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Chapter

4
Equity Valuation:
Applications and
Processes

Problems

1. Critique the statement: “No equity investor needs to understand valuation models be-
cause real-time market prices for equities are easy to obtain online.”
2. The chapter defined intrinsic value as “the value of an asset given a hypothetically com-
plete understanding of the asset’s investment characteristics.” Discuss why “hypothetically”
is included in the definition and the practical implication(s).
3. A. Explain why liquidation value is generally not relevant to estimating intrinsic value for
profitable companies.
B. Explain whether making a going-concern assumption would affect the value placed
on a company’s inventory.
4. Explain how the procedure for using a valuation model to infer market expectations about
a company’s future growth differs from using the same model to obtain an independent
estimate of value.
5. Example 1, based on a study of Intel Corporation that used a present value model (Cor-
nell 2001), examined what future revenue growth rates were consistent with Intel’s stock
price of $61.50 just prior to its earnings announcement, and $43.31 only five days later.
The example states, “Using a conservatively low discount rate, Cornell estimated that In-
tel’s price before the announcement, $61.50, was consistent with a forecasted growth rate
of 20 percent a year for the subsequent 10 years and then 6 percent per year thereafter.”
Discuss the implications of using a higher discount rate than Cornell did.
6. Discuss how understanding a company’s business (the first step in equity valuation) might
be useful in performing a sensitivity analysis related to a valuation of the company.
7. In a research note on the ordinary shares of the Milan Fashion Group (MFG) dated
early July 2007 when a recent price was €7.73 and projected annual dividends were
€0.05, an analyst stated a target price of €9.20. The research note did not discuss how

17
18 Problems

the target price was obtained or how it should be interpreted. Assume the target price
represents the expected price of MFG. What further specific pieces of information
would you need to form an opinion on whether MFG was fairly valued, overvalued, or
undervalued?
8. You are researching XMI Corporation (XMI). XMI has shown steady earnings per share
growth (18 percent a year during the last seven years) and trades at a very high multiple
to earnings (its P/E is currently 40 percent above the average P/E for a group of the most
comparable stocks). XMI has generally grown through acquisition, by using XMI stock to
purchase other companies whose stock traded at lower P/Es. In investigating the financial
disclosures of these acquired companies and talking to industry contacts, you conclude
that XMI has been forcing the companies it acquires to accelerate the payment of expenses
before the acquisition deals are closed. As one example, XMI asks acquired companies to
immediately pay all pending accounts payable, whether or not they are due. Subsequent
to the acquisition, XMI reinstitutes normal expense payment patterns.
A. What are the effects of XMI’s pre-acquisition expensing policies?
B. The statement is made that XMI’s “P/E is currently 40 percent above the average P/E
for a group of the most comparable stocks.” What type of valuation model is implicit
in that statement?

The following information relates to Questions 9–16


Guardian Capital is a rapidly growing US investment firm. The Guardian Capital research
team is responsible for identifying undervalued and overvalued publicly traded equities that
have a market capitalization greater than $500 million.
Due to the rapid growth of assets under management, Guardian Capital recently hired a
new analyst, Jack Richardson, to support the research process. At the new analyst orientation
meeting, the director of research made the following statements about equity valuation at
Guardian:
Statement 1: “Analysts at Guardian Capital seek to identify mispricing, relying on price
eventually converging to intrinsic value. However, convergence of the
market price to an analyst’s estimate of intrinsic value may not happen
within the portfolio manager’s investment time horizon. So, besides evi-
dence of mispricing, analysts should look for the presence of a particular
market or corporate event—that is, a catalyst—that will cause the market-
place to re-evaluate the subject firm’s prospects.”
Statement 2: “An active investment manager attempts to capture positive alpha. But
mispricing of assets is not directly observable. It is therefore important
that you understand the possible sources of perceived mispricing.”
Statement 3: “For its distressed securities fund, Guardian Capital screens its investable
universe of securities for companies in financial distress.”
Statement 4: “For its core equity fund, Guardian Capital selects financially sound com-
panies that are expected to generate significant positive free cash flow
from core business operations within a multiyear forecast horizon.”
Statement 5: “Guardian Capital’s research process requires analysts to evaluate the rea-
sonableness of the expectations implied by the market price by comparing
the market’s implied expectations to his or her own expectations.”
Chapter 4 Equity Valuation: Applications and Processes 19

