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Concept Questions
C6.1. Analysts typically forecast eps and eps growth without consideration for how
earnings are affected by payout. That is, they forecast ex-dividend growth, not cum-
dividend growth. Investors value ex-dividend earnings growth, but they also value
C6.2. The historical 8.5% growth rate that is often quoted is the ex-dividend growth
rate. It ignores the fact that earnings were also earned by investors from reinvesting
dividends (in the S&P 500 stocks, for example) that were typically 40% of earnings. The
C6.3. This formula capitalizes earnings at the ex-dividend earnings growth rate, g. This
ignores growth that comes from reinvesting dividends. Further, if earnings are expected
to grow at a rate equal to the required return, r, then the growth should not be valued , and
forward earnings should be capitalized at the rate, r, not r – g. Only growth in excess on
zero and the value is infinite. If g is greater than r (which is necessary for growth to have
1/0.12 = 8.33.
C6.5. The difference is that, for the trailing P/E, one more years of earnings are
involved (the current year). The trailing P/E can be interpreted as paying for the value of
forward earnings (at the multiple for forward earnings) plus a dollar for every dollar of
current earnings.
C6.6. Cum-dividend earnings growth incorporates earnings that are earned from the
reinvestment of dividends, and investors value those earnings. Ex-dividend growth rates
are affected by dividends: dividends reduce assets which then earn lower earnings. As
cum-dividend growth rates reflect the earnings from dividends, they are not affected by
dividends. Cum-dividend growth rates are effectively the rates that firms would have if
C6.8. Incorrect. As the normal (forward) P/E ratio is the inverse of the required return
and the required return for a bond is (usually) lower than that for a stock, the normal P/E
ratio for a bond is greater than that for a stock. However, a bond cannot deliver growth,
so the P/E ratio for a growth stock might well be greater than that for a bond.
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C6.9. Yes, she could. One expects the earnings yield on a stock to be greater than the
bond yield because a stock is riskier and thus has a higher required return.
C6.10. A PEG ratio is the ratio of the P/E to one-year-ahead expected earnings growth
(in percentage terms). As the P/E anticipates earnings growth, the PEG ratio should be
1.0 if the market is anticipating growth appropriately. However, more than one year of
growth is involved in assessing P/E ratios, so the measure should only be used as a first-
C6.11. Intrinsic P/E ratios are determined by the cost of capital and earnings growth
expectations. So P/E ratios might have been low in the 1970s because the market did not
see much earnings growth in the future for the typical firm, and saw considerable growth
in the 1960s and 1990s. Or the cost of capital increased in the 1970s (and fell in the
1960s and 1990s). The interest rate is one component of the cost of capital, and interest
rates were higher in the 1970s (particularly the late 1970s) than in the 1960s and 1990s.
The traded P/E ratios may also reflect market inefficiency: the market might have
priced earnings too low in the 1970s and too high in the 1960s and 1990s. That turned
out to be the case (after the fact) in the 1960s and 1970s (as P/E ratios and prices fell after
three things:
(3) Market inefficiency in pricing the required return and expected growth.
The argument assumes that factors (2) and (3) do not explain the change in the
earnings-to-price ratio. Were growth expectations higher in the 1990s than in the 1970s?
C6.13. The trailing P/E, based on current earnings, is affected by transitory earnings.
The forward P/E based on next years' forecasted earnings is less likely to be so affected,
and so is a better base for growth. (But the analyst does have to forecast next year's
earnings).
C6.14. Yes; eps growth can be increased with investment, but the investment may earn
only the required return, and thus not add value. A firm can also increase its expected
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Exercises
Drill Exercises
(a)
If earnings are $10, the value of the account at the beginning of the year must have been
$250. That is, $250 earning at 4% yields $10 in earnings. The value of the account
at the end of the year is given by the stocks and flows equation:
This exercise complements Exercise 5.3 in Chapter 5, using the same forecasts. The
question asks you to convert a pro forma to a valuation using abnormal earnings growth
methods. First complete the pro forma by forecasting cum-dividend earnings and normal
earnings. Then calculate abnormal earnings growth and value the firm.
