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Module 15

Market-Based Valuation

DISCUSSION QUESTIONS

Q15-1. The advantages of valuation using market multiples compared to valuation using discounted cash flows or discounted residual operating income include the following:  It is quick, straightforward, and requires little data.

 It is widely used in a variety of business contexts.

 It does not necessarily require forecasts of future earnings or cash flows.

Q15-2. The disadvantages of valuation using market multiples compared to valuation using discounted cash flows or discounted residual operating income include the following:  It does not have a rigorous theoretical model underlying it.

 It requires an assumption of market efficiency regarding the comparable companies.

 It requires an assumption of market inefficiency regarding the target company.  There are no formal guidelines for choosing the correct companies to use as

comparables.

Q15-3. The residual operating income model follows:

Company value = NOA + Present value of Future ROPI.

If the ratio of company value to NOA is 1, then the expected present value of future ROPI must be zero.

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Q15-4. For the company-value-to-net-operating-assets ratio, the comparables should be selected on the basis of expected future profitability (RNOA), expected future growth (growth in NOA), and expected operating risk (variance of operating income).

For the price-to-book-value ratio, comparables should be selected using the above factors as well as capital structure.

Q15-5. When PE ratios are reported by data aggregators or quoted in publications (such as Yahoo! and Google), earnings might be the past fiscal year’s earnings, trailing four quarters earnings, or forecasted future earnings. Earnings might also be as reported or adjusted for unusual or nonrecurring items. Consequently, it is important for us to determine what version of earnings is used before drawing inferences.

Q15-6. Recall that the residual income operating model yields the following formula for the PE ratio:

PE ≈ [(1+re) /re] × [1 + (Present value of expected changes in RI – Dividend /

Earnings)]

If the company had a payout ratio of zero, the capitalization factor on current earnings would be 11. This means a PE ratio of 11 implies that the market would expect no growth in residual operating income. A PE ratio higher than 11 implies that the market expects positive growth in residual operating income, and a PE ratio less than 11 implies that the market expects negative growth in residual operating income.

Q15-7. This headline means that an analyst(s) from Goldman Sachs increased the price target for Cisco Systems, based on an increased multiple of Cisco’s earnings. This analyst increased the multiple because she/he expected Cisco to show stronger earnings growth in the future.

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M15-8. (15 minutes)

Using the industry average PB of 7.1, the estimated intrinsic value of Burger King’s equity is $5,652 million, computed as 7.1 x $796 million.

This equates to $41.65 per share, computed as $5,652 million / 135.7 million.

M15-9. (15 minutes)

Using the industry average PB of 2.3, the estimated intrinsic value of Build-a-Bear’s equity is $21.97 per share, computed as 2.3 x $9.55.

M15-10. (15 minutes)

Using the industry average PE of 14.25, the estimated intrinsic value for JAKKS Pacific is $1,283 million, computed as 14.25 x $90 million.

This equates to $44.86 per share, computed as $1,283 million / 28.6 million.

M15-11. (15 minutes)

Using the industry average PE ratio of 10.4, Motorola’s intrinsic value per share is $6.45, computed as 10.4 x $0.62. M15-12. (20 minutes) Company A: ROPI: $8 = ($100 x 18%) – ($100 x 10%) PV of ROPI $100 = $8 / (10% – 2%) Value of equity $200 = $100 + $100 PB ratio 2.00 Company B: ROPI: $1 = ($100 x 11%) – ($100 x 10%) PV of ROPI $12.5 = $1 / (10% – 2%)

