Chap012.doc

Chapter 12 - Growth-Stock Investing

CHAPTER 12- GROWTH-STOCK INVESTING

SELF-TEST PROBLEMS & SOLUTIONS

ST12.1 At any point in time, it is possible to identify a handful of Wall Street favorites that enjoy an enthusiastic following among analysts and sell at astronomical P/E ratios. In mid-2008, for example, the spreadsheet shown below identifies 10 S&P 500 Favorites. As a group, analysts forecast rapid 26.8% per year EPS growth over the 2008-13 time frame, and these highflyers sell for 59.7 times current EPS. Conversely, the 10 S&P 500 Outcasts identified below are expected to enjoy fast EPS growth of 18.3% over the next 5 years, and sell for a modest below-market multiple of 12.4 times current EPS. Calculate the amounts of internally-funded and externally-funded growth implied by the data below, and PEG ratios for each stock. Which group of stocks is apt to appeal to growth at a reasonable price (GARP) investors?

Symbol Company NameEPS5 (%)

(expected)ROE5

(%)Payout5

(%)

Last Price

% of High5

% of Low5 P/E

Internally-Funded Growth

(%)

Externally-Funded Growth

(%) PEG

S&P 500 Favorites

EBAY eBay Inc 23.5 9.4 0.0 27.61 46.6 163.4 88.5 9.4 14.1 3.77

BRCM Broadcom Class A Ord Shs 20.0 -1.1 0.0 27.44 54.9 347.3 68.1 -1.1 21.1 3.41

ISRG Intuitive Surgical Inc 35.0 15.4 0.0 269.59 75.0 3693.0 64.3 15.4 19.6 1.84

AMZN Amazon.com Inc 22.0 23.5 0.0 74.66 73.8 401.4 62.9 23.5 -1.5 2.86

RRC Range Resources Corp 21.3 14.5 7.8 64.78 84.3 1963.0 60.6 13.4 7.9 2.85

SWN Southwestern Energy Co 24.5 16.1 0.0 46.62 94.2 3330.0 58.3 16.1 8.4 2.38

BTU Peabody Energy Corp 20.0 16.0 15.5 84.05 95.8 1377.9 55.5 13.5 6.5 2.78

AKAM Akamai Technologies Inc 24.4 26.2 0.0 34.56 57.9 2880.0 52.7 26.2 -1.8 2.16

GENZ Genzyme Corp 17.3 4.1 0.0 72.55 88.4 254.6 43.1 4.1 13.2 2.49

COG Cabot Oil & Gas Corp 60.4 24.0 4.9 65.19 90.5 869.2 42.9 22.8 37.6 0.71

Averages 26.8 14.8 2.8 76.71 76.1 1528.0 59.7 14.3 12.5 2.52

S&P 500 Outcasts

MHP McGraw-Hill Companies Inc 15.7 31.7 29.1 40.72 56.2 157.2 14.5 22.5 -6.8 0.92

NVLS Novellus Systems Inc 16.5 7.1 0.0 21.26 46.7 106.3 14.3 7.1 9.4 0.87

NVDA NVIDIA Corp 23.8 22.3 0.0 19.28 48.6 621.9 13.9 22.3 1.5 0.58

PH Parker Hannifin Corp 15.6 15.1 19.7 70.94 81.6 296.8 13.4 12.1 3.5 0.86

NE Noble Corp 21.3 18.6 2.7 64.76 94.1 426.1 13.0 18.1 3.2 0.61

RHI Robert Half International Inc 16.6 21.1 20.6 23.67 53.9 207.6 12.8 16.8 -0.2 0.77