Growth rates:
Earnings growth 46.91% 5.09% 5.00% 5.00%
Cum-div earn growth (AEG) 49.87% 7.89% 10.83% 10.83%
Growth in AEG 5.0%
Note that the AEG for 2008 and 2009 are discounted back to the end of 2007.
a. Forecasted abnormal earnings growth (AEG) is given in the pro forma above.
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AEG is the difference between cum-dividend earnings and normal earnings. So,
for 2008,
Normal earnings is prior year’s earnings growing at the required rate. So, for
2008,
601 .36
Value of the equity = 6,013.6
0.10
This is a Case 2 valuation. If you worked exercise E5.3 using residual earnings methods,
d. The forward P/E = 6,013.6/388 =15.5. The normal P/E is 1/0.10 = 10.
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E6.4. Abnormal Earnings Growth Valuation and Target Prices
This exercise complements Exercise 5.4 in Chapter 5, using the same forecasts.
Develop the pro forma to forecast abnormal earnings growth (AEG) as follows:
(b) As AEG is forecasted to be zero after 2009, the valuation is based on forecasted
AEG up to 2009:
1 − 0.548 − 0.714
E
V2006 = 3.90 + +
0.12 1.12 1.2544
= $23.68
Note that this is the same value as obtained using residual earnings methods in
Exercise 5.4.
(c) The expected trailing P/E for 2011 must be normal if abnormal earnings growth is
V2011 + d 2011
= 9.33
Eps 2011
= $36.387
(a) Firm B will have higher earnings in 2007 because it will pay no dividend
in 2006. Firm A’s 2002 earnings will be displaced by its 2006 dividend.
= 18.90
(b) Anticipated future dividends don’t affect current price (unless payment
the earnings of Firm B’s shareholders by reinvesting the dividend at the cost of capital.
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Applications
2003 2004
Cum-
Earnings on prior dividend eps
Year Eps Dps year’s reinvested
dividends
Using implied AEG growth rate, g = 1.039, we can calculate implied earnings growth
rates for years from 2006 to 2011 as following. This reverse engineers the AEG formula.
Next we can plot the sequence of the implied earnings growth rates as in Figure 6.3.
BUY
SELL
11.00%
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E6.9. Using Analysts’ Forecasts to Calculate PEG Ratios and Evaluate Stock
Prices: General Motors
2003 2004
Alternative calculation:
= 8.44/51.73
= 0.16
the ratio prices only one year of growth, it can be misleading. That is certainly the
case here: GM cannot maintain a 51.73% growth rate. A growth rate of 8.44%
(d) If the market saw GM’s earnings growing at 12% (the required return) after 2003,
it would give GM a normal P/E of 1/0.12 = 8.33, approximately the 8.44 P/E it
actually gave the firm. So the market forecasts no growth over the required rate
(that is, no abnormal growth) in the long run. So it must see the large forecasted
At a price of $12 and forward (one-year-ahead) earnings of $1.19 per share, the forward
a. If the cost of capital (required return) is 10%, the normal forward P/E is 1/0.10 =
10. This normal P/E is appropriate if one forecasts cum-dividend earnings growth
of 10%. So, at a P/E of about 10, the market is forecasting cum-dividend eps
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c. Forecasted cum-dividend eps for 2004, at 10% growth rate: $1.19 x 1.10 = $1.309
a. With a required return of 10%, the value from capitalizing forward earnings is
With a view to part d of the question, forward earnings explain most of the current
market price of $55. If one can forecast growth after the forward year, one would be
b. First forecast the ex-dividend earnings based of analysts’ growth rate of 12%. Then
d. With abnormal earnings growth forecasted after the forward year, the stock should be
worth more than capitalized forward earnings of $53, the approximate market price. (One
The growth rate forecast for AEG for 2005-2008 is 12% (allow for rounding error
in calculating this growth rate from the AEG numbers above). This cannot be sustained if
the required return is 10%, but there is plenty of short-term growth to justify a price
above $55. (Of course, one can call the analysts’ forecasts into question.)