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M15-13. (20 minutes) Company A: ROPI: $8 = ($100 x 18%) – ($100 x 10%) PV of ROPI $100 = $8 / (10% – 2%) Value of equity $200 = $100 + $100 PB ratio 2.00 Company B: ROPI: $1 = ($100 x 11%) – ($100 x 10%) PV of ROPI $16.7 = $1 / (10% – 4%) Value of equity $116.7 = $100 + $16.7 PB ratio 1.17 M15-14. (20 minutes) Company A: ROPI: $3 = ($100 x 18%) – ($100 x 15%) PV of ROPI $23.1 = $3 / (15% – 2%) Value of equity $123.1 = $100 + $23.1 PB ratio 1.23 Company B: ROPI: $1 = ($100 x 11%) – ($100 x 10%) PV of ROPI $12.5 = $1 / (10% – 2%) Value of equity $112.5 = $100 + $12.5 PB ratio 1.13 M15-15. (20 minutes) Company A: ROPI: $1 = ($100 x 11%) – ($100 x 10%) PV of ROPI $10 = $1 / (10% – 0%) Value of equity $110 = $100 + $10 PB ratio 1.10 Company B: ROPI: $1 = ($100 x 11%) – ($100 x 10%) PV of ROPI $10 = $1 / (10% – 0%) Value of equity $50 = $100 + $10 – $60 PB ratio 1.25 M15-16. (15 minutes)

Fresh Del Monte is more similar to Chiquita in terms of profitability, growth, and risk. Thus, we conclude it is a better comparable than Lancaster Colony for valuation using PB ratios.

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Hillshire Brands is more similar to Hershey in terms of profitability (ROE) and risk (debt-to-equity). Thus, we conclude that it is the better comparable to use for valuation using PE ratios.

M15-18. (20 minutes)

a. Note to instructor: There is more than one reasonable answer to this question. The

important point is to select companies that are as similar as possible to PNRA on the basis of profitability, growth, and risk.

One reasonable solution would be to eliminate BWLD and TXRH (both carry low ROE) and SONC (high ROE) on the basis of profitability. Next, we see that BAGL has a low historical growth rate. Finally, DNKN exhibits a high debt to equity ratio. Thus, this would leave THI, PZZA and CMG as three good comparables for Panera.

b. The comparables have an average PB ratio of 9.91. Multiplying Panera’s book value per

share of $27.18 by the 9.91 market multiple yields an estimate of its equity intrinsic value per share of $269.35.

c. The comparables have an average PE ratio of 27.88. Multiplying Panera’s earnings

estimate of $6.68 by the 27.88 market multiple yields an estimate of its equity intrinsic value per share of $186.24.

M15-19. (20 minutes)

ROE equals the current PB divided by the trailing PE. For the four following companies, the ROE results are shown below.

Company ROE

Apple (AAPL) 29.0%

Outerwall (OUTR) 27.9%

PPG Industries (PPG) 58.5%

Hershey (HSY) 57.8%

The market is most likely expecting future ROE to be highest for HSY. This is because it has the highest PB ratio by far.

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EXERCISES

E15-21. (20 minutes)

a. The price to net operating assets ratios for MDRX and MCK are 1.21 and 2.50, respectively. b. The simple average of the two ratios is 1.86. Also, we could weight one of the two

companies more heavily if we believe its ratio is more relevant for valuing Cerner Corporation.

Cerner’s estimated company intrinsic value is $2,760 million, using a 1.86 multiple on net operating assets.

Cerner’s estimated equity intrinsic value is $4,110 million, computed as $2,760 million plus nonoperating assets of $1,350 million.

Its estimated equity intrinsic value per share is $23.88, computed as $4,110 million / 172.1 million shares.

E15-22. (20 minutes)

a. The price to book value ratios for MDRX and MCK are 1.26 and 3.01, respectively.

b. The simple average of the two ratios is 2.14. Also, we could weight one of the two

companies more heavily if we believe its ratio is more relevant for valuing Cerner.

Cerner’s estimated equity intrinsic value is $6,065 million, using a 2.14 multiple on book value.

Cerner’s estimated equity intrinsic value per share is $35.24, computed as $6,065 million / 172.1 million shares.

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a. The price to NOPAT ratios for KLA Tencor and Lam Research are 14.53 and 8.84,

respectively.

companies more heavily if we believe its ratio is more relevant for valuing Applied Materials. Applied Materials’ estimated company intrinsic value is $18,599 million, using a 11.69 multiple.

Applied Materials’ estimated equity intrinsic value is $18,394 million, computed as $18,599 million minus debt of $205 million.

Its estimated equity intrinsic value per share is $13.63, computed $18,394 million / 1,350 million shares.

