FI 491 Lecture Notes - Lecture 44: Mutual Fund
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International Research Journal of Applied Finance ISSN 2229 â 6891
Vol. VI Issue â 8 August, 2015 Case Study Series
A Stock Valuation Case: An Application of the âMethod of Comparablesâ for Macyâs Shares
Halil D. Kaya* ,Julia S. Kwok
Abstract
The primary focus of this case is the application of the âMethod of Comparablesâ in the estimation of the value of a security. An investment decision will be made based on the comparison of the selling price and the estimated value. A security will be good for purchase if the estimated value is higher than the market price. This method utilizes basic financial ratios that are commonly provided by financial web sites. First, using Yahoo Finance website, the pricing, sales, book value of equity and shares outstanding data are collected for both the target firm and the competitor firms. Then, the pricing multiples (i.e. price earnings ratio, price to sales ratio and price to book ratio) of the competitors are calculated. After that, those multiples along with the target firmâs earnings, sales, book value and shares outstanding data are used to estimate target firmâs share value. The case also examines the impact of treating ânegativesâ in the data. Students will learn that replacing negative earnings with zeros tend to induce less bias in target firmâs value estimation than excluding the ânegativeâ data altogether.
Introduction
March 14, 2015 was a sunny day. Mary took advantage of the nice weather to have lunch at the Mall. On her way back to work, she walked by Susanâs investment office. Susan was Maryâs college roommate. They both liked shopping together to find new fashionable clothes. Looking at her watch, Mary realized she had half an hour to spend. She thought she would drop by and say hello to Susan.
The Performance of Macyâs
âHi, Susan, how are you?â How is your business?â said Mary. Susan was a recent finance graduate. Susan replied, âI am doing fine. Thank you. After so many years, the market is still recovering from the mortgage crisis; many investors have been buying back stocks that they have sold during the crisis. What are you up to?â âI want to start my investment in securities, too. I have a couple thousand dollars, would Macyâs be a good stock to invest in now? That was our favorite store to shop among all of the department stores,â Mary exclaimed. She added, âAlso, I read from Motleyâs Foolâs article on Macyâs today about its earnings per share growth for the last 16 quartersâ (Zahid Waheed, 2014).
In response to Maryâs questions, Susan checked the monthly adjusted returns of Macyâs in Yahoo Finance. She found that, since March 2010, Macyâs stock price had an average annual increase of 23.5% over the last 5 years. The stock rose from $19.98 to $57.38. Susan then told Mary that Macyâs was indeed a growing stock. She added that its success could be attributed to the omni-channel integration, e-commerce and magic selling strategies which allowed merging of sales channels, online shopping and better customer care. Since investment strategy 101 is to buy low, and sell high, given Macyâs stock price had been going up, Susan was not sure whether Macyâs was currently overvalued or undervalued by the market.
The Method of Comparables
Susan remembered her class lecture on the two types of valuation of stocks, namely absolute and relative evaluation. The absolute evaluation focuses on finding the intrinsic value of the security based on fundamentals. That involves more complicated models of discounting cash flows from dividends, operations and residual income.
On the other hand, relative evaluation is quick and easy to use. It assumes two similar securities should sell for one price in an efficient market, i.e. âLaw of One Price.â So an analyst can estimate its stock price by multiplying target companyâs specific earnings, sales and equity value data by the earning, sales and equity âper shareâ financial multiples of its competitors.
Since Mary was not familiarized with financial models, Susan decided to use the easy-toperform-and-analyze âComparables Methodâ to estimate the relative value of Macyâs stock.
The Financial Data
Dillards, JC Penney and Nordstrom were selected as competitors of Macyâs as they were all in retail department store business. Susan would need some financial data regarding these companies. She went to SECâs (i.e. Securities and Exchange Commission) website and downloaded these companiesâ most recent balance sheet and income statement data. Out of those statements, she knew that she would need the EPS (i.e. earnings per share), the sales number, the number of outstanding shares, and the book value of equity. She also knew that she would need the current share price for each company. After some work, she had found all the necessary information to run the analysis. Below were the data that she had gathered:
All data are in US$ except for the number of outstanding shares. The share price as of March 15, 2014 is shown in the first column. The âEarnings per shareâ is shown in the second column. The third column reports the book value of equity. The last column shows the number of outstanding shares.