ANF Abercrombie & Fitch Co 15.3 32.4 13.4 64.1 74.7 309.7 12.2 28.1 -12.8 0.80

ESV ENSCO International Inc 20.3 17.2 3.4 80.68 97.6 341.9 11.4 16.6 3.7 0.56

RIG Transocean Inc 21.7 13.8 0.0 152.5 93.6 778.1 10.1 13.8 7.9 0.47

HUM Humana Inc 15.7 17.2 0.0 41.27 46.8 474.4 8.3 17.2 -1.5 0.53

Averages 18.3 19.7 8.9 57.92 69.4 372.0 12.4 17.5 0.8 0.70

12-1

http://www.amazon.com/


ST12.1 SOLUTIONAs shown in the table, the amount of internally-funded (sustainable) growth is determined by the return on equity and the retention rate, where internally-funded growth = (1 – b) × ROE and b is the retention ratio. Notice that the amount of growth that can be internally funded is 14.3% per year for the group of S&P 500 Favorites and 17.5% per year for the S&P 500 Outcasts. Thus, the group of S&P 500 Favorites must depend on external financing to finance much of their expected growth opportunities whereas the S&P 500 Outcasts can fund almost all of their expected growth with funds generated internally. Therefore, financing risks add to the execution risks facing S&P 500 Favorites and makes their task of meeting Wall Street expectations especially difficult. As a group, the S&P 500 Outcasts are apt to appeal to growth at a reasonable price (GARP) investors. With PEG ≤ 1, all S&P 500 Outcast stocks can be described as conservative growth stock opportunities.

ST12.2 Apple, Inc. (AAPL) is a major developer, manufacturer, and marketer of personal computers and peripheral and consumer products, such as the iPod digital music player and the iPhone, for sale primarily to the business, creative, education, government, and consumer markets. Apple also sells operating systems, utilities, languages, developer tools, and database software. Foreign sales account for about 41.2% of total revenues, and 3.3% of revenues are spent on research and development. According to information obtained from The Value Line Investment Survey in mid-2008, AAPL then had a market price of 173 per share, expected earnings per share (EPS) of $5.10, expected EPS growth of 25% per year, and a typical P/E ratio of 25. To create an expected price range for 2013, use EPS growth estimates of 20% to 30% per year in 2.5% increments. To create discounted present values, use a risk-adjusted discount rate of 20%. Based upon these expectations, set up a spreadsheet to estimate a typical range in price for INTC in 2013 (5 years hence). Was AAPL a buy, sell or hold at a 2008 price of 173?

ST12.2 SOLUTIONBased on the assumptions given, a typical price range for AAPL in 2013 is $317.26 to $473.40 and a reasonable range for the 2008 value of AAPL is from $127.50 to $190.25. Because the 2008 price for AAPL of $173 was within the range specified for AAPL’s intrinsic economic value, AAPL represented a HOLD in 2008 and was expected to return an amount in line with the 20% per year cost of capital over the 2008-13 time frame. Pull up a current price for AAPL and see how shareholders who followed such an approach have fared since 2008.A spreadsheet analysis of AAPL is shown in the table below.

12-2


23-Jun-08 Dividend Yield

Apple, Inc. (AAPL) 173 0.00 0.00%

Intrinsic Expected Expected Expected

Economic Value Current EPS EPS in Expected Stock Price Risk-adjusted

of Stock EPS Growth 5 years P/EPS ratio in 5 years Discount Rate, k

(1) = (6)/(1 + (7))5 (2) (3) (4) = EPS (1 + g)5 (5) (6) = (4) × (5) (7)

127.50 5.10 20.0% 12.69 25.0 317.26 20.0%

141.35 5.10 22.5% 14.07 25.0 351.71 20.0%

156.37 5.10 25.0% 15.56 25.0 389.10 20.0%

172.65 5.10 27.5% 17.18 25.0 429.60 20.0%

190.25 5.10 30.0% 18.94 25.0 473.40 20.0%

QUESTIONS & ANSWERS

Q12.1 Describe the general approach of a growth stock investor. How is growth stock investing different from value investing?

Q12.1ANSWERGrowth stock investing is one of the two most popular styles of investment strategy. It is an approach to investing that focuses on companies expected to have above-average rates of growth in earnings and dividends. Rather than focusing on the current market price in relation to the current value of assets, a practice of value investors, growth stock investors look for securities selling for prices below the value of future growth opportunities. Many growth stock investors favor firms within industries that are also experiencing growth. Such investors are usually willing to accept much larger than typical levels of risk in the pursuit of above-average long-term investment results.