E15-24. (20 minutes)

a. The price to net income ratios for KLA Tencor and Lam Research are 14.53 and 8.42,

respectively.

companies more heavily if we believe its ratio is more relevant for valuing Applied Materials. Applied Materials’ estimated equity intrinsic value is $18,024 million, using an 11.48 multiple on net income.

Applied Materials’ estimated equity intrinsic value per share is $13.35, computed as $18,024 million / 1,350 million shares.

E15-25. (20 minutes)

a. Using the average forward PE ratio for MSI and ERIC of 14.75, the estimated intrinsic value

for Nokia is $2.95, computed as 14.75 x $0.20.

b. Nokia’s actual share price of $8.06 is significantly higher than the estimated intrinsic value of

$2.95 from part a. This result suggests that Nokia’s stock is overvalued, meaning the market likely expects its earnings to increase in the future.

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E15-26. (15 minutes)

a. The important thing is to select firms that are as similar as possible to McCormick on the

dimensions of profitability, growth, and risk. On this basis, CAG and FLO are most comparable.

b. TSN has had high recent earnings growth and low risk. Thus, it is a poor match for

McCormick.

E15-27. (15 minutes)

a. The important thing is to select firms that are as similar as possible to Kellogg’s in terms of

expected growth and risk. General Mills and ConAgra are closer to Kellogg’s on these dimensions than are Bunge and Hormel.

b. Bunge exhibits overly low recent earnings and high expected growth, and Hormel exhibits

high expected growth and low debt to equity. Both are different from that exhibited by Kellogg.

E15-28. (20 minutes)

a. Instructor note: There is more than one reasonable answer to this question. The important point is to select companies that are as similar as possible to Men’s Wearhouse on the basis of profitability, growth, and risk.

One reasonable solution would be to eliminate GES, JNY, and ANF on the basis of their negative historical earnings growth rates. We also could eliminate ZUMZ and TLYS on the basis of leverage. Only FRAN and SSI are eliminated due to the much higher or lower accounting profitability. Thus, this would leave GCO, ASNA, and EXPR as three good comparables for Men’s Wearhouse.

b. The comparables have an average PB ratio of 2.64. Multiplying MW’s book value of $1,096

million by the 2.64 market multiple yields an estimate of its equity intrinsic value of $2,893 million.

c. The comparables have an average PE ratio of 11.89. Multiplying MW’s earnings estimate of

$117.2 million by the 11.89 market multiple yields an estimate of its equity intrinsic value of $1,394 million.

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a. Instructor note: There is more than one reasonable answer to this question. The important point is to select companies that are as similar as possible to Fossil, Inc., on the basis of profitability, growth, and risk.

One reasonable solution would be to eliminate ZQK, SKX, PERY and ANF on the basis of their ROE. On the basis of earnings growth rates, we could eliminate GES, UNF, and WWW. In reviewing, DECK, RL and GPS they do not need to be eliminated on the basis of leverage. Thus, DECK, RL and GPS appear to be three good comparables for Fossil.

b. The comparables have an average PB ratio of 4.23. Multiplying Fossil’s equity value of

$2,894 million by the 4.23 market multiple yields an estimate of its equity intrinsic value of $12,242 million.

c. The comparables have an average PE ratio of 14.70. Multiplying Fossil’s earnings estimate

of $399 million by the 14.70 market multiple yields an estimate of its equity intrinsic value of $5,865 million.

E15-30. (25 minutes)

a. The theoretically correct PE ratio for a firm with zero expected growth in residual income

equals the capitalization rate, which is ([1+re] / re). Consequently, the PE for companies A

through E follows:

Company Cost of equity capital PE

A... 6% 17.67 B... 9% 12.11 C... 12% 9.33 D... ... 15% 7.67 E... 18% 6.56

b. A company with a cost of capital of 10% and no expected growth in residual income would

have a PE ratio of 11. A company with a cost of capital of 2% and no expected growth in residual income would have a PE of 52. Consequently, we could explain the range by claiming that all companies had a cost of capital between 2% and 10%. However, 2% seems implausibly low for a cost of capital, and 10% does not seem sufficiently high for a risky company. Therefore, it appears that differences in expectations about future residual income must explain a fair amount of the variation in PE ratios.

