The Earnings Factory
a. According to many analysts, The Earnings Factory is a ‘darling’ of the ASX. Its current market price is $15 per share and its book value is $5 per share. Analysts forecast that the firm’s book value will grow by 10% per year indefinitely, and the cost of equity is 15%. Given these facts, what is the market’s expectation of the firm’s long-term average ROE?
b. Given the information in part a, what will be The Earnings Factory’s share price if the market revises its expectations of long-term average ROE to 20%?
c. Analysts reassess The Earnings Factory’s future performance as follows: growth in book value increases to 12% per year, but the ROE of the incremental book value is only 15%. What is the impact on the market-to-book ratio?