Reading 34: The Equity Valuation Process- LOS e～ Q1-9

like, him, business, recently, companies

LOS e: Calculate alpha.

Q1. Marko Larraza recently sold a majority stake in his business, Larraza Loaves, to a national food manufacturer, and has been looking to invest the proceeds in a portfolio of actively managed equities. Larraza hired Alhaadi Wewege, a portfolio manager to help him select appropriate companies for consideration.

Larraza has researched two publicly traded companies that he would like Wewege to analyze for potential inclusion in the portfolio: Generic Gems, a wholesaler of gemstones, and Consolidated Cereals, a breakfast food manufacturer. Larraza has provided Wewege with the following information about the two firms:

Table 1: Valuation Inputs

Company	Price One Year Ago	Current Price	One-Year Target Price	Past Year’s Dividend	Expected Dividend Next Year
Generic Gems	29.00	32.50	35.00	$0.70	$0.75
Consolidated Cereals	14.00	14.25	15.00	$1.00	$1.25

Based on his knowledge of the market, Wewege believes that the required return for each company should equal the previous year’s holding period return on the relevant industry index. The Jewelry & Gemstone index returned 11% last year, while the Food & Beverage index returned 7%.

Larraza questions Wewege’s assumption about the appropriate return for Consolidated Cereals. “When I sold my bakery, I justified giving the buyer a discount on the price based on the lack of marketability and lack of liquidity since the shares aren’t publicly traded.” Wewege counters that the discount on the sale of Larraza Loaves was justified because the purchaser acquired a controlling interest, not because the shares were illiquid.

Wewege also points out that the valuation of Larraza Loaves was made using an asset-based model, which is an example of an absolute valuation model. He points out that using a liquidation value is inappropriate for a going concern. Larraza counters that Larraza Loaves was also valued using a dividend discount model, which is considered a relative valuation model. Larraza argues that a dividend discount model is an appropriate valuation approach for a going concern.

“Graham and Dodd first advanced the idea that the value of a stock could be determined by discounting future dividends,” points out Larraza, in justification of a dividend discount approach. Wewege acknowledges that Graham and Dodd’s investment valuation approach was the forerunner of the absolute valuation models of today.

Are Wewege and Larraza correct in their statements concerning the price discount on the sale of Larraza Loaves?

Wewege Larraza

A) Correct Correct

B) Correct Incorrect

C) Incorrect Correct

Q2. The ex post alphas for Consolidated Cereals and Generic Gems are closest to:

Consolidated Cereals Generic Gems

A) 7.0% -1.0%

B) 7.0% 3.5%

C) 1.9% 3.5%

Q3. Are Wewege and Larraza correct in their statements concerning absolute and relative valuation models?

Wewege Larraza

A) Incorrect Incorrect

B) Correct Correct

C) Correct Incorrect

Q4. Are Wewege and Larraza correct in their statements about appropriate valuation approaches for a going concern?

Wewege Larraza

A) Correct Correct

B) Incorrect Correct

C) Correct Incorrect

Q5. Which of the following quality of earnings issues is least likely to be directly addressed in the footnotes to accounting statements and other disclosures?

A) Sustainability of growth.

B) Reclassification of non-operating items as operating income.

C) Choice of depreciation and amortization rates.

Q6. Are Wewege and Larraza correct in their statements about Graham and Dodd?

Wewege Larraza

A) Incorrect Incorrect

B) Correct Incorrect

C) Correct Correct

Q7. The difference between a holding period return on an asset and the return on similar assets is called an asset’s:

A) ex ante alpha return.

B) ex post alpha return.

C) supernormal return.