After the orientation meeting, the director of research asks Richardson to evaluate three
companies that are retailers of men’s clothing: Diamond Co., Renaissance Clothing, and
Deluxe Men’s Wear.
Richardson starts his analysis by evaluating the characteristics of the men’s retail clothing
industry. He finds few barriers to new retail entrants, high intra-industry rivalry among retailers,
low product substitution costs for customers, and a large number of wholesale clothing suppliers.
While conducting his analysis, Richardson discovers that Renaissance Clothing included
three non-recurring items in their most recent earnings release: a positive litigation settlement,
a one-time tax credit, and the gain on the sale of a non-operating asset.
To estimate each firm’s intrinsic value, Richardson applies appropriate discount rates to
each firm’s estimated free cash flows over a ten-year time horizon and to the estimated value of
the firm at the end of the ten-year horizon.
Michelle Lee, a junior technology analyst at Guardian, asks the director of research for
advice as to which valuation model to use for VEGA, a fast-growing semiconductor company
that is rapidly gaining market share.
The director of research states that “the valuation model selected must be consistent with
the characteristics of the company being valued.”
Lee tells the director of research that VEGA is not expected to be profitable for several
more years. According to management guidance, when the company turns profitable, it will
invest in new product development; as a result, it does not expect to initiate a dividend for an
extended period of time. Lee also notes that she expects that certain larger competitors will
become interested in acquiring VEGA because of its excellent growth prospects. The director
of research advises Lee to consider that in her valuation.

9. Based on Statement 2, which of the following sources of perceived mispricing do active


investment managers attempt to identify? The difference between:
A. intrinsic value and market price.
B. estimated intrinsic value and market price.
C. intrinsic value and estimated intrinsic value.
10. With respect to Statements 3 and 4, which of the following measures of value would the
distressed securities fund’s analyst consider that a core equity fund analyst might ignore?
A. Fair value
B. Liquidation value
C. Fair market value
11. With respect to Statement 4, which measure of value is most relevant for the analyst of the
fund described?
A. Liquidation value
B. Investment value
C. Going-concern value
12. According to Statement 5, analysts are expected to use valuation concepts and models to:
A. value private businesses.
B. render fairness opinions.
C. extract market expectations.
13. Based on Richardson’s industry analysis, which of the following characteristics of men’s
retail clothing retailing would positively affect its profitability? That industry’s:
A. entry costs.
B. substitution costs.
C. number of suppliers.
20 Problems

14. Which of the following statements about the reported earnings of Renaissance Clothing
is most accurate? Relative to sustainable earnings, reported earnings are likely:
A. unbiased.
B. upward biased.
C. downward biased.
15. Which valuation model is Richardson applying in his analysis of the retailers?
A. Relative value
B. Absolute value
C. Sum-of-the-parts
16. Which valuation model would the director of research most likely recommend that Lee use
to estimate the value of VEGA?
A. Free cash flow
B. Dividend discount
C. P/E relative valuation

The following information relates to Questions 17–20


Bruno Santos is an equity analyst with a regional investment bank. Santos reviews the growth
prospects and quality of earnings for Phoenix Enterprises, one of the companies he follows. He
has developed a stock valuation model for this firm based on its forecasted fundamentals. His
revenue growth rate estimate is less than that implied by the market price.
Phoenix’s financial statements over the past five years show strong performance, with
above average growth. Santos has decided to use a lower forecasted growth rate in his models,
reflecting the effect of “regression to the mean” over time. He notes two reasons for his lower
growth rate forecast:

Reason 1: Successful companies tend to draw more competition, putting their high
profits under pressure.
Reason 2: Phoenix’s intellectual property and franchise agreements will be weakening over
time.