Growth rates:
Earnings growth 13.55% 5.09% 5.00% 5.0%
Cum-div earn growth (AEG) 15.84% 7.89% 10.83% 10.83%
Growth in AEG 5.0%
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(a) Forecasted earnings for 2007 increase by $114 million, to $502 million, because
of the lower cost of good sold. (This assumes that the write-down has no effect on
forecasted revenues on which forecasts for other years are based: it is often the
case the an inventory write-down means that the firm will have more trouble
601 .36
Value of the equity = 6,013.6
0.10
(c) As the additional earnings of $114 million in 2007 will incur a tax of $39.9
million, they will be lower by that amount, that is $462.1 million. However, the
lower earnings provide a lower base for calculating AEG for 2008, so AEG in
2008 is higher than that in the pro forma in (a). The net effect is to leave the
valuation unchanged. (This assumes forecasts for other years are already after
tax.)
(a) If Whirlpool’s shares are to trade at a normal forward P/E, the pro forma should show
zero expected abnormal earnings after the forward year, 1995. The following calculations
show that 1996 and 1997 abnormal earnings growth, based on the analyst’s forecasts, is
The AEG are close to zero. So Whirlpool’s forward P/E should be 1/0.10 = 10. The
(b) If Whirlpool is to trade at a normal trailing P/E, the pro forma must forecast zero
abnormal earnings growth for 1995 (the forward year) as well as for 1996 and 1997. This
At a market price of $47, Whirlpool actually did trade at (close to) a normal trailing P/E:
47 +1.22
Trailing P/E = = 10 .88
4.43
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E6.14. Is a Normal Forward P/E Ratio Appropriate? Maytag Corporation
The firm was trading below a normal P/E, so the market was forecasting negative
b. A five-year pro forma with a 3.1% eps growth rate after 2004 and forecasted dps
= $25.07
So, even if abnormal earnings growth were expected to recover to zero after 2007,
The answers to parts a, b and c of the question are in the last three lines of the pro forma.
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E6.16. Normal P/E Ratios
1 + required equity return
The normal trailing P/E ratio is required equity return
The schedule for the trailing P/E is as follows. Subtract 1.0 to get the forward P/E.
8% 13.50
9% 12.11
10% 11.00
11% 10.09
12% 9.33
13% 8.69
14% 8.14
15% 7.67
16% 7.25
Introduction
Part A of this case asks you to challenge the market price of $21 or, alternatively stated,
to challenge the forward P/E ratio of 23.60. As a P/E ratio is based of expected abnormal
earnings growth, this comes down to asking whether the P/E ratio is justified on the basis
of abnormal earnings growth (AEG) forecasts.
Given that we have only two years of analysts’ forecasts, we do not have the complete
set of forecasts to challenge the $21 price. Of course, we might develop a full analysis to
do this (as will be done in Chapters 7 – 15), but for now we are asked to challenge the
price with the limited forecasts. Reverse engineering gives us the handle: What are the
forecasts implicit in the market price, and are these reasonable? This is done in three
steps:
1. Calculate the implied AEG growth rate after 2006 that is implicit in the market
price.
2. Translate the AEG growth rate into an eps growth rate
3. Ask whether, given our knowledge of Cisco and its operations, the implied eps
growth rates are reasonable.
A break down of the building blocks of the valuation also give insights.
Part B of the case is a check on analysts’ recommendations, first against their target price
and, second, against their forecasts. Are the recommendations consistent with their target
price and their forecasts for the stock?
The case is a companion case to Minicase M5.1 in Chapter 5, using the same data but a
different valuation approach.
The Questions
Part A.
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To calculate the implied growth rate for AEG, set up the following pro forma:
2005 2006
Normal eps is 2006 eps growing at 12%: 0.89 × 1.12 = 0.9968. As Cisco pays no
dividend, cum-dividend eps is the same as eps.
1 0.0232
E
V2004 = 0.89 + 1.12 − g
0.12
E
Setting V2004 = $21 , then g = 1.1058 (a 10.58% growth rate)
Testing sensitivity to the cost of capital: If the required return is 10%, then
1 0.041
$21 = 0.89 + 1.10 − g
0.10
In this case, g = 1.066 (a 6.6% growth rate). While the case states that the required return
is 12%, always test conclusions against alternative measures, for we are never certain
about the precise required return.
