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BFM119

Security Analysis

Lecture 5

Worked Examples Using Valuation Models 1


Please attempt the following exercises and bring your solutions to the
next lecture:
(a) Questions 1-5 on page 61 of PHP; and
(b) Problem 1 about Hugo Boss on pages 298-299 of PHP.

References: PHP Chs 1-7; DMD Chs 1-11 and


PMN Chs 1-12.
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Questions 1-5 on page 61 of PHP
Question 1
Judith, an accounting student, states “Strategy analysis seems to
be an unnecessary detour in doing financial statement analysis. Why can’t we
just get straight to the accounting issues?”. Explain to Judith why she might
be wrong.

Answer to Question 1
It is necessary to conduct strategy analysis when one wants to carry out a
financial statement analysis for the following reasons:

- Strategy analysis will enable an analyst to identify the industry/industries


the company is operating in, the performance(s) of the industry in recent
times, and their prospects, the key profit drivers of the company, the major
risks that the company is exposed to, the competitive strategies that a
company is using, the company’s competences and weaknesses, etc.;

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Questions 1-5 on page 61 of PHP (cont’d)
Answer to question 1 (cont’d)
An analyst can then use the information that it obtains about a company’s
profit drivers and the risks that the company faces to assess the company’s
performance in the past, at the present as well as make forecasts of the likely
future performance of the company.

An analyst can also use the information obtained about the strategy of the
company to assess its capital structure and dividend policies to see whether
they make sense or not.

Given the possible uses of the outcomes of a business strategy analysis


described above, it is obvious that it is “not an unnecessary detour in doing
financial statement analysis”, but a very essential part of it.

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Questions 1-5 on page 61 of PHP (cont’d)
Question 2
What are the critical drivers of industry profitability?

Answer to Question 2
The critical drivers of industry profitability are as follows:

Rivalry among existing companies: The greater the rivalry, the lower average
profitability is likely to be. The factors that usually influence rivalry among
existing firms are growth rate, concentration and balance of competitors, degree
of product differentiation and switching costs, scale/learning economies, the
ratio of fixed to variable costs, excess capacity and exit barriers.

Threat of new entrants: Threat of new entrants can make the companies in an
industry to set prices that will keep profit low. The threat of new entry can be
mitigated by economies of scale, first mover advantages, better access to
distribution channels, relationships with existing customers, legal barriers to
entry, etc.
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Questions 1-5 on page 61 of PHP (cont’d)
Answer to Question 2 (cont’d)
Threat of substitute products: Also, the threat of substitute products can
make companies set lower prices and reduce industry profitability. The
importance of substitutes will depend on the price sensitivity of buyers and
the degree of substitutability among the products.

Bargaining power of buyers: The greater the bargaining power of buyers, the
lower will be the industry’s profitability. Bargaining power of buyers will be
determined by the buyers’ price sensitivity and their importance to the
individual company.

Bargaining power of suppliers: The greater the bargaining power of suppliers,


the lower will be the industry’s profitability. Suppliers bargaining ability will
increase as the number of suppliers decreases, when there are few
substitutes available.

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Questions 1-5 on page 61 of PHP (cont’d)
Question 3
One of the fastest growing industries in the last twenty years is the memory
chip industry, which supplies memory chips for personal computers and other
electronic devices. Yet the average profitability has been very low. Using the
industry analysis framework, list all the potential factors that might explain
this apparent contradiction.

Answer to Question 3
Low concentration and balance of power: Concentration of the memory chip
market is relatively low. There are many players that compete on a global
basis, none of which has a dominant share of the market. Due to this high
degree of fragmentation, price wars are frequent as individual companies
lower prices to gain market share.

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Questions 1-5 on page 61 of PHP (cont’d)
Answer to Question 3 (cont’d)
Low degree of differentiation and switching costs: In general, memory chips
are a commodity product characterised by little product differentiation While
some product differentiation occurs as chip makers squeeze more memory on
a single chip or design specific memory chips to meet manufacturers’ specific
power and/or size requirements, there differences are typically short-lived
and have not significantly reduced the level of competition within the
industry.