Firm | P ($) | EPS ($) | Sales ($) | BV of equity ($) | # of shares |
Macy's | 58.58 | 3.93 | 27,931 mil. | 6,249 mil. | 378.3 mil. |
Dillard's | 90.61 | 7.10 | 6,532 mil. | 1,992 mil. | 45.6 mil. |
JC Penney | 8.71 | -5.57 | 11,859 mil. | 3,087 mil. | 249.3 mil. |
Nordstrom | 61.33 | 3.77 | 12,166 mil. | 2,080 mil. | 194.5 mil. |
The Decision
Susan thinks that the following steps would be necessary to perform the analysis:
1.Based on the data above, calculate Sales per share, BV of equity/share values of all firms. Note that EPS is directly given.
2.Calculate P/E, P/Sales, and P/B for all of Macyâs competitors based on the data obtained.
3.Find the average of the P/E, P/Sales, and P/B multiples for the three competitors.
4.Multiply those averages calculated in step 3 with Macyâs EPS, Sales per share, and BV of equity/share values, respectively to get three value estimates for Macyâs shares.
5.The average of the three estimates would then be Susanâs best estimate of Macyâs value per share.
answer # 1-5 please
Instructions: Use the formula below to compute the problems: âPlease Read the question carefully.â
Kd = Yield (1 â T)
1. Telecom Systems can issue debt yielding 8 percent. The company is in a 35 percent bracket. What is its after-tax cost of debt?
2. After-tax cost of debt: Royal Jewelers Inc., has an aftertax cost of debt of 6 percent. With a tax rate of 40 percent, what can you assume the yield on the debt is?
3.
Cash flow: Assume a corporation has earnings before depreciation and taxes of $100,000, depreciation of $50,000, and that it has a 30 percent tax bracket. Compute its cash flow using the format below.
Earnings before depreciation and taxes _____
Depreciation _____
Earnings before taxes _____
Taxes @ 30% _____
Earnings after taxes _____
Depreciation _____
4.
Cost of preferred stock: Medco Corporation can sell preferred stock for $80 with an estimated flotation cost of $3. It is anticipated the preferred stock will pay $6 per share in dividends.
a. Compute the cost of preferred stock for Medco Corp.
b. Do we need to make a tax adjustment for the issuing firm?
5. Cost of preferred stock: The Meredith Corporation issued $100 par value preferred stock 10 years ago. The stock provided an 8 percent yield at the time of issue. The preferred stock is now selling for $75. What is the current yield or cost of the preferred stock? (Disregard flotation costs.)
6. Costs of retained earnings and new common stock: Barton Electronics wants you to calculate its cost of common stock. During the next 12 months, the company expects to pay dividends (D1) of $1.20 per share, and the current price of its common stock is $30 per share. The expected growth rate is 9 percent.
a. Compute the cost of retained earnings (Ke). Use Formula 11-6.
b. If a $2 flotation cost is involved, compute the cost of new common stock (Kn). Use Formula 11-7.
7. A firm's cost of preferred stock is equal to the preferred dividend divided by market price plus the dividend growth rate (Kp= D/Po+ g).
8. The coefficient of variation, calculated as the standard deviation of expected returns divided by the expected return, is a standardized measure of the risk per unit of expected return.
a. True
b. False
9. The standard deviation is a better measure of risk than the coefficient of variation if the expected returns of the securities being compared differ significantly.
a. True
b. False
10. The CAPM is built on historic conditions, although in most cases we use expected future data in applying it. Because betas used in the CAPM are calculated using expected future data, they are not subject to changes in future volatility. This is one of the strengths of the CAPM.
a. True
b. False
11. You have the following data on three stocks:
Stock | Standard Deviation | Beta |
A | 20% | 0.59 |
B | 10% | 0.61 |
C | 12% | 1.29 |
If you are a strict risk minimizer, you would choose Stock if it is to be held in isolation and Stock if it is to be held as part of a well-diversified portfolio.
a. A; A.
b. A; B.
c. B; A.
d. C; A.
e. C; B.