With a growth rate for AEG, we can forecast AEG in subsequent years:
AEGt = AEGt −1 × g
= 0.0232 × 1.1058 = 0.0257 for 2007
Normal earnings is prior year’s earnings growing at 12%. So, for 2007,
For Cisco, the calculation is made a little easier because Cisco pays no dividends (and
this ex-dividend eps = cum-dividend eps). So, the eps forecasts for 2006-2010 are as
follows:
This pro forma simply is the standard pro for AEG analysis worked backwards. Year-to-
year growth rates are readily calculated:
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These growth rates can be plotted as in Figure 6.3:
BUY
SELL
15.50%
The plot of the implied eps growth path defines the border of the BUY and SELL
regions. If the analyst forecasts growth rates above the path implied by the market, she
15.25%
would say that Cisco was underpriced at $21. If the analyst forecasts growth rates below
the path implied by the market, she would say that Cisco was overpriced at $21. Chapters
7-15 will give you the tools to challenge the implied growth rates.
Identifying the speculative component of the market price: the Building Blocks
Refer to Figure 6.4 in the text. The speculative component is that which involves the
more uncertain forecasts for the longer term. The building blocks are:
15.00%
0.12
1.61
21.00
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Cisco System the Building Blocks
$21.00
Current Market Value
$11.97
$9.03
$1.61
$7.42
As you can see, a considerable portion of Cisco’s price is based on speculation about the
long-term growth.
At this point, the analysis asks himself whether this speculation is justified. Maybe the
market is pricing events beyond the forecast horizon or other factors, other than
immediate eps growth, that are pertinent to the value. The analyst (and the
student) asks: what is the market anticipating that I do not anticipate; what do
others know that is not factored into my forecasts? What is the market speculating
about to give Cisco such a high Block 3 value? Is the firm on a takeover list?
(Unlikely for Cisco) Does it have new strategic plans? Is it ripe for breakup?
(Unlikely for Cisco) Having posed these questions, the analyst furthers his
research to check on the answers before being confident in his BUY/HOLD/SELL
recommendation.
A note:
If you worked the companion case in Minicase 5.1 of Chapter 5 – which uses residual
earnings methods on the same data – you will notice that different implied eps forecasts
and growth rates were obtained than those here. Why is this? Well, there is a subtle
difference in RE models and AEG models:
If any case, the “long-term” growth path is the most elusive (speculative) part of
the valuation. All the better to have two ways of coming at it when characterizing
the growth path, rather than be restricted with an assumed path by one model. So,
to exploit this, take the average of the growth rates from the two models, or
weight either one by the degree you think it more representative for a particular
firm. Again, the issue is: will RE grow at a constant rate or at a declining rate?
Part B
This part of the case conducts two tests to challenge the integrity analysts’
recommendation (to buy, hold or sell Cisco). Is the recommendation consistent with their
analysis?
If one bought Cisco at $21 at the beginning of 2005 and accepted 12% as the required
return, a target price of $23.52 at the end of 2005 would yield the required (normal)
return: $21 × 1.12 = $23.52 (there are no dividends). So, a target price of $24 would be a
(marginal) buy. (Of course, analysts may have a lower required return, which would
make a $24 target price a solid BUY). Analysts were indeed recommending a BUY at the
time (on average).
Analysts were forecasting an eps growth rate for 2006 of $1.02/$0.89 = 14.61% and a
five-year growth rate of 14.5%. These are about the same as the forecasts implicit in the
market price, so imply a HOLD recommendation. However, most analysts were issuing
BUY recommendations. That recommendation is inconsistent with their forecasts.
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First, analysts may see higher growth after their 5-year forecast horizon (2010), and are
basing their recommendation on this.
Second, analysts may indeed see the lower growth in the future, but may anticipate that
the market price will (irrationally) increase: the price will move away from fundamentals.
In making a call on the target price, they are predicting prices, not values.
One further point should be noted. The implied forecasts are roughly in line with
analysts’ forecasts. There is a possibility that the market is pricing based on analysts
consensus forecasts and both a wrong! Indeed, there are claims that mispricing is led by
analysts (poor) forecasting, as in the bubble. If we do not trust analysts’ forecasts, there is
no avoiding developing our own. There rest of the book is designed to do this.