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E15-31. (20 minutes)

To determine ROE, we follow three steps:

First, for us to earn a minimum 12% return on investment (ROE), Google’s market cap would have to increase to $722.5 billion five years from now—computed from $409.98 billion x (1.12)5_.

Second, for the market cap to be 3.0 times book value, book value must be $240.8 billion— computed as $722.5 billion / 3.0 times.

Third, for book value to increase from $87.31 billion to $240.8 billion in five years, ROE would have to average approximately 22.5%—solving for ROE from the following relation: $87.31 billion x (1 + ROE)5_{= $240.8 billion.}

E15-32. (20 minutes)

One likely explanation for the relation between prices is that the companies with negative 5% growth in net operating assets do not have growth opportunities and, thus, are not expected to have increases in future residual operating income.

Another way to see this is to consider the companies with 34% growth in net operating assets. These companies would appear to be expanding, thus, we can expect growth in future residual operating income.

E15-33. (25 minutes)

Our first step is to compute current ROE by dividing PB by PE, which results in the Ps cancelling out and we are left with EB, which is ROE. Then, we recognize that the PB ratio should correlate with future ROE; thus, we can infer the direction of the change in earnings as well as the level of future profitability. This results in the following matches.

PB PE ROE Description

5 3 167% E . 1. High current profitability, earnings expected to decline but profitability will remain high

1.5 12 12.5% B . 2. Average current profitability, profitability expected to remain at the average

1.5 40 3.8% C . 3. Low current profitability, earnings expected to increase but future profitability will be about average

4 15 27% D . 4. High current profitability, profitability will remain high 0.7 3 23% A . 5. High current profitability, earnings expected to decline

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Instructor note: There are alternative ways to solve for the missing values; solutions will

differ slightly due to rounding.

a. To find common shares outstanding, we divide market cap by stock price per share—see

results below.

b. To find total book value of equity, multiply common shares outstanding (from a) by the book

value per share—see results below.

c. To find EPS, we divide stock price per share by the trailing four quarters PE ratio—see

results below.

d. To find ROE, we divide EPS (from part c) by book value per share—see results below.

Company Market Cap ($ mil.) Stock Price PB Current BV per Share Trailing 4Q PE CSO (sh) Book

Value* EPS ROE*

Alcoa $ 30,016 $35.39 1.89 $18.34 11.88 848 $ 15,552 $2.98 0.16 Boeing 67,578 87.19 10.55 8.44 16.80 775 6,541 5.19 0.61 Citigroup 148,886 29.89 1.17 25.86 8.03 4,981 128,809 3.72 0.14 Coca-Cola 143,928 62.28 7.32 8.51 23.59 2,311 19,667 2.64 0.31 McDonalds 69,534 58.79 4.65 12.63 21.22 1,183 14,941 2.77 0.22 3M 60,261 84.49 5.49 15.35 17.24 713 10,945 4.90 0.32 Wal-Mart 191,630 47.85 3.04 15.57 15.90 4,005 62,358 3.01 0.19 Exxon Mobil 503,364 92.13 4.24 21.68 13.47 5,464 118,460 6.84 0.32

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PROBLEMS

P15-35. (40 minutes) a. Identification of comparables Ticker Market Cap ($ mil.) PB Current EPS 5-Year Historical Growth Rate ROE (T 4Q) Debt-to-Equity (Prior Q) Basis of Exclusion: Profitability Growth Financial Risk GIB - - 20.65% 15.99% 0.73 EQIX 9,380 3.84 7.72% 3.84% 1.61 X JCOM 2,310 3.20 11.60% 16.53% 0.35 XXIA 933 1.87 60.34% 4.68% 0.40 QNST 294 1.24 -15.91% -18.89% 0.36 X X VOCS 269 2.93 -24.05% -12.57 % 0.01 X X X NTES 8,650 2.74 26.59% 24.86% 0.05 X ULTI 4,740 25.41 47.25% 16.86% 0.04 X DMD 498 1.01 9.50% -0.81% 0.10 DRIV 554 1.41 -17.73% -4.44% 0.75 X X