Furthermore, because memory chips are typically interchangeable, switching


costs for users of memory chips (computer assemblers and computer owners)
are low. This encourages buyers to look for the lowest priced memory chips.

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Questions 1-5 on page 61 of PHP (cont’d)
Answer to Question 3 (cont’d)
Scale/learning economies and the ratio of fixed to variable costs: Scale and
learning economies are both important in the memory chip market. Memory
chip production requires significant investment in “clean” production
environments. Consequently, it is less expensive to build larger
manufacturing facilities than to build additional ones to satisfy additional
demand.

Also, the yield of acceptable chips goes up as employees learn the intricacies
of the extremely complicated and sensitive manufacturing process.

Moreover, while investments in memory chip manufacturing plants are


typically very high, the variable costs of materials and labour are relatively
low, providing an incentive for manufacturers to reduce prices to fully utilize
their plant’s capacity.

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Questions 1-5 on page 61 of PHP (cont’d)
Answer to Question 3 (cont’d)
Excess capacity: Memory chip plants tend to be built in waves. Consequently,
several plants will open at the same time. This tends to lead to periods of
significant excess capacity where manufacturers will cut price engage in price
competition among themselves in order to increase their capacity utilisation.

Threat of substitute products: There are alternatives to memory chips, including


other information storage media (such as hard drives and disk drives) and
memory management software which “creates” additional memory through
more efficient use of computer system resources.

Price sensitivity: There are two main groups of buyers, namely, computer
manufacturers and computer owners. Faced with an undifferentiated product
and low switching costs, buyers are very price sensitive.

All the factors stated above cause returns to memory chip manufacturers to be
relatively low.
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Questions 1-5 on page 61 of PHP (cont’d)
Question 4
Joe argues, “Your analysis of the five forces that affect industry profitability is
incomplete. For example, in the banking industry, I can think of at least three
other factors that are also important, namely, government regulation,
demographic trends and cultural factors.” His classmate, Jane, disagrees and says
“These three factors are important only to the extent that they influence one of
the five forces.” Explain how, if at all, the three factors discussed by Joe affect the
five forces for the banking industry.

Answer to Question 4
Government regulation, demographic trends and cultural factors will each impact
the analysis of the banking industry. While these may be important, they can
each be recast using the five forces framework to provide a deeper understanding
of the industry. The power of the five forces framework is its ability to
incorporate industry-specific characteristics into the analysis for any industry. To
see how government regulation, demographic trends and cultural factors are
important in the banking industry, we can apply the five forces framework as
follows: 10
Questions 1-5 on page 61 of PHP (cont’d)
Answer to Question 4 (cont’d)
Rivalry among existing companies: Government regulation has played a
central role in promoting, maintaining and limiting competition among banks.
Banks are regulated at the national and European levels. In the past, national
regulations restricted banks from operating across (some European) borders.

The government also regulates the riskiness of a bank’s portfolio in an effort


to prevent banks from competing for new customers by taking on too many
high-risk investments, loans or other financial instruments. These regulations
have limited the degree of competition among banks.

However, European deregulation of the industry has made it easier for banks
to expand into new geographical areas. This has increased the level of
competition.

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Questions 1-5 on page 61 of PHP (cont’d)
Answer to Question 4 (cont’d)
Threat of new entrants: Government regulations have limited entry of new
players into the banking industry. New banks must meet the requirements
set by regulators before they can begin operation.

However, as noted above, deregulation of some aspects of banking has made


it easier for out-of-country banks to enter new markets. Further, it appears to
be relatively easy for non-anking companies to successfully set up financial
services units (e.g. car manufacturers, departmental stores, etc.).

Finally, as consumers have become more comfortable with technology,


“internet banks” have formed. These “banks” provide the same services as
traditional banks, but with a very different cost structure.