Note that, by the end of Cisco’s 2005 fiscal year, the stock price had dropped to $19.
Introduction
Parts A and B of this case ask students to reverse engineer the traded prices for PepsiCo
and Coca-Cola and then ask whether the implied earnings forecasts are different from
those that analysts are making. Set up the case with two questions:
1. How do we impute the forecasts that are implicit in the market price?
2. How do we challenge the market price?
The first question leads to the second: Rather than challenging a price, we challenge a
forecast. The core tool is the implied earnings growth plot, like that displayed for Reebok
in Figure 6.3. This plots the market’s implied earnings growth path and separates BUY
and Sell regions for the analyst who disagrees with the market’s forecast. Rather than
using residual earnings methods (as in Minicase M5.2), this case applies abnormal
earnings growth methods.
Part C of the case elicits the sales growth forecast that is implicit in the market price –
under the assumption that percentage profit margins will be constant.
Part D of the case introduces students to the common PEG ratio, and carries some
warnings about dealing with this ratio.
The Questions
A. The implied earnings forecasts are calculated in two steps. First, reverse engineer the
AEG valuation model to get the implied growth rate for AEG. Second, reverse engineer
the AEG calculation to get forecasted eps.
PepsiCo
2004 2005
Earnings 2.310 2.560
Dividends (payout = 42.4%) 0.980 1.086
Reinvested dividends (at 9%) 0.088
Cum-dividend earnings 2.648
Normal earnings (2.31 x 1.09) 2.518
AEG 0.130
1 0.130
V0E = 2.31 +
0.09 1.09 − g
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E
Setting V 0 = $49.80, then g = 1.03 (a 3.00% growth rate).
Now forecast AEG for years 2006 and after, and then convert these AEG forecast to eps
forecasts:
The AEG are just 2005 AEG growing at 3%. For year 2006:
Earnings2007 = 3.112
Earnings2008 = 3.415
Coca Cola
2004 2005
Earnings 1.990 2.100
Dividends (payout = 50.3%) 1.000 1.055
Reinvested dividends (at 9%) 0.090
Cum-dividend earnings 2.190
Normal earnings (1.99 x 1.09) 2.169
AEG 0.021
1 0.021
V0E = 1.99 +
0.09 1.09 − g
E
Setting V 0 = $40.70, then we have g = 1.0775 (a 7.75% growth rate)
In similar fashion,
Earnings2007 = 2.340
Earnings2008 = 2.471
B. From the pro forma in part a, EPS growth rates for each year are:
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Coke Cola 2004 2005 2006 2007 2008
Note that these are ex-dividend growth rates. Cum-dividend growth rates can be also be
calculated from the pro formas above. For example, for Coke for 2007, the cum-dividend
growth rate is 2.440/2.217, that is, 10.06 %.
These growth rates can be depicted in a plot, like that in Figure 6.3 for Reebok. This plot
separates BUY and SELL regions.
BUY
SELL
12.00%
For PepsiCo, analysts were forecasting an eps growth rate of 11%. The eps growth rates
implied by the market price are lower than that forecasted by analysts: The market
is seeing somewhat lower eps growth than that forecasted by analysts. If the
analysts’ forecasts are to be believed, the market price is a little low: A weak
BUY is indicated. The alternative interpretation is that analysts are too optimistic
in their forecasts. Indeed, sell-side analysts are notorious for being too high with
their 5-year eps growth rates.
BUY
SELL
7.00%
For Coca-Cola, the market’s implied growth rates are lower than the analysts’ five-year
rate of 8%. If analysts’ forecasts are to be believed, a BUY is indicated.
There is a proviso to these conclusions: Maybe the market is pricing events beyond the
forecast horizon or other factors, other than immediate eps growth, that are
pertinent to the value. The analyst (and the student) asks: what is the market
anticipating that I do not anticipate; what do others know that is not factored into
my forecasts. Does the market see a damaging event ahead? Is the firm on a
takeover list? (Unlikely for Coke and Pepsi.) Does it have new strategic plans? Is
it ripe for breakup? (Unlikely for Coke and Pepsi.) Having posed these questions,
6.50%
the analyst furthers his research to check on the answers before being confident in
his BUY/HOLD/SELL recommendation.