To value a firm as a multiple of book value using comparable firms, the comparable firms should be selected so that they have similar profitability, growth, and risk. In doing so, we know we are not going to find perfect matches, but seek to exclude the firms that are most different from our firm of interest. On this basis, we exclude 6 of the 9 firms, which leaves JCOM, XXIA, and DMD to provide the basis for valuing GIB.

b. Estimate of equity intrinsic value

GIB’s equity intrinsic value = GIB’s book value x PB ratio $8,010 million = $3,946 million x 2.03

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c. Memorandum to superior

MEMORANDUM TO:

FROM: SUBJECT:

The body of the memorandum should make the following points:

I estimated GIB’s intrinsic value at $8,010 million; computed as its book value of $3,946 million times a PB market multiple of 2.03.

To value a firm as a multiple of book value using comparable firms, the comparable firms should be selected so that they have similar profitability, growth, and risk. On this basis, I excluded 6 of the 9 firms, which leaves JCOM, XXIA, and DMD to provide the basis for valuing GIB. I have indicated on the attached table the reasons for excluding the other firms.

If you wish, I can prepare models using other valuation techniques, including discounted cash flows and discounted residual operating income. These models incorporate estimates of future cash flows and earnings for GIB. If we have a good handle on GIB’s future prospects, these models can generate more dependable estimates of intrinsic value.

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P15-36. (40 minutes)

a. Identification of comparables

Ticker Market Cap($ mil.) ForwardPE

EPS 5-Year Historical

Growth Rate (T 4Q)ROE

Debt-to-Equity (Prior Q)

Basis of Exclusion: Growth FinancialRisk

GIB - - 20.65% 15.99% 0.73 EQIX 9,380 33.30 7.72% 3.84% 1.61 X JCOM 2,310 13.31 11.60% 16.53% 0.35 XXIA 933 13.03 60.34% 4.68% 0.40 QNST 294 14.40 -15.91% -18.89% 0.36 X VOCS 269 33.09 -24.05% -12.57% 0.01 X NTES 8,650 9.86 26.59% 24.86% 0.05 X ULTI 4,740 67.40 47.25% 16.86% 0.04 X DMD 498 26.43 9.50% -0.81% 0.10 DRIV 554 29.06 -17.73% -4.44% 0.75 X

To value a firm as a multiple of PE using comparable firms, the comparable firms should be selected so that they have similar growth and risk. In doing so, we know we are not going to find perfect matches, but seek to exclude the firms that are most different from our firm of interest. On this basis, we exclude 6 of the 9 firms, which leaves JCOM, XXIA, and DMD to provide the basis for valuing GIB.

b. Estimate of equity intrinsic value

GIB’s equity intrinsic value = GIB’s earnings estimate x PE ratio

$15,251 million = $867 million x 17.59

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c. Memorandum to superior

MEMORANDUM TO:

FROM: SUBJECT:

The body of the memorandum should make the following points:

I estimated GIB’s intrinsic value at $15,251 million; computed as its earnings estimate of $867 million times a PE market multiple of 17.59.

To value a firm as a multiple of earnings using comparable firms, the comparable firms should be selected so that they have similar growth and risk. On this basis, I excluded 6 of the 9 firms, which leaves JCOM, XXIA, and DMD to provide the basis for valuing GIB. I have indicated on the attached table the reasons for excluding the other firms.

If you wish, I can prepare models using other valuation techniques, including discounted cash flows and discounted residual operating income. These models incorporate estimates of future cash flows and earnings for GIB. If we have a good handle on GIB’s future prospects, these models can generate more dependable estimates of intrinsic value.

A cordial closing that indicates willingness to discuss the issue further would be appropriate.

P15-37. (40 minutes)

a. The price to net operating assets ratios for Kohl’s and Wal-Mart are 3.7 and 2.4,

respectively.

b. A simple average of the two ratios from part a is 3.1. We could weight one of the two

companies more heavily if we believe its ratio is more relevant for valuing Target.

Target’s estimated company intrinsic value is $79,521 million, using a 3.1 multiple from net operating assets. Target’s estimated equity intrinsic value is $69,412, and its estimated equity intrinsic value per share is $81.

