1. Lauren Entertainment, Inc., has an 18 percent annual growth rate compared to the market rate of 8 percent. If the market multiple is 18, determine P/E ratios forLauren Entertainment, Inc., assuming beta is 1.0 and you feel it can maintain its superior growth rate for:
a. The next 10 years.
b. The next 5 years.
2. You are given the following information about two computer software firms and the S&P Industrials:
_______ Company A Company B S&P Industrials
P/E ratio 30.00 27.00 18.00
Expected annual growth rate 0.18 0.15 0.07
Dividend yield 0.00 0.01 0.02
a. Compute the growth duration of each company stock relative to the S&P Industrials.
b. Compute the growth duration of Company A relative to Company B.
c. Given these growth durations, what determines your investment decision?
3. The value of an asset is the present value of the expected returns from the asset during the holding period. An investment will provide a stream of returns during this period, and it is necessary to discount this stream of returns at an appropriate rate to determine the asset's present value. A dividend valuation model such as the following is frequently used:
Pi = D1 / (ki -gi) where:
Pi = the current price of Common Stock i
D1 = the expected dividend in period 1
ki = the required rate of return on Stock i
gi = the expected constant-growth rate of dividends for Stock i
a. Identify the three factors that must be estimated for any valuation and explain why these estimates are more difficult to derive for common stocks than for bonds.
b. Explain the principal problems involved in using a dividend valuation model to value:
(1) Companies whose operations are closely correlated with economic cycles.
(2) Companies that are of very large and mature.
(3) Companies that are quite small and are growing rapidly.
Assume that all companies pay dividends.
4. The constant-growth dividend discount model can be used both for the valuation of companies and for the estimation of the long-term total return of a stock.
Assume: $20 = price of a stock today
8% = expected growth rate of dividends
$0.60 = annual dividend one year forward
a. Usingonly the preceding data, compute the expected long-term total return on the stock using the constant-growth dividend discount model.
b. Briefly discuss three disadvantages of the constant-growth dividend discount model in its application to investment analysis.
c. Identify three alternative methods to the dividend discount model for the valuation of companies.
5. An analyst expects a risk-free return of 4.5 percent, a market return of 14.5 percent, and the returns for Stocks A and B that are shown below.
Annual Cash Flow from Lease
End of Year
1 $ 0
2 lease receipts 15,000
3 lease receipts 25,000
4 sales proceeds $100,000
Present Value of $ 1
Periods 6% 8% 10% 12%
1 0.943 0.926 0.909 0.893
2 0.890 0.857 0.826 0.797
3 0.840 0.794 0.751 0.712
4 0.792 0.735 0.683 0.636
5 0.747 0.681 0.621 0.567
Stock Information
Stock Beta Analyst's Estimated Return
A 1.2 16%
B 0.8 14%
a. Show on a graph.
(1) where stocks A and B would plot on the security market line (SML) if they were fairly valued using the capital asset pricing model (CAPM).
(2) where stocks A and B actually plot on the same graph according to the returns estimated by the analyst and shown Stock Information above.
b. State whether stocks A and B are undervalued or overvalued if the analyst uses the SML for strategic investment decisions.
Discussion
I. Determine whether a steel company or a retail food chain would have a greater business risk. Provide support for your rationale.
II. Select one of the limitations of ratio analysis and indicate why you believe it is a major concern when predicting future financial performance.
III. Discuss the proposition that differences in the performance of various firms within an industry limit the usefulness of industry analysis. Provide an example of an industry where this statement holds true.
IV. Analyze an industry that you believe is in stage 2 of the industry life cycle. Provide evidence that supports your analysis.
V. From the e-Activity and based on the growth company selected, assess why it is a growth stock and if that status is sustainable.
VI. Evaluate whether or not P/E is an effective indicator of a growth stock. Suggest an alternative.
VII. Assess the gaps with the availability of information related to international markets, industries, and stocks. Recommended a strategy for investment professionals to analyze foreign markets given the data limitations.
VIII. Discuss how foreign countries' accounting differences make foreign analysis difficult and whether or not adopting a global accounting standard will elevate this difficulty. Provide support for your answer.