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A basic point to be made from the case (and indeed the material in the Chapter):
Valuation models are not formulas into which you plug in numbers and magically
an intrinsic value pops out. Yes, you can use the models to convert a forecast to a
valuation. But the models are, more broadly, a way of developing tools for
challenging the market price. They enable you to convert a price to a forecast
which you can then compare to your own forecast. Indeed, the scheme enables
you to challenge your own forecasts with the forecast in the market price.
Broadly, valuations models tell you how to think about the problem (of
appropriate pricing) and to bring tools to resolving the problem. They get you
asking the right questions before reaching a conclusion.
If you worked the companion case in Minicase 5.2 of Chapter 5 – which uses residual
earnings methods on the same data – you will notice that different eps forecasts and
growth rates were obtained than those here. Why is this? Well, there is a subtle difference
in RE models and AEG models:
If RE is forecasted to grow at a rate, g, then AEG will also grow at the same rate.
So, if we forecast Pepsico’s RE of $1.812 in 2005 to grow at 4.97% per year (as
we did in Minicase 5.2), it must be that we also forecast AEG to grow at 4.97%.
You can prove this by calculating the AEG in Minicase 5.2 from the forecast of
eps and dps obtained there. However, the converse is not true; that is, if we
forecast AEG to grow at 3% (as above for PepsiCo), it is not the case that RE will
grow at 3%. Indeed, a given growth rate for AEG implies a positive, but
declining, growth rate for RE. So, the AEG model implies a different growth path
than the AEG model. Some think the AEG path is more plausible: RE will grow,
not at a constant rate, but at a declining rate as firms lose their ability to grow.
If any case, the “long-term” growth path is the most elusive part of the valuation.
All the better to have two degrees of freedom in characterizing the growth path,
rather than be stuck with an assumed path by one model. So, to exploit this, take
the average of the growth rates from the two models, or weight either one by the
degree you think it more representative for a particular firm. Again, the issue is:
will RE grow at a constant rate or at a declining rate?
C. If a firm can maintain its current profit margin in the future, its sales growth rate
will equal its earnings growth rate:
The constant-margin assumption implicit in this calculation is more realistic for Coke
than Pepsi. Coke maintains fairly constant operating profit margins (before net interest).
See Box 14.3 in Chapter 14. Analysts, at the time, were indeed forecasting a sales growth
rate of 5.2% for 2006 over 2005.
D. The PEG ratio is the ratio of the forward P/E ratio to forecasted eps growth for the
PEG ratios:
Taken literally, the PEG ratios indicate that the forward P/E ratios are too high relative to
the subsequent growth. The benchmark PEG for a required return of 9% is 11.11/9.0 =
1.23; that is, if one expected growth at the required return, and the market is pricing this
growth correctly with a (normal) forward P/E of 11.11, the PEG should be 1.23. The
actual PEG ratios are in excess of this. Note the following problems, however:
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(i) The growth rates calculated here are ex-dividend eps growth rates (as is
typical when analysts calculate the growth rates and the PEG ratio). Cum-
With this revision, the PEG is 1.48 for Pepsico and 2.04 for Coke.
(ii) One year of growth is not enough with which to evaluate a P/E ratio (in the
numerator).
Note that the PEG ratio is sometimes calculated with the 5-year percentage
growth rate in the denominator. So, with analysts forecasting a 5-year eps growth
rate of 11% for PepsiCo at the time, the PEG ratio = 21.6/11.0 = 1.96 (using the
Introduction
This case asks the student to test a market price with little information: just two years of
earnings forecasts. So, with no forecasts for subsequent years, the valuation is
going to be incomplete. However, students should be impressed about how far one
The case demonstrates the mechanics of using the abnormal earnings growth model
The forward P/E is 17/1.28 = 13.3. So the question is one of asking whether a
forward P/E of 13.3 is appropriate. That question turns on whether subsequent growth
beyond 2002 warrants a forward P/E of 13.3. The normal forward P/E for a cost of capital
of 10% is 1/0.10 = 10, so we have so see some abnormal earnings growth to justify a P/E
With only two years of earnings forecasts, we do not know analysts’ earnings
growth rate into the future. But we can apply reverse engineering techniques and ask
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Normal earnings for 2003 is 2002 earnings growing at 10%. Cum-dividend earnings for
2003 is the forecasted earnings (with no reinvestment of dividends) because Borders pays
no dividends. AEG is the difference between earnings and normal earnings. Note that
AEG could have been calculated as cum-dividend earnings growth minus normal
Now ask the reverse engineering question: What growth in AEG after 2003 is
required to justify a price of $17? Using the abnormal earnings growth P/E model,
1 0.032
17 = 1.28 +
0.10 1.10 − g
So, g = 1.024 (2.4% growth). The calculation does depend on a cost of capital of 10%, of
course, but one can look at implied growth rates under alternative estimates for the cost
of capital.