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Questions 1-5 on page 61 of PHP (cont’d)
Answer to Question 4 (cont’d)
Threat of substitute products: The primary functions of banks are lending
money and providing a place to invest money. Potential substitutes for these
functions are provided by thrifts, credit unions, brokerage houses, mortgage
companies, and the financing arms of companies, such as car manufacturers,
departmental stores, etc. Government regulation of these entities varies
dramatically, affecting how similar their products are to those of banks.

In addition, consumers have become increasingly familiar with non-bank


options for investing money. As another example, some brokerage houses
provide money market accounts that function as current accounts. As a
result, the threat of substitutes for bank services has grown over time.

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Questions 1-5 on page 61 of PHP (cont’d)
Answer to Question 4 (cont’d)
Bargaining power of buyers: Business and consumer buyers of credit have
little direct bargaining power over banks and financial institutions. The
buying power of customers is probably also stronger in relationship banking
than under a transaction approach, where consumers seek the lowest-cost
lender for each new loan. Because the use of these approaches varies across
countries (due to differences in law), the bargaining power of buyers may also
vary.

Bargaining power of suppliers: Historically, depositors have had little


bargaining power.

In summary, bank regulations have historically played a very important role in


determining bank profitability by restricting competition. However,
deregulation in the industry as well as the emergence of non-bank substitutes
have increased competition in the industry.

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Questions 1-5 on page 61 of PHP (cont’d)
Question 5
Examples of European firms that operate in the pharmaceutical industry are
GlaxosmithKline and Bayer. Examples of European firms that operate in the
tour-operating industry are Thomas Cook and TUI. Rate the pharmaceutical
and tour operating industries as high, medium or low n the following
dimensions of industry structure:

(1) Rivalry;
(2) Threat of new entrants;
(3) Threat of substitute products;
(4) Bargaining power of suppliers; and
(5) Bargaining power of buyers.

Given your ratings, which industry would you expect to earn the highest
returns?

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Questions 1-5 on page 61 of PHP (cont’d)
Answer to Question 5
Historically, pharmaceutical companies have had some of the highest rates of
return in the economy whilst tour-operators have had moderate returns. The
following analysis why:

Pharmaceutical industry Tour operating industry


Rivalry Medium High
Companies compete fiercely to develop In the 1990s, the European
and patent drugs. However, once a drug tourism industry exhibited
is patented, a firm has a monopoly for strong growth. After a
that drug. This dramatically reduces slowdown in growth, due to the
competition. Competitors can only 2001 terrorism attacks, growth
enter the same market by developing a has been steady in the 2000s.
drug that does not infringe on the However, the trend towards
patent. short-term bookings and web-
based bookings (in combination
with high price transparency)
has structurally changed the
industry and increased
competition.
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Questions 1-5 on page 61 of PHP (cont’d)
Answer to Question 5 (cont’d)
Pharmaceutical industry Tour operating industry
Threat of new entrants Low Medium to high
Economies of scale and first “Tourism e-mediaries” such as
mover advantages are very exedia.com can relatively easily
high for the industry. Patents enter the market. In addition,
deter new entrants. In suppliers of accommodation
addition, drug companies sales and travel services (such as
forces have established Ryanair) start bypassing tour
relationships with doctors operators by offering their
which act as a further products online.
deterrent to a new entrant.
This distribution advantage is
changing as managed-care
firms have begun negotiating
directly with drug companies
on behalf of the doctors in
their network.

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Questions 1-5 on page 61 of PHP (cont’d)
Answer to Question 5 (cont’d)

Pharmaceutical industry Tour operating industry


Threat of substitute Low Medium to high
products New drugs are protected by See the comments for “Threat
patents giving manufacturers a of new entrants” above.
monopoly position.
Competitors are forced either
to invent around the patent or
to wait until the patent expires.
Once the patent expires, a
company will reduce prices as
other manufacturers enter the
market. The threat of
substitute products, however, is
likely to increase as
biotechnology products enter
the market.

