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  • 9.1 Introduction
  • 9.2 Key Concepts
  • 9.3 Normal Earnings
  • 9.4 AEG
  • 9.5 Cost of Capital
  • 9.6 Implied Equivalence: IBM
  • 9.7 Residual Income
  • 9.8 Entering Data via Excel
  • 9.9 Forecasting Price
  • 9.10 Sensitivity Analysis
  • 9.11 Conclusions
  • 9.12 Questions

9.12  Questions

Question 1:  The residual income approach to valuation and the abnormal earnings approach to valuation differ in terms of their relative emphasis upon the balance sheet and income statements.  Which technique places more emphasis on the income statement?  Provide support for your answer.

Question 2:  Residual income and Normal Earnings exploit the economic concept of an “opportunity cost.”  Describe how each concept exploits the concept of an opportunity cost including how they differ in how they measure opportunity costs.

Question 3:  Describe in words what Normal Earnings is.

Question 4:  What is Cum-Dividend Earnings?

Question 5:  Explain how the economic concept of opportunity costs is applied to the concept of Cum-Dividend Earnings.

Question 6:  Define abnormal earnings growth and describe its meaning in your own words.

Question 7:  Explain precisely how the economic concept of opportunity costs is applied to the concept of abnormal earnings growth. 

Question 8:  What is the relationship between abnormal earnings growth and the concept of residual earnings?

Question 9:  Suppose you are assessing the intrinsic value of a firm that pays zero accounting dividends.  Can you apply the abnormal earnings growth model to this firm?  Provide reasons in support of your answer.

Question 10:  When computing the intrinsic value of a stock using the abnormal earnings growth model an analyst identifies the earnings to be capitalized in perpetuity and divides by the discount rate (i.e., the cost of equity capital).  What are the three components that make up the earnings to be capitalized in this model?

Question 11:  Describe in words what is the Present Value of Abnormal Earnings Growth at time t.

Question 12:  Describe in words what the Present Value of Continuing Value at time t is.

Data for next few questions

For Wal-Mart, assume the following inputs for CAPM:

 

The following additional information contains the Consolidated Statement of Shareholder’s Equity and Consolidated Income Statement for Wal-Mart from their 2010 10-K filed with the SEC:

Excerpt from the Consolidated Statement of Financial Position (Year ending Jan 31, 2010, Jan 31, 2009 respectively)

Additional Information:  Total Walmart shareholders’ equity for year end Jan 31, 2008 = $64,608

Additional Information:

Total Dividends Paid

Year ending Jan 31, 2010  $4271, Year Ending  Jan 31, 2009  $3746, Year Ending  Jan 31, 2008  $3586

Non-controlling interest:  Year ending Jan 31, 2010 2180, Jan 31, 2009 1794 and Jan 31, 2008 not reported

Question 13:  By referring to the information available for this question calculate Comprehensive Income and Comprehensive Income per share for the purposes of valuing Wal-Mart for 2009.  Provide brief reasons in support of your answer.

Question 14:  Calculate the Dividend Payout Ratio relative to Comprehensive Earnings for year ending January 2010.  (Assume that outstanding common stock is the ending balance of share for Jan 2010 provided).

Question 15:  Assuming CAPM and the data provided calculate Wal-Mart’s Normal Earnings for 2010.

Question 16:  Assuming CAPM and the data provided calculate the Cum-Dividend Earnings for Wal-Mart for 2009.

Question 17:  Assuming CAPM and the data provided calculate the 2009 Abnormal Earnings Growth for Wal-Mart.

Question 18:  Assume the CAPM data provided remains constant over time, calculate the difference between Residual Income for 2009 and 2008.

Question 19:  In the light of your answers to the two previous questions are they consistent with what the predicted relationship is between Abnormal Earnings Growth for 2009 and the difference between Residual Income for 2009 and Residual Income for 2008.

Question 20:  Compute the ROCE (Return on Common Equity) for the year ending Jan 31, 2010 using Comprehensive Income for Wal-Mart.

Real World Exercise: Assessing Intrinsic Value Using the Abnormal Earnings Growth Model Approach to Estimating Intrinsic Value

Select two companies from the Current FTS Dataset that are competitors, or at least are in the same industry even if they do not directly compete with each other. 

Prepare an analysis of each stock’s intrinsic value by applying the Abnormal Earnings Growth Model of Intrinsic Value.  You should identify the major inputs you need from the Valuation Tutor’s Calculator. 

 

This model requires estimating the growth rates for projecting Comprehensive Income 1 year ahead, 2-year ahead and for the next n-years depending on how many years you define stage 1 to be and then finally the normal growth rate.  In addition, you need to assess the discount rates (i.e., cost of equity capital inputs).  It is recommended that you first refer to the real world projects at the end of chapter 4 when completing these parts.

Identify the major inputs required to assess the intrinsic value using the Abnormal Earnings Growth approach including the important assumptions you have made to come up with this assessment.  You should discuss issues that arose when implementing this model.  That is, what are the critical variables that underlie your analysis and how reliable do you assess your estimates for these variables to be when valuing your two stocks. 

What is the intrinsic value for your two stocks and what is your forecast of Expected Return (Implied Expected Return in the calculator).  These are the calculated values from the Valuation Tutor calculator.  In addition, the support working for how these numbers were arrived at is provided in a support window.  You are encouraged to refer to the text to understand where these numbers have come from.

Bottom Line Requirements:

1.   What is your bottom line analyst recommendation for your two stocks?  This should be a recommendation that can range from Strong Buy, Moderate Buy, Hold, Moderate Sell, and Strong Sell.

2.      What is you forecast for the future stock price in 1-year’s time?  Hint:  Apply the Expected Return calculated in Valuation Tutor and multiply by the spot stock price such that the forecast price equals P * (1+E(Return)^1-Year

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