Thinking about growth in AEG is a bit difficult. But AEG growth can be translated into
earnings growth. A scenario of 2.4% growth in AEG can be translated into one for
growth in eps, as follows.
The numbers in bold here are the earnings forecasts for future years.
The question of whether $17 is a reasonable price is answered by asking whether these
eps forecasts are reasonable: can you justify eps growth from 1.28 in 2002 to 1.81 in
2005? Note that the implied growth in (cum-dividend) eps is 12.5% per year, compared
The analysis in Parts II and III of the book is designed to forecasts growth rates. The
analysis here is one that can be applied in absence of any further analysis.
You may choose to introduce the alternative form of the AEG model developed in the
If one expects AEG to grow at a constant rate from year 2 ahead onwards, the
model is
1 AEG2
V E0 = Earn1 +
ρE − 1 ρE − g
Earn1 g 2 − g
V E0 = •
ρE − 1 ρE − g
where g is, as before, one plus the long-term growth rate of AEG and g2 is one plus the
growth rate forecasted for cum-dividend eps in year 2 ahead. For Borders, analysts’
expected growth rate for eps in year 2 (2003), g2, is 1.44/1.28 = 1.125 (12.5%). So, for a
2.4% long-term AEG growth rate, the $17 price for Borders can be calculated as:
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E 1.28 1.125 −1.024
V2000 = ×
0.10
1.10 −1.024
= $17
So the model can be seen as building in a short-term growth rate (g2) and a long-
term growth rate, g. Often short term expected growth rates are high and not indicative
of long-term growth. But one wants to value short-term growth as well as long-term
growth. Firms with high expected growth in the short term should be valued higher, for
the same long-term growth. So, think of this variant of the model as forecasting a short-
term growth rate, but recognizing that the short-term growth typically falls off to a long-
term level. What might that long-term level be? Well, a starting point is typical growth
Introduction
This case is designed to show the student how one can get a good rough cut at a valuation
from the little information supplied. It also touches on the issue (raised in Chapter 3) of
how (and when) share repurchases generate value for shareholders You might work the
Bps(2001) $8.61
Eps(2001) $0.42
Dps(2001) $0.00
Price-to-book 1.16
Question A
The benchmark rule for stock repurchases says that repurchases at fair value do not
Cendant had 1,040 million shares outstanding in October, 2002 with a market
capitalization (at $10 per share) of $10.4 billion. Suppose the $10 per share is a fair value
(intrinsic value). If Cendant buys back 100 million shares at $10 each, market
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capitalization falls to $9.4 billion. But as there are now only 940 million shares
outstanding, the value per share is still $10. The share repurchase had not added value to
holding a share.
• Students might note that share repurchases increase earnings per share and
earnings growth (as commentators argue). They might then imply that
higher eps and eps growth warrant higher valuations. Stock repurchases do
indeed increase eps and eps growth, but the effect is a leverage effect that
higher value), and so will increase the stock price. But this can only be the
• Stock repurchases may be desirable if the firm does not have investment
fair value do. Shareholders can buy the stock cheaply, but so can the firm on their behalf.