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P15-38. (40 minutes)

a. The price to NOPAT ratios for Kohl’s and Wal-Mart are 20.1 and 17.8, respectively.

b. A simple average of the two ratios is 19.0. We could weight one of the two companies more

heavily if we believe its ratio is more relevant for valuing Target. Target’s estimated company intrinsic value is $60,021 million, using an 18.9 multiple. Target’s estimated equity intrinsic value is $49,912 and its estimated equity intrinsic value per share is $58.

c. The price to net income ratios for Kohl’s and Wal-Mart are 20.3 and 16.3, respectively. d. A simple average of the two ratios is 18.3. We could weight one of the two companies more

heavily if we believe its ratio is more relevant for valuing Target. Target’s estimated equity intrinsic value is $51,002, using a 18.3 multiple on net income. Target’s estimated equity intrinsic value per share is $59.

P15-39. (20 minutes)

a. Instructor note: There is more than one reasonable answer to this question. The important point is to select companies that are as similar as possible to Marinemax on the basis of profitability, growth, and risk.

One reasonable solution would be to eliminate BC, JAKK and PII on the basis of profitability. PII has a much higher historical growth rate than the others and we could eliminate it for that reason (we might also eliminate CPRT and BC due to the earnings growth rate). JAKK and POOL have higher leverage and should be eliminated. Thus, this leaves CPRT and CKH as two good comparables for Marinemax.

b. The comparables have an average PB ratio of 3.34. Multiplying HZO’s book value per share

of $9.31 by the 3.34 market multiple yields an estimate of HZO’s equity intrinsic value per share of $31.10.

c. The comparables have an average PE ratio of 18.91. Multiplying HZO’s earnings estimate

of $0.58 by the 18.91 market multiple yields an estimate of HZO’s equity intrinsic value per share of $10.97.

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Preliminary computation: PB ratio = 2.95; PB* = PB – 1 = 1.95

a. Solve for implied growth rate

Assumed parameters

ROE 18.0%

Discount rate, re 8.0%

Implied parameter

Growth rate, (re + [PB* × re] - ROE) / PB* 2.9%

b. Solve for implied discount rate

Assumed parameters

ROE 18.0%

Growth rate, g 3.0%

Implied parameter

Discount rate, (ROE + [PB* × g]) / (1+PB*) 8.1%

c. Solve for implied future ROE

Assumed parameters

Growth rate, g 3.0%

Implied parameter

ROE, (PB* × [re – g]) + re 17.8%

d. Recall that this valuation model assumes a constant ROE and a growth rate in perpetuity. In

case a, the implied growth rate is 2.9% (this is growth in residual income, not income). In case b, the implied discount rate seems plausible. In case c, the ROE is what Wolverine has achieved recently. Thus, the market expectations underlying the observed PB ratio seem reasonable.

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P15-41. (40 minutes)

Preliminary computation: PB ratio = 1.78; PB* = PB - 1 = 0.78

a. Solve for implied growth rate

Assumed parameters

ROE 11.0%

Implied parameter

Growth rate, (re + [PB* × re] – ROE) / PB* 6.4%

b. Solve for implied discount rate

Assumed parameters

ROE 11.0%

Growth rate, g 4.0%

Implied parameter

c. Solve for implied future ROE

Assumed parameters

Growth rate, g 4.0%

Implied parameter

ROE, (PB* × [re – g]) + re 12.9%

d. Recall that this valuation model assumes a constant ROE and a growth rate in perpetuity. In

case a, the implied growth rate is 6.4% (this is growth in residual income, not income), which might be difficult to sustain. In case b, the implied discount rate seems reasonable. In case c, the ROE is higher than what CVS has achieved recently. Thus, the market expectations underlying the observed PB ratio might be difficult to obtain. It is possible that investors are assuming that CVS’s acquisition of Caremark will substantially improve its performance going forward.

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Preliminary computations

PB ratio observed = 4.69; PB* = PB – 1 = 3.69 Case 1: Solve for implied growth rate

Assumed parameters

ROE 15.0%

Implied parameter

Case 2: Solve for implied discount rate Assumed parameters

ROE 15.0%

Growth rate, g 8.0%

Implied parameter

Case 3: Solve for implied future ROE Assumed parameters

Growth rate, g 8.0%

Implied parameter

ROE, (PB* × [re – g]) + re 17.4%

a. Case 1: The growth rate implied is 8.6%. b. Case 2: The discount rate implied is 9.5%. c. Case 3: The future ROE rate implied is 17.4%.

d. Recall that this valuation model assumes a constant ROE and a growth rate in perpetuity.

