition, by Jerald e. Pinto, CFA, elaine henry, CFA, Thomas r. robinson, CFA, and John D. stowe, CFA. Copyright © 2009 by CFA institute.

ProbleMs

1. Amy tanner is an analyst for a us pension fund. her supervisor has asked her to value the stocks of general electric (nyse: ge) and general Motors (nyse: gM). tanner wants to evaluate the appropriateness of the dividend discount model (DDM)



Chapter 5 Discounted Dividend Valuation 37

for valuing ge and gM and has compiled the following data for the two companies for 2000 through 2007.

ge gM

year ePs ($) DPs ($) Payout ratio ePs ($) DPs ($) Payout ratio

2007 2.17 1.15 0.53 −68.45 1.00 −0.01

2006 1.99 1.03 0.52 −3.50 1.00 −0.29

2005 1.76 0.91 0.52 −18.50 2.00 −0.11

2004 1.61 0.82 0.51 4.94 2.00 0.40

2003 1.55 0.77 0.50 5.03 2.00 0.40

2002 1.51 0.73 0.48 3.35 2.00 0.60

2001 1.41 0.66 0.47 1.77 2.00 1.13

2000 1.27 0.57 0.45 6.68 2.00 0.30

Source: Compustat.

For each of the stocks, explain whether the DDM is appropriate for valuing the stock. 2. vincent nguyen, an analyst, is examining the stock of british Airways (london stock

exchange: bAy) as of the beginning of 2008. he notices that the consensus fore-cast by analysts is that the stock will pay a £4 dividend per share in 2009 (based on 21 analysts) and a £5 dividend in 2010 (based on 10 analysts). nguyen expects the price of the stock at the end of 2010 to be £250. he has estimated that the required rate of return on the stock is 11 percent. Assume all dividends are paid at the end of the year.A. using the DDM, estimate the value of bAy stock at the end of 2009.b. using the DDM, estimate the value of bAy stock at the end of 2008.

3. Justin owens is an analyst for an equity mutual fund that invests in british stocks. At the beginning of 2008, owens is examining domestic stocks for possible inclusion in the fund. one of the stocks that he is analyzing is british sky broadcasting group (london stock exchange: bs

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