Q12.2 Google is now a verb in the authoritative Oxford English Dictionary. The Google entry reads “To use the Google search engine to find information on the Internet. To search for information about a person or thing using the Google search engine.” Describe how Google and other firms with solid brand names can create long term competitive advantages and stockholder value. Cite some examples from Business Week’s annual surveys (www.businessweek.com). Also explain how familiarity bias can make stocks like Google poor choices for growth-stock investors.

12-3

http://www.businessweek.com/


Q12.2ANSWERThe Google brand name is stronger than ever. With Google’s market share in Internet search still surging, it can afford to gamble with its universally recognizable brand. That allows Google to launch a slew of new products with small investments, gain valuable user input at early stages of development, and in turn challenge market leaders such as Microsoft (MSFT ) in mature businesses. That's what the company did with Google Video, which was expanded to let people upload and showcase their own creations. Google's brand may not always ride this high, but the company has launched an online finance site, a spreadsheet tool, and a word processor, and it plans to resell radio and TV ad time to its clients. Google is not alone in having a valuable brand name asset. According to Business Week, the world's best brand names include: Coca-Cola, Microsoft, IBM, GE, Intel, Nokia, Toyota, Disney, McDonald's, Mercedes-Benz, Citi, Marlboro, Hewlett-Packard, American Express, BMW, Gillette, Louis Vuitton, Cisco, Honda, Samsung, Merrill Lynch, Pepsi, Nescafe, Google, Dell, and Sony, among others. Familiarity bias hurts investment results when investors automatically think that because they are familiar with a company’s products that they are similarly familiar with the company’s investment prospects. However, well-known companies like Google benefit from customer goodwill that often spills over into an enthusiastic following among investors. Google is a poor investment choice if customer goodwill results in investors bidding up in their share price to an unsustainable level. To judge the investment merit of Google or any other stock, investors must conduct a detailed fundamental analysis of the company’s earning prospects and investment potential.

Q12.3 Investors in growth stocks are subject to price risk. Describe this variety of risk and explain why exposure to price risk is of particular concern to growth stock investors.

Q12.3ANSWERPrice risk is the risk of overpaying for a company even though it may have attractive economic prospects. One of the most important potential pitfalls tied to growth stock investing is that the approach seldom offers clear guidance about how much is too much to pay for a stock with attractive growth prospects. This lack of a strict buying discipline leaves growth stock investors open to price risk and the risk of suffering gut-wrenching devastation to their investment portfolios after even modest temporary declines in the overall market.

Q12.4 What is the danger of buying the common stock of current leaders in rapidly changing industries?

12-4


Q12.4ANSWERLarge companies tend to have trouble adapting to new market conditions in rapidly changing environments. Sustained earnings growth is difficult even among the largest and most powerful corporations. Smaller existing companies or new entrants are often better able to successfully anticipate and adapt to the challenges in evolving industries. For this reason, large dominant corporations in rapidly changing industries often have trouble living up to the expectations of investors. It is important for investors to realize that historical earnings growth often is a poor indicator of future growth.

Q12.5 List five or more criteria identified by T. Rowe Price as important characteristics of Ainvestment opportunities.@

Q12.5ANSWERAccording to T. Rowe Price, attractive investment opportunities include companies that:

manufacture products or furnish service not vulnerable to takeover or onerous regulation by government.

require especially trained employees who are well paid, but total payroll is not large in relation to gross revenue.

have a liberal profit margin. are not vulnerable to devastating competition. are able to lower costs and expand their market without materially reducing

the return on invested capital. have active officers and directors. have a substantial stock interest in their company. plan for the future through intelligent research. understand social trends and have the goodwill of their employees.

Q12.6 Explain the PEG ratio and the PEG ratio rule-of-thumb.