Google’s ROE and growth have been high in recent years, but it is unlikely that these can be sustained over very long horizons. It is more likely that Google’s valuation is explained by several more years of hyper-growth, likely followed by a reversion to economy-wide norms.

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P15-43. (40 minutes)

a. This analyst mentions considering a PE multiple to value Disney.

b. The price target for Disney is $85; and, at the date of this report, Disney’s stock price was

$71.05.

An investor would realize a 19.6% return if the company actually achieved the target within 12 months.

c. This analyst estimates Disney’s earnings by considering expected sales growth including

separate analysis by major segment. The analyst also considers expected margins in each of these segments in determining their contribution to Disney’s earnings. After determining an estimated earnings per share, the analyst applies a PE multiple to obtain a price target of $85. This analyst believes the multiple is justified after consideration of Disney’s business and competitive environment historically and relative to peers.

d. The analyst appears to have spent effort learning about Disney’s business and competitive

environment. An analysis of recent financial information has been conducted, followed by the preparation of forecasts focusing on growth in sales and the associated profit margins. These steps mirror those shown in our study of financial statement analysis. Without an understanding of the differing elements of Disney’s product lines (theme parks, broadcasting, and retail stores) one could misconstrue the growth that has been recently occurring for the company and the effects of the overall economy.

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D15-44. (35 minutes)

a. The price to net operating assets ratios for Ralph Lauren and Gap are 3.45 and 5.70,

respectively.

b. The simple average of the two ratios is 4.58. You could weight one of the two companies

more heavily if you believe its ratio is more relevant for valuing Guess.

Guess’ estimated intrinsic company value is $3,508 million, using a 4.58 multiple on net operating assets.

Guess’ estimated equity intrinsic value is $3,829 million, and its estimated equity intrinsic value per share is $44.84.

c. The price to book value ratios for Ralph Lauren Gap are 2.73 and 5.27, respectively.

d. The simple average of the two ratios is 4.00. You could weight one of the two companies

Guess’ estimated equity intrinsic value is $4,348 million, using a 4.00 multiple on book value. Guess’ estimated equity intrinsic value per share is $50.91.

D15-45. (35 minutes)

a. The price to NOPAT ratios for Ralph Lauren and Gap are 12.00 and 12.55, respectively. b. The simple average of the two ratios is 12.28. You could weight one of the two companies

Guess’ estimated company intrinsic value is $2,260 million, using a 12.28 multiple.

Guess’ estimated equity intrinsic value is $2,581 million and its estimated equity intrinsic value per share is $30.22.

c. The price to net income ratios for Ralph Lauren and Gap are 13.77 and 13.45, respectively. d. The simple average of the two ratios is 13.61. You could weight one of the two companies

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D15-46. (25 minutes)

a. Guess and Ralph Lauren have similar operating profitability, which implies a good

profitability match. Gap has much higher RNOA.

Guess is much similarly leveraged to Ralph Lauren while GAP has much higher leverage, which implies Gap would be a poor financial risk match.

Finally, we have no data on the growth of the firms, so we do not know how well matched they are on that dimension.

b.

TO: ________, Senior Analyst FROM: DATE:

SUBJECT: Further considerations when applying valuation multiples

Using the method of comparables, with Ralph Lauren and Gap as the reference firms, I estimated Guess’ equity intrinsic value per share to be between $28 and $51.

To value a firm as a multiple of book value using comparable firms, the comparable firms should be selected so that they have similar profitability, growth and risk. To value a firm as a multiple of earnings the firms should have similar growth and risk. Ralph Lauren has similar RNOA and leverage to Guess, but Gap is more highly leveraged and we have no data on their growth. If you would like, I can prepare models using other valuation techniques, including discounted cash flows and discounted residual operating income. These models incorporate estimates of future cash flows and earnings for Guess. If we have a good handle on Guess’ future prospects, these models may generate more dependable estimates of intrinsic value.

c. There are a range of possible answers to this question. However, one should definitely

eliminate APO due to negative expected growth and HD, CAB, and DDS whose expected growth rates exceed 15%. If you are comfortable with the analysts’ forecast of 4.3% earnings growth for Guess, then it would also make sense to eliminate HBI, TJX, ZQK and ANF with growth rates over 10%. FL and MW have very low leverage, so they might be eliminated. This leaves only PERY and KSS.