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Questions 1-5 on page 61 of PHP (cont’d)
Answer to Question 5 (cont’d)
Pharmaceutical industry Tour operating industry
Bargaining power of Low High
buyers Historically, doctors have had little The online offering of
buying power. However, in some accommodation, flight services,
countries, managed-care providers car rentals, etc., has increased
have become more powerful price transparency and,
recently, and have begun negotiating consequently, increased buyers’
substantial discounts for drug bargaining power.
purchases.
Bargaining power of Low Medium
suppliers The chemical ingredients for Tour operators are large and
drugs can be obtained from a concentrated relative to
suppliers of accommodation
the
and
variety of chemical suppliers. other services. However, the
suppliers have the ability to
“bypass” tour operators by selling
their accommodation directly
through the internet. Tour
operators respond to this threat by
means of vertically integrating their
activities (e.g. owning their own
hotels and airlines). 19
Problem 1 on Inditex SA on pages 209-210 of PHP
Inditex SA is the Spain-based parent company of a large number of clothing
design, manufacturing and retail subsidiaries. The company’s brands include
Zara, Pull & Bear and Massimo Dutti. At the end of the fiscal year ending on
31st January, 2009 (fiscal year 2008), the subsidiaries of Inditex operated
4,359 stores across 73 countries, making Inditex one of the three largest
clothing retailers in the world.

The following tables show the standardised and adjusted income statements
and balance sheets of Inditex for the years ended 31st January 2007 and 2008.
Operating lease obligations have been capitalised and the operating lease
expense has been replaced with depreciation and interest expense.

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Problem 1 on Inditex SA on pages 209-210 of PHP (cont’d)

Standardised and adjusted income statement (€ million) 2008 2007


Sales 10,407 9,435
Cost of sales -4,493 -4,086
Personnel expense -1,703 -1473
Depreciation and amortisation -910 -803
Other operating income, net of other operating expense -1,108 -1,039
Operating profit 2,133 2,033
Investment Income 0 -9
Net interest expense -84 -72
Profit before tax 2,050 1,953
Tax expense -456 -474
Profit after tax 1,595 1,479
Minority interest -8 -7
Net profit 1,587 1,471
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Problem 1 on Inditex SA on pages 209-210 of PHP (cont’d)

Standardised and adjusted balance sheet (€ million) 2008 2007


Non-current tangible assets 6,325 6,000
Non-current intangible assets 148 139
Deferred tax asset 203 133
Other non-current assets 188 165
Total non-current assets 6,863 6,437
Trade receivables 585 464
Inventories 1,055 1,007
Other current assets 158 45
Cash and marketable securities 1,466 1,466
Total current assets 3,264 2,982
TOTAL ASSETS 10,127 9,418

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Problem 1 on Inditex SA on pages 209-210 of PHP (cont’d)

Standardised and adjusted balance sheet (€ million) 2008 2007


Shareholders’ equity 5,055 4,414
Minority interest 27 24
Non-current debt 2,003 2,095
Deferred tax liability 343 197
Other non-current liabilities (non-interest bearing) 308 229
Total non-current liabilities 2,655 2,522
Current debt 234 371
Trade payables 2,073 1,975
Other current liabilities 84 112
Total current liabilities 2,391 2,458
TOTAL LIABILITIES AND SHAREHOLDERS EQUITY 10,127 9,418

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Problem 1 on Inditex SA on pages 209-210 of PHP (cont’d)
(1) Calculate Inditex’s net operating profit after tax, operating working capital,
net non-current assets, net debt and net assets in 2007 and 2008. (Use the
effective tax rate [tax expense/profit before tax] to calculate NOPAT).

(2) Decompose Inditex’s return on equity in 2007 and 2008 using the
traditional approach.

(3) Decompose Inditex’s return on equity in 2007 and 2008 using the
alternative approach. What explains the difference between Inditex’s return
on assets and its operating return on assets?

(4) Analyse the underlying drivers of the change in Inditex’s return on equity.
What explains the decrease in return on equity? How strongly does Inditex
appear to be affected by the economic crisis of 2008? (In your answer, make
sure to address issues of store productivity, cost control, pricing and
leverage.)

