Equity Valuation【 Reading 39】Sample 2012

HuskyGrad2010

Multi-stage growth models can become computationally intensive. For this reason they are often referred to as:

A) spreadsheet models.

B) quadratic models.

C) R-squared models.

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The computationally intensive nature of these models make them a perfect application for a spreadsheet program, hence the name spreadsheet models.

HuskyGrad2010

Historical information used to determine the long-term average returns from equity markets may suffer from survivorship bias, resulting in:

A) deflating the mean return.

B) unpredictable results.

C) inflating the mean return.

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Survivorship bias refers to the weeding out of underperforming firms, resulting in an inflated value for the mean return.

HuskyGrad2010

Which of the following is least likely a limitation of the two-stage dividend discount model (DDM)?

A) use of one required rate of return for both stages might overstate the value.

B) most of the value is due to the terminal value, which is very sensitive to the estimates of stable growth.

C) the length of the high-growth stage is difficult to measure.

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The two-stage DDM uses a different required rate of return (cost of equity) for high-growth period (r) and steady state (rn). Most of the time r > rn, since during the stable period the firm is less risky and shareholders require a lower rate of return

HuskyGrad2010

If an investor were attempting to capture an asset’s alpha returns, the expected holding period return (HPR) would be:

A) higher than the required return.

B) lower than the required return.

C) the same as the required return.

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Alpha returns are returns in addition to the required returns, so the expected HPR would be higher than the required return.

HuskyGrad2010

an asset was fairly priced from an investor’s point of view, the holding period return (HPR) would be:

A) equal to the alpha returns.

B) lower than the required return.

C) the same as the required return.

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A fairly priced asset would be one that has an expected HPR just equal to the investor’s required return.

HuskyGrad2010

Flyaweight Foods is a vertically integrated producer and distributor of low-calorie food products operating on a consumer club model. They have enjoyed rapid growth in the southwest United States during their 5-year history and are planning rapid expansion throughout the rest of the country. To fund their expansion, they are soliciting investments from a variety of venture capital groups.
One of the groups considering a bid for Flyaweight is Angelcap Investors, a private equity fund run by Harry Moskowitz. Angelcap is interested in acquiring a 10% interest in Flyaweight.  Moskowitz’ partner, Bill Sharpless, runs the group doing due diligence on Flyaweight. He provides Moskowitz with financial data on the firm:

Table 1: Flyaweight Foods Historical Data
(Dollars per share)

	FY1	FY2	FY3	FY4	FY5
Sales per share	4.25	5.60	6.40	7.35	8.05
EPS	1.20	1.85	2.30	2.79	3.10
Dividends	0	0	0.10	0.20	0.35
Free Cash Flow	-2.50	-2.10	-1.85	-1.60	-1.25

Moskowitz suggests that a Dividend Discount Model (DDM) would be an appropriate means for valuing Flyaweight because Angelcap would be a minority shareholder. Sharpless points out that the primary advantage of using a DDM is that dividends are more stable than earnings or cash flow.
They ask Merle Muller, an analyst at the firm, to calculate an appropriate required return on Flyaweight. Muller collects the following market consensus information:

Table 2: Current Market Conditions
(Consensus estimates)

Expected 5-year EPS growth	8.0%
Expected 1-year Dividend yield	2.2%
Current Treasury yield (10-year note)	4.8%
Food industry beta (specialty segment)	0.95

Muller says, “If we assume that the beta for Flyaweight should equal the beta of the specialty food industry, then our required rate of return in less than 10%.” Moskowitz disagrees strongly with using a discount rate that low and insists on using a multi-factor model such as the Arbitrage Pricing Theory (APT) instead. Sharpless disagrees that the APT will solve the estimation problem, pointing out, “A principal limitation of both the Capital Asset Pricing Model (CAPM) and the APT is uncertainty about the correct measurement of the market and factor risk premiums.”
Sharpless argues in favor of using the Gordon Growth Model (GGM). “We know what the company growth rate is, we know what the dividend is, and we can decide what our required rate of return is. The GGM will give us the most accurate valuation because it uses the inputs we can measure most accurately.” Moskowitz points out, “An H-model would be more appropriate because it assumes a linear slowdown in growth to a constant rate in perpetuity.”
While Sharpless and Moskowitz debate the appropriate valuation approach, Muller prepares forecasts for Flyaweight.

Table 3: Forecast Values for Flyaweight

	Forecast
Average total liabilities per share	$14.40
Average owners’ equity per share	$12.70
Profit margin	29%
Sales per share	$10.70
Dividend payout ratio	10%

Judging by the data in Table 1, the most appropriate method for valuing Flyaweight would be:

A) justified P/E because it is a high-growth company.

B) residual income because the firm is likely to have high capital demands and negative cash flow for the foreseeable future.

C) the DDM because the firm has a history of dividend growth.