Q12.6 ANSWERThe PEG ratio is simply the P/E ratio divided by the expected EPS growth rate. If a company has a P/E of 20, and is expected to enjoy EPS growth of 20% per year, the company=s PEG ratio would be 1. Generally speaking, a stock is fully valued if it sports a PEG ratio of 1 or more. If the PEG ratio is less than 1, the stock is often worthy of investment consideration. The PEG ratio rule of thumb goes something like this: If PEG 1, the stock may be worthy of investment attention and possible purchase; If PEG 0.5, the stock is definitely worthy of investment attention, and may represent a very attractive investment; If PEG 0.33, the stock is apt to represent an extraordinarily attractive investment opportunity. Needless to say, the investment merit of a stock increases with a decrease in the PEG ratio. Strict growth-at-a-reasonable-price investors seldom, if ever, buy growth stocks with PEG ratios that are far greater than 1.

12-5


Q12.7 Over the long run, growth and value stocks categorized by price-book ratios, P/E ratios, or dividend yields display comparable rates of return. However, during different parts of the economic cycle, and during bear and bull markets, growth and value stocks behave very differently. Describe the type of economic environment and stock-market environment that is best for growth versus value stocks.

Q12.7 ANSWEROver the past quarter century, total rates of return have been similar for the value and growth components of the S&P 500. This means that a long-term investor could expect to receive similar rates of return on value and growth stocks. This fact is also consistent with the efficient market hypothesis that most stocks are at most times appropriately valued given available information. This is despite the fact that there clearly are periods when either the value or growth style of investing is favored in the equity market. Growth stocks tend to outperform value stocks during periods of robust stock market returns and strong economic expansion. Value stocks tend to do relatively well during periods of tepid stock market returns and economic recession.

Q12.8 Growth stock investors are especially vulnerable to investment mistakes caused by the need for social validation. If emotional investors buy on the basis that popular stocks must be good investments because friends or other respected individuals are buying them, prices can exceed fundamental values. Similarly, if emotional investors sell on the basis that unpopular stocks must be bad investments because friends or other respected individuals are selling them, prices can become depressed below fundamental values Explain how investors can minimize chances for losses caused by this type of “buy high and sell low” behavior.

Q12.8 ANSWERNaïve investors who play “follow the leader” in the stock market often end up with investment losses tied to their resulting “buy high and sell low” investment philosophy. In the long run, popular investment choices cannot lead to above-average results. A simple rule of thumb is that “Popular cannot be profitable in the stock market.” If you read a really compelling story about a stock in The Wall Street Journal, assume somebody has a lot of the stock in inventory they want to sell. If you read a really compelling story about shorting a stock in The Wall Street Journal, assume the shorts are getting nervous and want to cover. If an investor owns the same stocks as everyone else, it is simply impossible to have superior rates of return. To get rates of return that are different from the market return, an investor has to own different stocks than the market portfolio. The best way to avoid getting whipsaws by changes in the popularity of specific investments is to buy and sell only on the basis of a careful analysis of the firm’s fundamentals. As Warren Buffett is fond of saying, “You are neither right nor wrong on the basis of who agrees with you. You are right or wrong based upon your independent reading of the facts.

12-6


Q12.9 The S&P 500 Index earned 10.88% in 2004, 4.91% in 2005, and 15.79% in 2006. Meanwhile, growth stock favorite NutriSystem Inc. (NTRI) stockholders earned 65.7% in 2004, 1,263.9% in 2005, and 76.0% in 2006. Given representativeness bias, how would you expect investors to reallocate their portfolio between a conservative large-cap Index fund and red-hot NTRI going into 2007?

Q12.9 ANSWEROver the three-year period from 2004-06, NTRI dramatically outperformed the overall market and trading activity in the stock soared with growing investor interest. Investors suffering from representativeness bias would focus on these three-year returns as indicative of what to expect going forward and buy NTRI while cutting their conservative exposure to the stock market. Such extrapolation of short-term trends in the stock market is seldom profitable, as witnessed by the -57.4% return suffered by NTRI stockholders during 2007 (when stocks rose 5.49%).

Q12.10 Go to the Standard & Poor’s Market Insight website and look up software giant Oracle Corp. (ORCL) (www.mhhe.com/edumarketinsight). How is ORCL rated by S&P? What are the overall percentages of stocks rate buy, hold, and sell by S&P analysts? Do you see evidence of a positive bias among analysts?