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Problem 1 on Inditex SA on pages 209-210 of PHP (cont’d)
Answer to Question 1
€ millions
Value in Value in
Variable required Measurement 2008 2007
Operating profit As reported in the Income Statement 2,133 2,033
Effective tax rate Tax expense/Profit before tax 0.2220 0.2427
NOPAT Operating profit x (1 – effective tax rate) 1,659.47 1,539.59
Operating working (Current Assets – cash and marketable
capital securities) – (Current liabilities – current
debt - current portion of non-current
debt) – see page 187 of PHP -359 -571
Net non-current Total non-current assets – Total non- 4,208 3,915
assets current liabilities
Net debt Current debt + Non-current debt – cash 771 1,000
and marketable securities
Net assets Total assets – Total liabilities 5,081 4,438

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Problem 1 (Hugo Boss) on pages 298-9 of PHP
The problem
Hugo Boss AG is a German designer, manufacturer and distributor of men’s
and women’s clothing, operating in the higher end of the clothing retail
industry. During the period 2001-2008, the company consistently earned
returns on equity in excess of 18 percent, grew its book value of equity
(before special dividends) by 5.5 percent per year, on average, and paid out
65-70 percent of its net profit as dividends. In 2008, the company paid out a
special dividend of €345.1 million. Consequently, the company’s book value
of equity decreased from €546.8 million in 2007 to €199.0 million in 2008.

On April 1, 2009, one month before the publication of the first-quarter


results, when Hugh Boss’s 70.4 million common shares trade at about €11 per
share, an analyst produces the following forecast for Hugo Boss:

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Problem 1 (on Hugo Boss) on pages 298-299 of PHP (cont’d)
The problem (cont’d)

INCOME STATEMENT (€ millions) 2009E 2010E 2011E

Sales 1548.1 1493.9 1561.2


Gross Profit 897.9 875.1 923.7
EBIT 179.6 176.9 196.2
Interest expense -45 -40 -35
PBT 134.6 136.9 161.2
Tax expense -36.3 -37 -43.5
Net profit 98.3 99.9 117.7

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Problem 1 (on Hugo Boss) on pages 298-299 of PHP (cont’d)
The problem (cont’d)

BALANCE SHEET (€ millions) 2008R 2009E 2010E 2011E

Total non-current assets 459.2 480.8 499.1 512.0


Inventories 381.4 325.1 304.3 305.3
Trade receivables 201.0 175.4 160.8 156.1
Cash and cash equivalents 24.6 33.5 32.5 47.2
Other current assets 95.4 136.5 172.5 203.2
Total current assets 702.4 670.5 670.1 711.8

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Problem 1 (on Hugo Boss) on pages 298-299 of PHP (cont’d)
The problem (cont’d)
BALANCE SHEET (€ millions) 2008R 2009E 2010E 2011E

Shareholders’ equity 199.0 200.2 221.6 259.0


Non-current provisions 27.9 25.6 24.7 25.6
Non-current debt 588.5 576.7 565.2 553.9
Other non-current liabilities
(non-interest bearing) 26.7 24.5 23.6 24.8
Deferred tax liabilities 17.9 18.3 18.7 19.0
Total non-current liabilities 661.0 645.1 632.2 623.5
Current provisions 59.3 59.3 59.3 59.3
Current debt 40.2 40.2 40.2 40.2
Other current liabilities 202.1 206.5 215.9 241.8
Total current liabilities 301.6 306.0 315.4 341.3
TOTAL EQUITY AND LIABILITIES 1161.6 1151.3 1169.2 1223.8
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Problem 1 (on Hugo Boss) on pages 298-299 of PHP (cont’d)
The problem (cont’d)
Assume that Hugo Boss’s cost of equity capital is 12 percent.

(1) Calculate free cash flows to equity, abnormal earnings and abnormal
earnings growth for the years 2009-2011.

(2) Assume that in 2012,Hugo Boss AG liquidates all its assets at their book
value, uses the proceeds to pay off debt and pay out the remainder to its equity
holders. What does this assumption imply about the company’s:

(a) Free cash flow to equity holders in 2012 and beyond?