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A residual income model is appropriate for firms with long term negative free cash flow due to high capital demands. A DDM would not be appropriate since the dividend payout ratio is fluctuating widely. Justified P/E is not a preferred valuation method for high-growth companies because it assumes a constant growth rate in perpetuity. (Study Session 11, LOS 39.a)

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Regarding their statements about calculating a required rate of return for Flyaweight:

A) both are correct.

B) only Muller is correct.

C) only Sharpless is correct.

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Sharpless is correct that uncertainty surrounding estimates of inputs and risk premiums is a key limitation of both the CAPM and the APT. Muller is correct that the required rate of return on Flyaweight is less than 10% if the beta of the specialty foods industry is used:

Equity risk premium:

one-year dividend growth + long-term EPS growth − long-term risk free rate
Equity risk premium = 2.2% + 8.0% – 4.8% = 5.4%

Thus the required rate of return is:

Required rate of return = Risk free rate + (beta × market risk premium)
Required rate of return = 4.8% + (0.95 × 5.4)
Required rate of return = 9.9%

(Study Session 10, LOS 35.b, c, d)

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With respect to their statements about the use of the GGM and the H-model:

A) both are correct.

B) only Moskowitz is correct.

C) only Sharpless is correct.

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Moskowitz is correct that an H-model assumes a linear slowdown in growth until a constant growth rate is achieved. Sharpless is incorrect that the GGM would be an appropriate technique for valuing Flyaweight because the GGM assumes a constant rate of growth in perpetuity and Flyaweight has not yet reached a constant growth rate. (Study Session 11, LOS 39.h, i)

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Which of the following is least likely to be a characteristic of a company in the initial growth phase?

A) Low dividend payout ratio.

B) High profit margin.

C) Return on equity equal to the required rate of return.

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Companies in the initial growth phase tend to have a return on equity higher than the required rate of return, along with high profit margins and a low dividend payout. (Study Session 11, LOS 39.j)

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With respect to their statements about the use of DDMs:

A) only Moskowitz is correct.

B) only Sharpless is correct.

C) both are correct.

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Moskowitz’ statement is correct. A dividend discount approach is most appropriate when the perspective is that of a minority shareholder. Sharpless’ statement is incorrect because the primary advantage of a DDM is that it is theoretically justified. The stability of dividends is an additional advantage. (Study Session 11, LOS 39.a)

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Based on the forecast data in Table 3, Flyaweight’s sustainable growth rate (SGR) is closest to which value? If asset turnover were to rise from the forecast level, what would be the impact on SGR?  

SGR

Impact on SGR

A) 24% Increase

B) 22% Increase

C) 22% Decline

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Note that total assets for the firm must equal total liabilities plus owners’ equity, so assets are ($14.40 + $12.70) = $27.10.

Thus the Return on Equity (ROE) of the firm equals:

ROE = profit margin × asset turnover × financial leverage
ROE = (0.29) × ($10.70 / $27.10) × ($27.10 / $12.70)
ROE = 0.244 = 24.4%
ROE will rise as asset turnover rises.

The SGR of the firm equals:

SGR = retention rate × ROE
SGR = (1 – 0.10) × 0.244
SGR = 0.90 × 0.244
SGR = 0.22
The SGR of the firm is approximately 22%.
SGR will increase as rising asset turnover increases ROE.

(Study Session 11, LOS 39.n)

HuskyGrad2010

Free cash flow to equity models (FCFE) are most appropriate when estimating the value of the firm:

A) to creditors of the firm.

B) to equity holders.

C) only for non-dividend paying firms.

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FCFE models attempt to estimate the value of the firm to equity holders. The models take in to account future cash flows due to others, including debt and taxes, and amounts required for reinvestment to continue the firm’s operations.

HuskyGrad2010

Which of the following dividend discount models has the limitation that a sudden decrease to the lower growth rate in the second stage may NOT be realistic?

A) Gordon growth model.

B) H model.

C) Two-stage dividend discount model.

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The two-stage DDM has the limitation that a sudden decrease to the lower growth rate in the second stage may not be realistic. Further, the model has the difficulty in trying to estimate the length of the high-growth stage.

HuskyGrad2010

The H-model is more flexible than the two-stage dividend discount model (DDM) because:

A) initial high growth rate declines linearly to the level of stable growth rate.

B) payout ratio changes to adjust the changes in growth estimates.

C) terminal value is not sensitive to the estimates of growth rates.

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A sudden decline in high growth rate in two-stage DDM may not be realistic. This problem is solved in the H-model, as the initial high growth rate is not constant, but declines linearly over time to reach the stable-growth rate.

HuskyGrad2010

the three-stage dividend discount model (DDM) results in extremely high value, the:

A) growth rate in the stable growth period is probably too high.

B) growth rate in the stable growth period is lower than that of gross national product (GNP).

C) transition period is too short.

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If the three-stage DDM results in an extremely high value, either the growth rate in the stable growth period is too high or the period of growth (high plus transition) is too long. To solve these problems, an analyst should use a growth rate closer to GNP growth and use shorter high-growth and transition periods.