Q12.10 ANSWERIn July 2008, S&P gave ORCL its top 5-Star rating, meaning that they projected the company to significantly outperform the overall market during the next 12 months. On an overall basis, Standard & Poor's Equity Research Services have recommended 34.2% of issuers with buy recommendations, 57.3% with hold recommendations and 8.5% with sell recommendations. This breakdown suggests some positive bias among S&P analysts.

PROBLEMS & SOLUTIONS

P12.1 Yahoo! Inc. (YHOO) recently had a share price of $21, P/B ratio of 3, and EPS of 704. Calculate the rate of book-value growth made possible by internally generated funds.

P12.1 SOLUTION10%. The rate of growth made possible by internally generated funds is determined by the retention rate and ROE. In this case, a price-book ratio of 3 implies book value per share of $7 = $21/3, and ROE = $0.70/$7 = 10%. If a company earns a 10% ROE and retains all earnings for future investment, the amount of book-value growth that could be funded internally is 10%.

12-7

http://www.mhhe.com/edumarketinsight


P12.2 According to the dividend discount or constant growth model, calculate the required rate of return for The Walt Disney Co. (DIS) at a current price of $35 per share, a projected dividend of 354 per share, projected dividend growth of 11% per year.

P12.2 SOLUTIONk = D1/P0 + g

= $0.35/$35 + 11%= 12%.

P12.3 Wal-Mart Stores, Inc. (WMT) recently sold for $55 per share and paid a $0.93 dividend. If the dividend is expected to grow at 13% per year, use the constant growth model to calculate the expected rate of return.

P12.3 SOLUTIONFrom the constant growth model, the E(R) = 14.9% on WMT:

P0 = D0(1 + g)/(k – g)$55 = ($0.93 1.13)/( k – 0.13)

Rearranging gives:

k – 0.13 = $1.05/55k = 1.9% + 13%

= 14.9%

P12.4 Suppose a fast growing company paid a $1 dividend per share this year that is expected to grow by 20% for three years. Afterwards, the dividend growth rate will be 7% per year indefinitely. If the required rate of is 9%, calculate the value of this stock.

P12.4 SOLUTION

P12.5 Over the 2002-07 time frame, the Russell 2000 Index earned a 14.87% annual rate of return. Instead of investing in a low-cost mutual fund designed to match the Russell 2000, suppose you bought 1,000 shares of non-dividend paying eBay, Inc. (EBAY) common stock for 16.95 at the end of 2002 and sold it five years later at a price of 33.19. Use a financial calculator and annual compounding to compute the dollar amount by which you have out performed the index.

12-8


P12.5 SOLUTIONIn both cases, the amount of investment is $16,950 (= $16.95 1,000). An investment in the Russell 2000 would have grown to $33,900 because if N = 5, I =14.87%, and PV = $16,950, FV = $33,900. The terminal value of the EBAY investment is almost exactly the same $33,910, or only $10 (= $33,910 - $33,900) more than the amount that would have been earned in the Russell 2000. EBAY performed almost exactly in line with the Russell 2000 from 2002-07.

P12.6 According to The Value Line Investment Survey, Chevron Corp. (CHV) recently had an expected dividend per share of $2.53, and expected dividend growth of 7.5% per year. Using the dividend discount model, calculate the maximum price a conservative growth investor would pay for CHV if that investor had a required rate of return of 10% per year.

P12.6 SOLUTIONP0 = D1/(k-g)

= $2.53/(0.1 - 0.075) = $101.20

P12.7 According to The Value Line Investment Survey, Intel Corp. (INTC) had expected dividend growth of 13% per year for the 2008-13 period. At the time, INTC was priced at 22 and expected to pay a 55¢ dividend. Using the dividend discount model, calculate the maximum required rate of return for INTC shareholders.

P12.7 SOLUTIONk = D1/P0 + g

= $0.55/$22 + 13%= 2.5% + 13%= 15.5%

P12.8 If Intel Corp. (INTC) has an expected dividend of 55¢ per share and dividend growth of 13% per year, use the dividend discount model to calculate the maximum price an investor would pay for JNJ if that investor had a 15% required rate of return.