(b) Abnormal earnings growth in 2012 and beyond?
(c) Abnormal earnings growth in 2012 and beyond?

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Problem 1 (on Hugo Boss) on pages 298-299 of PHP (cont’d)
The problem (cont’d)

(3) Estimate the value of Hugo Boss’s equity on April 1, 2009, using the above
forecasts and assumptions. Check that the discounted cash flow model, the
abnormal earnings model and the abnormal earnings growth model yield the same
outcome.

(4) The analyst estimates a target price of €20 per share. What is the expected
value of Hugo Boss’s equity at the end of 2011 that is implicit in the analysts’
forecasts and target price?

(5) Under the assumption that the historical trends in the company’s ROE (i.e.
approximately 18 percent), payout ratio (70 percent) and book value growth (5.5
percent) continue in the future, what would be your estimate of Hugo Boss’s equity
value-to-book ratio before the company paid out its special dividend? How does
the special dividend payment change your estimate of the equity value-to-book
ratio?
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Problem 1 (on Hugo Boss) on pages 298-299 of PHP (cont’d)
Solution
Answer to Question 1
The calculations are as follows:

Description (€ millions) 2008R 2009E 2010E 2011E


Net current assets 400.8 364.5 354.7 370.5
Net non-current assets 414.6 438.0 456.8 468.2
Investment assets 0 0 0 0
Business Assets 815.4 802.5 811.5 838.7
Financed by:
Debt 616.4 602.3 589.9 579.7
Equity 199.0 200.2 221.6 259.0
Total Capital 815.4 802.5 811.5 838.7

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Problem 1 (on Hugo Boss) on pages 298-299 of PHP (cont’d)
Solution - Answer to Question 1 (cont’d)
Calculations of net cash flow to equity, abnormal earnings and abnormal earnings
growth are as follows:

Description (€ millions) 2008R 2009E 2010E 2011E


Net profit 98.3 99.9 117.7
- Change in assets 12.9 -9.0 -27.2
+ Change in debt -14.1 -12.4 -10.2
= Free cash flow to equity 97.1 78.5 80.3
Net profit 98.3 99.9 117.7
- (Beginning BE x 0.12) 23.88 24.024 26.592
= Abnormal earnings 74.42 75.876 91.108
Change in net profit at time t 1.6 17.8
- (Profit at t-1 – Dividends at t-1) x 0.12) 0.144 2.568
= Abnormal earnings growth 1.456 15.232
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Problem 1 (on Hugo Boss) on pages 298-299 of PHP (cont’d)
Solution (cont’d) – Answer to Question 2
If Hugo Boss liquidates all its assets at their book value in 2012, the company’s
2012 net profit would be zero and:

(a) 2012 free cash flow to equity (defined as net profit minus the change in net
assets plus the change in net debt) would be: (0 – (-891.0) + (-632.0)) = 259, i.e.
expected equity at the end of 2011.

(b) 2012 abnormal earnings (defined as net profit minus 12 percent of the book
value of equity at the end of 2011) would be: (0 – (0.12 x 259)) = 31.08.

(c) 2012 abnormal earnings growth (defined as change in abnormal earnings)


would be: -31.08 – 91.108 = -122.188.

In 2013 and beyond, free cash flows to equity and abnormal earnings would be
zero. Abnormal earnings growth would be 31.08 in 2013 (i.e. 0 – (-31.08)) and zero
in the years after 2013. 37
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Problem 1 (on Hugo Boss) on pages 298-299 of PHP (cont’d)
Solution – Answer to Question 5 (cont’d)
This multiple implies an equity value of €701.25 million, or €9.96 per share, on
1st January, 2009.

This is equivalent to €10.24 per share on 1st April, 2009, when Hugo Boss’s
shares traded at €11.00.

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Next week’s lecture will be on:

“Valuation Models 2
(based on decomposition of RoE and other
ratios)”

References
PHP Chs 8-9; DMD Chs. 18-24 plus 26-33 and PMN Chs. 13-19.

END OF LECTURE 5

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