Thomas Riolo is considering adding either Multifactory Ltd. or Analogesous Corp. to his equity portfolio. He has concluded that Multifactory is likely to have a higher valuation than Analogesous because of two factors:
Factor #1: Multifactory has a higher franchise factor than Analogesous.
Factor #2: Multifactory has a lower inflation pass-through than Analogesous.
Riolo is correct with respect to:
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The more positive the franchise factor and the higher the inflation pass-through, the higher the valuation of the firm.
Firm 1 and Firm 2 are both based in countries with a 3% rate of inflation. The real rate of return required by investors from both companies is 4%. Firm 1 can pass on 70% of inflation through its earnings and Firm 2 can pass on 90%. Based on the above information, which of the following statements is most accurate? Firm 1's estimated price-to-earnings (P/E) ratio is:
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Firm 1’s P/E ratio = 1 / (4% + (1 ? 70%) × 3%) = 20.41 Firm 2’s P/E ratio = 1 / (4% + (1 ? 90%) × 3%) = 23.26 Therefore, Firm 1’s estimated P/E ratio is lower than Firm 2’s.
Which of the following statements about inflation and share value is CORRECT? All other things being equal:
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The more inflation that a firm is able to pass on to its customers (higher inflation flow-through rate), the less negative impact inflation has on earnings and therefore, the value of the firm would increase. Also, the higher the inflation rate, the lower the value of the firm’s shares if full inflation pass-through does not occur (i.e., the inflation flow-through rate is less than 100%), all else equal.
Assume a simple service firm earns only service revenue and incurs depreciation as its most significant expense. In the current year, there is 3 percent inflation. However, due to government regulations, the firm is unable to pass on any of the inflation to its customers. In real terms, the firm’s net income is:
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Depreciation expense is an example of historical cost accounting (no inflation taken into account). If there is also no inflation reflected in the service revenue, then from an economic and real standpoint, the net income is correctly stated.
Nichole Wolf, CFA, is completing a DuPont model for her boss, Robert.
| NI/EBT | NI/EBIT | EBIT/Sales | Sales/Assets | Assets/Equity | ROE | |
| 2008 | 0.60 | 0.90 | 0.12 | 2.10 | 1.90 | 25.9% |
| 2009 | 0.61 | 0.92 | 0.13 | 2.15 | 1.95 | 30.6% |
| 2010 | 0.59 | 0.93 | ?? | ?? | 2.00 | 24.7% |
The missing terms are closest to:
| EBIT/Sales | Sales/Assets |
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The correct answers are 0.11 and 2.05. (0.59)(0.93)(0.11)(2.05)(2.00) = 24.7%. The two missing terms must multiply such that EBIT/Assets = 0.2255.
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