P12.8 SOLUTION

P0 = D1/(k-g) = $0.55/(0.15 - 0.13) = $27.50

12-9


P12.9 According to Yahoo! Finance, non-dividend paying Google, Inc. (GOOG) recently had a book value per share of $77.58 and was expected to earn $24.70 per share during the coming year. Calculate the company’s retention rate, ROE, and the amount of sustainable growth.

P12.9 SOLUTION

Retention rate = 1 – Dividends/EPS= 1 - $0.00/$24.70= 100%

ROE = EPS/Book value= $24.70/$77.58= 31.8%

Sustainable growth = Retention rate ROE= 100% 31.8%= 31.8%

P12.10 The Home Depot, Inc., (HD) operates a chain of retail building supply/home improvement >>warehouse== stores across the U.S. and Canada. According to The Value Line Investment Survey, HD recently had a book value per share of $11.75, is expected to earn $1.85 and pay a dividend of $0.90 per share during the coming year. Calculate the company’s retention rate, ROE, and the amount internally-funded growth.

P12.10 SOLUTIONRetention rate = 1 – Dividends/EPS

= 1 - $0.90/$1.85= 51.4%


Internally-funded growth = Retention rate ROE= 51.4% 15.7%

=8.1%

P12.11 The American Express Company (AXP) is a leading global payments, network, and travel firm. According to The Value Line Investment Survey, AXP recently had a book value per share of $10.50, was expected to earn $3.35 and pay a dividend of $0.72 per share during the coming year. Calculate the company’s retention rate, ROE, and the amount of sustainable growth. Explain why the anticipated amount of capital appreciation may or may not equal the sustainable growth rate.

12-10


P12.11 SOLUTIONThe anticipated amount of capital appreciation may or may not equal the sustainable growth rate. The sustainable growth rate shows the amount of book-value growth that can be supported by internally generated funds. If the company’s P/B ratio is constant over time, the amount of capital appreciation will exactly equal the sustainable growth rate. In many case, this is a reasonable and conservative assumption. However, if the company’s P/B ratio falls over time, the amount of capital appreciation enjoyed by investors will be less than the sustainable growth rate. If the company’s P/B ratio rises over time, the amount of capital appreciation will exceed the sustainable growth rate.

Retention rate = 1 – Dividends/EPS= 1 - $0.72/$3.35= 78.5%


Sustainable growth = Retention rate ROE= 78.5% 31.9%= 25.0%

P12.12 United Technologies Inc.(UTX) earned $4.27 in 2007. At that time, The Value Line Investment Survey projected five-year EPS growth of 13% and a typical P/E ratio of 16. Compute the stock price projected for UTX in five years.

P12.12 SOLUTIONIf UTX grows EPS of $4.27 at an annual growth rate of 13%, the company will earn $3.46 per share in five years and, at 16 times earnings, sell for 125.88:

P5 = EPS5 P/E= EPS0 (1 + g)5 P/E = $4.27 (1.13)5 16 = $125.88

P12.13 According to The Value Line Investment Survey, mutual fund giant Legg Mason, Inc. (LM) has a typical dividend payout ratio of 20% and a typical P/E ratio of 18. LM recently reported EPS of $4.55 and Value Line expects EPS growth of 7.5% per year. Calculate the five-year total rate of return anticipated by LM buyers at a recent share price of 44.

12-11


P12.13 SOLUTIONWith a dividend payout ratio of 20%, LM pays a current dividend of $0.91 (= 0.2 × $4.55) and has an expected dividend yield of 2.1% (= $0.91/$44). The expected future price per share in t = 5 for LM is 117.58 (= 18 × $4.55 × 1.0755). With an expected price of 117.58 in five years, the anticipated rate of capital appreciation per year is 21.7% [= [(117.58/44)1/5 - 1]. The five-year total rate of return anticipated for LM is the projected dividend yield plus the anticipated annual rate of capital appreciation, or 23.8% (= 2.1% + 21.7%).

