Behavioral Corporate Finance 1e Hersh Shefrin Solutions Manuals 9780072848656
Chapter Two
Valuation
1. Mary Meeker’s price-to-sales valuation for eBay is premised on the same assumption as her P/E-based analysis. In both analyses, she assumes that eBay’s earnings per share will grow to $2.26 in 2005. Because Meeker assumes that earnings are 2.2 percent of GMS, earnings of $2.26 per share are associated with GMS per share of $103.88. Yet the P/E-based heuristic and price-to-sales based heuristic produce very different target values for eBay’s stock. Discuss what the two heuristics have in common, and what features lead them to produce different valuations.
Answer: In her P/E-based analysis, Meeker uses a P/E ratio of 40. Her price-to-sales valuation assumes that EPS will be $2.26 in 2005, and concludes that P will be $156 at year-end 2004. Therefore her implicit forward P/E (for year-end 2004) is 69.4 (=156/2.26). This means that Meeker uses a P/E ratio in her price-to-sales analysis that is 1.7 times as large as the P/E ratio she used in her P/E-based analysis. Not surprisingly, the valuation she obtains in her price-to-sales valuation is 1.7 times the valuation that she obtains for her P/E-based valuation.
2. The Prudential analysts valuing eBay justify the P/E values in their analysis by appeal to PEG. Their report states that their assumptions of a P/E of 75 to multiply 2003 earnings, and a P/E of 50 to multiply 2004 earnings
… equates to P/E/G ratios of 1.5 and 1.0, respectively, which we believe are reasonable, compared with those of other growth companies. We note that the S&P 500 currently trades at approximately 16.5 times forward-year earnings, equating to a P/E/G ratio of 1.3.
Discuss the reasoning of Prudential analysts.
Answer: PEG has no basis in fundamental analysis. Nevertheless, the Prudential analysts are typical in believing that PEG ratios are stable determinants that relate the P/E of a firm’s stock to its forecasted growth rate, with the constant of proportionality being roughly the same across firms.
3. In her report, Mary Meeker uses a PEG ratio of 1.5, and assumes that the required return on eBay stock is 12 percent. She also assumes that the firm plows back all of its earnings. Suppose that the present value of eBay’s growth opportunities amounted to zero in April 2003. Use the traditional textbook approach to compute the intrinsic value of PEG, and compare it to the value in Meeker’s report.
Answer: Assuming that the dividend payout ratio d=0, intrinsic PEG, is computed as follows. Theoretically, for a firm having zero growth opportunities, P/E is 1/r. Growth rate g is the product of ROE and the plowback ratio, which is ROE x (1-d) = ROE. If eBay has zero growth opportunities, then ROE = r. Therefore, PEG = (1/r)/100r = 1/(100 x r2). The value turns out to be PEG = 1/(100 x 0.122) = 0.69.
4. The column “Ahead of the Tape” that appeared in the February 13, 2004 issue of The Wall Street Journal states that prudent investors prefer to value firms using free cash flow instead of EBITDA. The article explains that the typical definition of free cash flow is cash flow from operations minus capital expenditure, not EBITDA minus capital expenditure. Discuss these comments.
Answer: The article is correct in saying that free cash flow is not EBITDA minus capital expenditures. However, free cash flows are not cash flow from operations minus capital expenditure either. Missing items to be subtracted from cash flow from operations also include change in net working capital and change in short-term debt. Moreover, the change in net working capital needs to include change in cash.
5. Analyst Safa Rashtchy’s developed his 2010 forecast for eBay’s revenue by assuming that its annual growth would to about a 30 percent compounded annual growth rate between 2002 and 2010. In the previous year, eBay’s revenue had grown at the rate of 62 percent, and the firm forecast that its revenue would increase by 58 percent in 2003. Which, if any, of the behavioral elements described in chapter 1 might have affected Rashtchy’s long-term forecast?
Answer: A strong candidate is bias stemming from anchoring, in that predicting a 30 percent annual growth rate over an 8-year period was anchored on eBay’s growth rate of 62 percent in 2002 and its growth rate forecast of 58 percent for 2003.