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d.

PB ratio observed = 2.32; PB* = PB – 1 = 1.32 Case 1: Solve for implied growth rate

Assumed parameters

ROE 14%

Discount rate, re 11%

Implied parameter

Case 2: Solve for implied discount rate Assumed parameters

ROE 14%

Growth rate, g 5%

Implied parameter

Case 3: Solve for implied future ROE Assumed parameters

Discount rate, re 11%

Growth rate, g 5%

Implied parameter

ROE, (PB* × [re – g]) + re 18.9%

a. Case 1: See table; the implied growth rate is 8.7%. b. Case 2: See table; the implied discount rate is 8.9%. c. Case 3: See table; the implied ROE is 18.9%.

Remember that this valuation model assumes constant ROE and a growth rate in perpetuity. In case 1, the growth rate of 8.7% (remember this is growth in residual income, not income) implies that Guess has many investment opportunities. In case 2, the discount rate seems implausibly low given for the current market and Guess beta of 1.74. In case 3, the ROE is much higher than Guess’ current ROE. These findings, however, do not imply that Guess is irrationally priced. More careful modeling of its future profitability, growth, and risk is required to draw such a conclusion.

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D15-47. (30 minutes)

a. The numerator of this ratio is impacted primarily by assets that are recorded below market

value and also by assets that are not recorded by accounting such as intangibles or items created through R&D. The denominator being R&D expense provides the clue that this ratio is seeking to measure the valuation of items by the market created through R&D efforts which are not included on the balance sheet. In industries for which R&D plays a significant role, determining their value is an important element of valuation as the current accounting standards do not allow these items to be recorded as assets.

b. Of the companies you are currently following the obvious candidate is Pfizer as they are

primarily a research oriented pharmaceutical company whose value will be greatly affected by the success of their R&D efforts. The other company that would be engaging a large amount of R&D is Procter & Gamble as they attempt to create new products or expand existing product lines.

c.

TO: ____, Senior Analyst FROM:

DATE:

SUBJECT: Considerations when applying industry-based multiples

Using the method of comparables with the suggested multiple of (Price – Book) / R&D Expense must be done with caution. The choice of comparable companies will be key and should be done to match types of products as closely as possible. For example, when looking at Pfizer, companies researching drugs specific to certain applications may be valued differently than those seeking drugs with broad usage.

Another element of the use of this ratio is that it implies that all differences between price and book arise due to the R&D efforts. However, if a company’s accounting is conservative, there will be a difference not attributable to the R&D. This must be considered when using this multiple. To value a firm using multiples, the comparable firms should be selected so that they have similar profitability, growth and risk.

If you would like, I can prepare models using other valuation techniques, including discounted cash flows and discounted residual operating income. These models incorporate estimates of future cash flows and earnings for the companies. If we have a good handle on their future prospects, these models may generate more dependable estimates of intrinsic value.

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a. This analyst is applying an EBITDA multiple to estimate the enterprise value of Marriott. b. The price target for Marriott is $43; and, at the date of this report, the Marriott’s stock price

was $54.23.

An investor would realize a 20.7% negative return if the company actually achieved the target within 12 months.

c. This analyst estimates Marriott’s earnings for 2013 and 2014 to be $2.01 and $2.29 per

share, respectively. The analyst applies a 13.0 EBITDA multiple to obtain a price target of $43. This analyst believes the higher than average, but lower than historical, multiple is justified because of Marriott’s international operations.

d. One alternative is to apply a RevPAR multiple using the data disclosed in the MD&A section.

The analyst references this industry based multiple which looks at revenue per available room. This data could be obtained for Marriott’s competitors, and then the RevPAR multiple could be used to value Marriott.