Santos meets with Walter Hartmann, a newly hired associate in his department. In their
conversation, Hartmann states, “Security analysts forecast company performance using both
top-down and bottom-up analysis. I can think of three examples:

1) A restaurant chain forecasts its sales to be its market share times forecast industry sales.
2) An electric utility company forecasts that its sales will grow proportional to increases
in GDP.
3) A retail furniture company forecasts next year’s sales by assuming that the sales in its newly
built stores will have similar sales per square meter to that of its existing stores.”

Hartmann is reviewing some possible trades for three stocks in the health care industry
based on a pairs-trading strategy. Hartmann’s evaluations are as follows:

• HG Health is 15% overvalued.


• Corgent Cell Sciences is 10% overvalued.
• Johnson Labs is 15% undervalued.
Chapter 4 Equity Valuation: Applications and Processes 21

17. Based on Santos’s revenue growth rate estimate, the shares of Phoenix are most likely:
A. undervalued.
B. fairly valued.
C. overvalued.
18. Which of the reasons given by Santos most likely justifies a reduction in Phoenix’s forecast-
ed growth rate?
A. Reason 1 only
B. Reason 2 only
C. Both Reason 1 and Reason 2
19. Which of Hartmann’s examples of company performance forecasting best describes an
example of bottom-up forecasting?
A. Restaurant chain
B. Electric utility company
C. Retail furniture company
20. Based on his trading strategy, which of the following should Hartmann recommend?
A. Short HG Health and Corgent Cell Sciences
B. Buy Johnson Labs and Corgent Cell Sciences
C. Buy Johnson Labs and short Corgent Cell Sciences

The following information relates to Questions 21–24


Abby Dormier is a sell-side analyst for a small Wall Street brokerage firm covering publicly and
actively traded companies with listed equity shares. Dormier is responsible for issuing either
a buy, hold, or sell rating for the shares of Company A and Company B. The appropriate
valuation model for each company was chosen based on the following characteristics of each
company:

Company A is an employment services firm with no debt and has fixed assets consisting primarily
of computers, servers, and commercially available software. Many of the assets are intangible, in-
cluding human capital. The company has a history of occasionally paying a special cash dividend.
Company B operates in three unrelated industries with differing rates of growth: tobacco (60%
of earnings), shipbuilding (30% of earnings), and aerospace consulting (10% of earnings). The
company pays a regular dividend that is solely derived from the earnings produced by the tobacco
division.

Dormier considers the following development in making any necessary adjustments to


the models before assigning ratings:

Company B has finalized the terms to acquire 70% of the outstanding shares of Company X, an
actively traded tobacco company, in an all-stock deal.

Dormier assigns ratings to each of the companies and provides a rationale for each rat-
ing. The director of research asks Dormier: “How did you arrive at these recommendations?
Describe how you used a top-down approach, which is the policy at our company.”
Dormier replies, “I arrived at my recommendations through my due diligence process. I
have studied all the public disclosure documents; I have participated in the company conference
calls, being careful with my questions in such a public forum; and I have studied the dynamics
22 Problems

of the underlying industries. The valuation models are robust and use an extensive set of com-
pany-specific quantitative and qualitative inputs.”

21. Based on Company A’s characteristics, which of the following absolute valuation models
is most appropriate for valuing that company?
A. Asset based
B. Dividend discount
C. Free cash flow to the firm
22. Based on Company B’s characteristics, which of the following valuation models is most
appropriate for valuing that company?
A. Asset based
B. Sum of the parts
C. Dividend discount
23. Which of the following is most likely to be appropriate to consider in Company B’s valua-
tion of Company X?
A. Blockage factor
B. Control premium
C. Lack of marketability discount
24. Based on Dormier’s response to the director of research, Dormier’s process could have
been more consistent with the firm’s policy by:
A. incorporating additional micro-level inputs into her valuation models.
B. evaluating the impact of general economic conditions on each company.
C. asking more probing questions during publicly available company conference calls.

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