So, Cendant might buy back its own stock if indeed it feels that, at $10 per share, its
An historical note: Stock repurchases at prices greater than fair value destroy shareholder
value (by the same argument). During the stock market bubble of the l990s, there were
many large stock repurchases, financed by borrowings. Stock prices were high (as any
rough calculation of fair value would have indicated), so value was destroyed for
shareholders. The legacy for many firms was a high debt load (from the borrowings) that
became difficult to service in 2001-03. Share issues (to raise cash to buy down the debt)
became problematical because share prices were much lower (and firms should not issue
shares when they are underpriced!). Firms resorted to assets sales to get cash, so upsetting
their ability to generate value from operations. Share repurchases of overpriced stock
Question B
Challenge the current price of $10 using the valuation frameworks in Chapters 5 and 6.
The following pro forma incorporates the information in the case and also forecasts
residual earnings and abnormal earnings growth. A 12% required return for Cendant’s
equity is used:
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2001A 2002E 2003E
Dps 0 0 0
AEG2003 0.167
The 12% required return is used judiciously. With the (risk-free) rate on 10-year US
Treasuries of 3.61% at the time, a 12% rate ascribes a risk premium of 8.39% to
Cendant’s equity, a hefty amount. So we are probably overstating the required return.
Accordingly, an estimated price (as below) is biased downwards; we are getting a floor
valuation. With a lower required return we would estimate a higher price. This suits our
purpose, for we are testing whether the $10 price is too low, so need a number for which
The traded P/B ratio is 1.16. Does the information here indicate that this P/B is too low?
The pro forma shows that growth in RE is expected from 2002 to 2003. Suppose that one
expected no growth in RE after 2002, that is, RE is forecasted to be constant from 2002
So,
0.2368
V2001 = 8.61 + = $10 .58
0.12
That is, on the assumption of no growth in RE, the stock is worth more than $10. And
this is a valuation where we are charging a high required return (of 12%). If we charge
10% as a required return, the value is $12.40. Based on the pro forma that indicates
We have to be careful, of course, for we have only a 2-year pro forma. But we
have focused our questioning: to argue that $10 is too expensive, we have to forecast a
With a required return if 12%, the stock is worth a normal forward P/E of 1/0.12 = 8.33 if
we expect no abnormal earnings growth (AEG) after the 2002 forward year. The traded
forward P/E is 7.9, so the market is implicitly forecasting negative AEG after 2002. But
the pro forma indicates positive (and substantial) AEG for 2003. Put another way,
capitalizing forward earnings at 12%, the estimated value is $1.27/0.12 = 10.33, more
than the actual price of $10 and, in addition, analysts see AEG of 0.167 in 2003 that adds
further value.
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Further, these calculations use a high required return. If the required return is
10%, the value from forward earnings is $1.27/0.10 = $12.70 and there is extra value
To suggest that the stock is fairly (or overpriced) one would have to forecast
The PEG ratio is the ratio of the forward P/E (for 2002 here) to the subsequent one-year
P / E 2002
PEG =
Growth 2003
This is low against the benchmark of 1.0. The PEG suggests that the P/E of 7.9 is
undervaluing subsequent growth. But, we have to be careful. The P/E evaluates long-term
growth, and the 2003 growth rate may not continue. At the time, analysts were
forecasting a five-year growth rate of 14%. With this rate in the denominator, the PEG
Using both the RE and AEG approaches, we establish a case for underpricing by
the market (and a case for a stock repurchase). However, we have based our analysis on
sell-side analysts’ consensus forecasts and our analysis is only as good as those forecasts.
If we doubt those forecasts, we have a doubtful analysis. We might then substitute our
One must always be concerned about the quality of sell-side analysts’ forecasts.
After all, they come for free and what comes for free must be questioned. During the
bubble, there was strong suspicion of bias in these forecasts, brought on by over
enthusiasm (at best) and deliberate misleading of retail investors (at worse) in the pursuit
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One could add further information to an analysis like the one here by bringing in
the 3- or 5-year eps growth rates that analysts forecast. In 2002, analysts were
forecasting a 5-year eps growth rate of 14% for Cendant. As the firm pays no dividends,
this is the cum-dividend growth rate. Even with a required return of 12%, this rate is
excess of the required rate, so further AEG is forecasted for 2004 onwards (further
reinforcing the impression that the shares are underpriced at $10). But, these “long-term”
growth rates are often not very reliable, so should be treated with care.