12. A portfolioâs risk is measured by the weighted average of the standard deviations of the securities in the portfolio. It is this aspect of portfolios that allows investors to combine stocks and thus reduce the riskiness of their portfolios.
a. True
b. False
13. You are considering two bonds. Bond A has a 9% annual coupon while Bond B has a 6% annual coupon. Both bonds have a 7% yield to maturity, and the YTM is expected to remain constant. Which of the following statements is CORRECT?
a. The price of Bond B will decrease over time, but the price of Bond A will increase over time.
b. The prices of both bonds will remain unchanged.
c. The price of Bond A will decrease over time, but the price of Bond B will increase over time.
d. The prices of both bonds will increase by 7% per year.
e. The prices of both bonds will increase over time, but the price of Bond A will increase at a faster rate.
14. A 12-year bond has an annual coupon of 9%. The coupon rate will remain fixed until the bond matures. The bond has a yield to maturity of 7%. Which of the following statements is CORRECT?
a. If market interest rates decline, the price of the bond will also decline.
b. The bond is currently selling at a price below its par value.
c. If market interest rates remain unchanged, the bondâs price one year from now will be lower than it is today.
d. The bond should currently be selling at its par value.
e. If market interest rates remain unchanged, the bondâs price one year from now will be higher than it is today.
15. Suppose the real risk-free rate is 3.50% and the future rate of inflation is expected to be constant at 2.20%. What rate of return would you expect on a 1-year Treasury security, assuming the pure expectations theory is valid? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.
a. 5.14%
b. 5.42%
c. 5.70%
d. 5.99%
e. 6.28%
16. Suppose 1-year T-bills currently yield 7.00% and the future inflation rate is expected to be constant at 3.20% per year. What is the real risk-free rate of return, r*? Disregard any cross-product terms, i.e., if averaging is required, use the arithmetic average.
a. 3.80%
b. 3.99%
c. 4.19%
d. 4.40%
e. 4.62%
17. Assume that interest rates on 20-year Treasury and corporate bonds are as follows:
T-bond = 7.72% AAA = 8.72% A = 9.64% BBB = 10.18%
The differences in these rates were probably caused primarily by:
a. Tax effects.
b. Default and liquidity risk differences.
c. Maturity risk differences.
d. Inflation differences.
e. Real risk-free rate differences.
18. You plan to analyze the value of a potential investment by calculating the sum of the present values of its expected cash flows. Which of the following would lower the calculated value of the investment?
a. The cash flows are in the form of a deferred annuity, and they total to $100,000. You learn that the annuity lasts for only 5 rather than 10 years, hence that each payment is for $20,000 rather than for $10,000.
b. The discount rate increases.
c. The riskiness of the investmentâs cash flows decreases.
d. The total amount of cash flows remains the same, but more of the cash flows are received in the earlier years and less are received in the later years.
e. The discount rate decreases.
19. Assume that inflation is expected to decline steadily in the future, but that the real risk-free rate, r*, will remain constant. Which of the following statements is CORRECT, other things held constant?
a. If the pure expectations theory holds, the Treasury yield curve must be downward sloping.
b. If the pure expectations theory holds, the corporate yield curve must be downward sloping.
c. If there is a positive maturity risk premium, the Treasury yield curve must be upward sloping.
d. If inflation is expected to decline, there can be no maturity risk premium.
e. The expectations theory cannot hold if inflation is decreasing.
20. Disregarding risk, if money has time value, it is impossible for the present value of a given sum to exceed its future value.
a. True
b. False