6. Consider the following excerpt from a Prudential report on Wal-Mart, dated May 13, 2003. The report states:
We are maintaining our Hold rating on Wal-Mart as we believe the stock’s current valuation of 28 times our 2003 EPS estimate of $2.01 adequately reflects the company's 13% 5-year EPS growth rate… Wal-Mart is currently trading at 28.2 times our 2003 EPS estimate of $2.01, a 57% premium to S&P 500. This is not far from the retailer's five-year average high premium of 59%. The stock is also close to its 52-week high of $59.30, achieved in May 2002. It is difficult for us to envision investors paying an even larger premium, particularly for 13% projected grower. We believe the stock will continue to hover around a 55% premium to the market multiple or 27.9 times. Using this valuation and our 2003 EPS estimate of $2.01 yields a 12-month price target of $56, up from $55.
Discuss the merits of the valuation technique mentioned in this excerpt, with reference to the contents of the chapter. Base your discussion on the following questions.
Answers: Note: answers are in parentheses after question.
· Is using a heuristic necessarily wrong in respect to valuation? (If this analysis is fundamentally based, then it is wrong. The premium (P/E of eBay relative to the P/E of the S&P 500) should be based on required return and growth opportunities, not historical averages).
· Do you think eBay is an anomalous case, and there are situations where the use of heuristics makes sense? (Assessing market value might be different from assessing fundamental value. Using heuristics when assessing market value might be appropriate if other investors rely on heuristics.)
· Is valuation part science and part art? (Yes, since valuation relies on forecasts of the future, and this task involves both art and science.)
· What advice would you give financial managers when it comes to valuing their firms? (Use textbook techniques as well as crude heuristics and be clear about the relative merits of each.)
Minicase: Palm
1. On the basis of the data presented in the case, use the textbook techniques to compute the fundamental value of Palm on February 23, 2001. The file Chapter 2 answer template.xls is a spreadsheet that is set up along the lines of the textbook valuation of eBay’s stock in the text.
Answer: The following tables describe the calculation of Palm’s intrinsic value FVE.
The computation above shows that earnings are 26 percent of prior year book value of equity for six years out, and then fall to 16 percent of prior year book value. Dividends are zero during the first six years, and then become positive when the payout ratio changes from 0 percent to 50 percent. All the value stemming from dividends comes from Year 7 on.
The $4,444,230,560 value at the end of period 6 is in Year 6 dollars. To convert to Year 5 dollars, form the present value by dividing by 1.16. To convert to Year 0 dollars, divide by 1.166. This results in a Year 0 valuation of $1,824,100,011, which on a per share basis amounts to $3.22.
As was mentioned in the minicase, Palm held $742.9 million in cash in early 2001. On a per share basis, this amounted to $1.31. Adding together the cash per share and the $3.22 from above produces a sum of $4.54 per share. If none of the cash is needed to produce the future earnings stream, then Palm’s intrinsic value would be $4.54 per share. If all of the cash is needed to produce the future earnings stream, then Palm’s intrinsic value would be $3.22 per share.
- Compare the ratio of the fundamental value per share that you computed in the previous question to Palm’s market price per share (for February 23, 2001).
Answer: On February 23, 2001 Palm’s market price was $21.688. Assuming that all of its cash will be used to fund future earnings, Palm’s fundamental value can be taken to be $3.22. The associated ratio is 3.22/21.688 = 0.148. Therefore, its fundamental value, based on the assumptions articulated by Palm’s CFO’s, represented about 15 percent of its market capitalization. That is, the assumptions made by Palm’s CFO did not support Palm’s intrinsic value at the time equating to its market capitalization.
- Compare Palm’s market P/E on February 23, 2001 with the fundamental P/E you derive.
Answer: The fundamental forward P/E for Palm is obtained by dividing its FVE (from question 1 of the minicase) to the forecasted earnings in Year 1. This leads to
P/E = 1,824,100,013/288,766,400 = 6.3
In contrast, Palm’s forward market P/E was 145 and its trailing P/E was 180.7.
- Analyze the approach that Palm’s CFO took in trying to ascertain whether or not Palm was fairly valued in February 2001.
Answer: Presumably fair value means fundamental or intrinsic value. Many executives rely on valuation heuristics such as those used by Palm’s CFO. Price-to-sales and trailing P/E do not provide the basis for computing fundamental value. Fundamental value derives from total cash flows, including costs, not just cash flow from sales. Indeed, sales itself is not a cash flow item, and usually needs to be adjusted by the change in accounts receivable to obtain a cash flow. Trailing P/E uses past earnings, whereas the P/E heuristic uses forward looking earnings.
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