Dividend yield = Dividend/Share price= (0.2 × $4.55)/$44= 2.1%

Capital gain = (Future price/Current price)1/5 – 1= [(P/E × EPS5)/Current price]1/5 – 1= [(18 × $4.55 × 1.0755)/44]1/5 -1= 21.7%

Total return = 2.1% + 21.7%= 23.8%

P12.14 E. I. du Pont de Nemours and Company is a science and technology company active in agriculture and nutrition, coatings and color technologies, electronic and communication technologies, performance materials, and safety and protection. According to The Value Line Investment Survey, DuPont (DD) recently paid an annual dividend of $1.65 per share, reported EPS of $3.50, and has a typical P/E ratio of 18. Value Line expects EPS and dividend growth of 6.5% per year. Calculate the maximum share price that would be paid by a buy-and-hold growth investor with a three-year time horizon and a 12% required rate of return.

P12.14 SOLUTION

P0 = Expected price + Dividends= (P/E × EPS3)/1.123 + D1/1.12 + D2/1.122 + D3/1.123

= (18 × 3.50 × 1.0653)/1.123 + (1.65 × 1.065)/1.12+ (1.65 × 1.0652)/1.122 + (1.65 × 1.0653)/1.123

= 76.10 + 1.57 + 1.49 + 1.42= $80.58

P12.15 According to The Value Line Investment Survey, McDonald’s Corp. (MCD) recently paid a $1.50 dividend per share, reported EPS of $3.40, and has a typical P/E ratio of 17. Value Line expects EPS growth of 11.5% per year. Assuming a constant payout ration, calculate the three-year total rate of return anticipated by MCD buyers at a recent share price of 56.50. Is MCD fairly priced for growth investors with a 15% required rate of return?

12-12


P12.15 SOLUTIONYes, with a 15% projected three-year total rate of return, MCD is fairly priced for growth investors with a 15% required rate of return.

Dividend yield = Dividend/Share price= $1.50/$56.50= 2.7%

Capital gain = [Future price/Current price]1/3 – 1= [(P/E × EPS3)/Current price]1/3 – 1= [(17 × $3.40 × 1.1153)/56.50]1/3 -1= 12.3%

Total return = 2.7% + 12.3%= 15%

P12.16 The analyst consensus EPS forecast for Amazon.com, Inc. (AMZN) was recently $2.10 for the coming year. At the same time, EPS growth of 22% per year was forecast over the next five years. Calculate the highest price that growth at a reasonable price investors would be willing to pay for AMZN. In their eyes, is AMZN a bargain at 75 per share?

P12.16 SOLUTIONGrowth at a reasonable-price investors normally consider a PEG ratio of 1 to be the maximum appropriate valuation for a growth stock, so the highest reasonable AMZN price in their eyes is $46.20 (= 22 × $2.10). Therefore, AMZN would not be a bargain at 75 per share.

P12.17 Drug giant Merck & Co. (MRK) was recently expected to earn $3.20 per share, pay a $1.60 dividend, and earn a 25% return on shareholders’ equity. If a reasonable risk-adjusted discount rate for MRK is 15%, use the constant growth model to calculate the highest P/E ratio aggressive growth-stock investors would be willing to pay for MRK. Would MRK appeal to growth at a reasonable price investors?

P12.17 SOLUTIONFrom the constant-growth model, the amount of internally-funded growth is 12.5% and a maximum P/E ratio of 20 would be paid for Merck under these circumstances. Growth at a reasonable-price investors normally consider a PEG ratio of 1 to be the maximum appropriate valuation for a growth stock, so MRK is not apt to appeal to GARP investors:

P0/E1 = (D1/E1)/[k – b × ROE]= ($1.60/$3.20)/(0.15 – [1 – ($1.60/$3.20)] 0.25)= 0.5/(0.15 – 0.125)= 20

12-13

http://www.amazon.com/


P12.18 As of mid-year 2008, the Nasdaq stock market was home to 3,025 companies. Calculate probability that by pure luck you could choose to invest in the best-performing Nasdaq company over 1, 5, and 10-year time periods. In this context, explain what Warren Buffett meant by saying, “In the stock market, it’s better to be approximately right than precisely wrong.”

P12.18 SOLUTION Warren Buffett is fond of the saying, “In the stock market, it’s better to be approximately right than precisely wrong.” In other words, intelligent investors should not worry about trying to find the very best investment opportunity. The chances of picking the best Nasdaq stock, for example, are very remote over any investment horizon. Be satisfied with making sensible investment choices. By pure chance alone, the probability of investing the best-performing Nasdaq stock over 1, 5, and 10-year time periods is simply:

Pr(Best Performer) = 1/n= 1/3,025= 0.033%

P12.19 Standard & Poor’s Index Versus Active (SPIVA) scoreboards provide an objective apples-to-apples comparison of fund performance relative to appropriate style indices. During a recent three-year period, the S&P SmallCap 600 outpaced 80.2% of all small cap funds. Calculate the probability that a given small cap fund outperformed the S&P SmallCap 600 over a three-year period. Would you expect individual growth-stock investors to perform better or worse that the investment professionals. Explain.

P12.19 SOLUTION With superior training and better information resources, there is every reason to expect the professionals to outperform individual growth-stock investors, and the professionals have a rough time beating the market averages. The probability that a given mid-cap fund outperformed the S&P SmallCap 600 over a three-year period is simply:

Pr(Beating S&P SmallCap 6003) = 1- Pr(Index outperformance3)

= 1 - 0.802= 19.8%

12-14


P12.20 A recent Standard & Poor’s Index Versus Active (SPIVA) scoreboard reported that the S&P SmallCap 600 beat 80.2% of all small cap funds over a three-year period. Assuming that this result is typical of the long-term average, calculate the probability that a given small cap fund will outperform the S&P SmallCap 600 over the next 15 years. Would you expect individual growth-stock investors to perform better or worse than the investment professionals. Explain.

P12.20 SOLUTION With superior training and better information resources, there is every reason to expect the professionals to outperform individual growth-stock investors, and the professionals have a rough time beating the market averages. Assuming that the percentage of managed funds outperformed by the market index is constant over time, the probability that a given small cap fund will outperform the S&P SmallCap 600 over a three-year period is simply:

Pr(Beating S&P SmallCap 6003) = 1- Pr(Index outperformance3)= 1 - 0.802= 19.8%

Then, the probability of outperforming the S&P SmallCap 600 over five such periods (15 years) is simply:

Pr(Beating S&P SmallCap 60015)= Pr(Beating S&P SmallCap 6003)5

= 0.198 × 0.198 × 0.198 × 0.198 × 0.198= 0.03%

CFA PROBLEMS & SOLUTIONS

CFA12.1An industry is currently growing at twice the rate of the overall economy. New competitors are entering the industry and the formerly high profit margins have begun to decline. The life cycle stage that best characterizes this industry is:

A. mature growth.B. pioneering development.C. rapid accelerating growth. D. stabilization and market maturity.

Answer: A

12-15


CFA12.2An analyst applied the DuPont System to the following data for a company:

• Equity turnover 4.2• Net profit margin 5.5%.• Total asset turnover 2.0• Dividend payout ratio 31.8%

The company's return on equity is closest to:

A. 1.3 %.B. 11.0%.C. 23.1 %. D. 63.6%.Answer: C

CFA12.3Two companies are identical except for substantially different dividend payout ratios. After

several years, the company with the lower dividend payout ratio is most likely to have:

A. lower stock price.B. higher debt/equity ratio.C. less rapid growth of earnings per share.D. more rapid growth of earnings per share.

Answer: D

CFA12.4Financial leverage differs from operating leverage because financial leverage accounts for a company's:

A. use of debt.B. variability in sales.

C. use of plant and equipment.D. variability in fixed operating costs.

Answer: A

12-16


CFA12.5A company's return on equity is greater than its required rate of return on equity. The earnings multiplier (FI/E) for that company's stock is most likely to be positively related to the:

A. risk-free rate.B. market risk premium.C. earnings retention ratio.D. stock's Capital Asset Pricing Model beta.

Answer: C

12-17

Documents

Chap012.doc