Tutorial 8: Company analysis - Forecasting Earnings & Valuation

6. Refer to data & answers from question 2 of Tutorial 6,

Estimate 20x3 EPS, using the Dupont model, and based on the following judgemental adjustments
following an interview with management:

- A new inventory management system is projected to improve total asset turnover to 8.7x

- Cheap&Good intend to change its merchandise mix towards more house brands, building on
its successful marketing campaign using the theme ‘value-for-money’ supermarket.
Management expects the strategy to improve operating margin by 0.25% points (from 4% to
4.25%).

- Conservatively estimate the end 20x3 Equity at the 20x2 Equity level. (The actual level
should be higher resulting from profits in 20x3).

Answer:
(1 - tax Interest Total
ROE = rate) x [(EBIT x Net Sales) - Expense] x assets
[(Net
Sales Total Assets) Total assets] Equity
ROE = (1 - 0.20) x [(0.04 x 7.95) - 0.02] x 1.66 = 0.04
(20x o 39.60
2) r %

ROE = (1 - 0.20) x [(0.0425 x 8.70) - 0.02] x 1.66 = 0.46

o 46.40
r %
Equi $3,030,00
ty = Equity (20x2 actual) = 0

Net
profi $1,407,33
t = ROE x Equity = 0.46 x $3,030,000 = 8
(20x3 estimate)

EPS = Net / Number = $1,407,33 / 2,000,000 = $0.70

profit of 8
 shares

7. U.S. Steel has averaged about 27% over the 4 year period (2000 - 2004) for its payout ratio. Its
actual payout ratio was 30% and 25% for the last of these years (equal to a DPS of $2 in both years),
although it paid 26% in 2000. The next year's (2005) EPS is expected to be $7.25. Today is the 1 Jan
2005.

a) Forecast the dividend payable next year.

Answer:
Using the EPS of $7.25, one arrives at a forecast of $1.81 (i.e. 25% of $7.25) to $2.18 (i.e. 30% x
$7.25) for the next year’s dividend. Using the average payout of 27%, a possible forecast is $1.96 (i.e.
27% x $7.25).

Empirical evidence suggests firms are reluctant to cut the absolute dollar amount of dividends.
Cutting DPS from $2 to $1.96 is only a small cut but may be interpreted by investors as the company
not having sufficient cash resources to maintain dividends.

Therefore, a good forecast is that the previous year’s level of $2.00 per share is likely to be
maintained, rather than a small cut which might be more damaging for investors’ confidence.

b) If U.S. Steel ‘normal’ PE is 4.5, what will be expected share price by end 05?

Answer:
Projected intrinsic value (Expected share price at the end of 05)
= Forecast EPS x ‘normal’ P/E
= $7.25 x 4.5
= $32.63

The expected price is $32.63 (i.e. 4.5 x $7.25)

c) Compute the holding period yield one year from today assuming yesterday's closing for U.S. Steel
is $19.38.

Answer:
The forecast of a one-year holding period yield for U.S. Steel can be made using the projected
dividend of $2.00, projected PE of 4.5 and the projected price of $32.63.

Yesterday’s price was $19.38, implying that a holding period yield would equal 78.7%, i.e.

HPY = (32.63 + 2.00 – 19.38) / 19.38 = 78.7%

d) If you change your assumptions to a period of supernormal growth (20% p.a. growth in dividends
for the next three years) before reverting to a long-term sustainable growth in dividends of 5%
p.a. from the fourth year, and you require a return of 15% p.a., what is the stock’s intrinsic value
currently?

Answer:
D0 = $2.00
D1 = $2.00 x 1.20 = $2.40
D2 = $2.40 x 1.20 = $2.88
D3 = $2.88 x 1.20 = $3.46
D4 = $3.46 x 1.05 = $3.63

Using the Constant-Growth formulae,

Fair value, P3 = D4 / (k-g)
= $3.63 / (0.15 – 0.05)
= $36.30

Using the 2-stage Growth formulae,

Fair value, P0
= D1 x PVIF(k, 1) + D2 x PVIF(k, 2) + (D3 + P3) x PVIF(k, 3)
= $2.40 x PVIF(15%, 1) + $2.88 x PVIF(15%, 2) + ($3.46 + $36.30) x PVIF(15%, 3)
= $2.40 x 0.870 + $2.88 x 0.756 + $39.76 x 0.658
= $30.43 ($30.21 if calculated directly without tables)

8. Lion Airways Ltd is a loss-making airline that does not intend to pay any dividends. Your
assessment is that the losses are temporary and the company will become profitable within the next
two years. You have been tasked to do a valuation of Lion Airways shares.

a) Is the DDM an appropriate valuation tool to use? Why?

Answer:
No, the DDM approach is to discount forecasted dividends for present value to arrive at a stock’s
intrinsic value.

Since Lion Airways does not intend to pay any dividends, there would be no dividends to discount
and the DDM approach will give a zero intrinsic value. This is probably under-stating the true value
of Lion Airways.

b) How about the P/E approach? Also discuss any two valuation approaches you would consider
useful in this case.

Answer:

Definitely not P/E since EPS is negative an P/E would be meaningless.

(Any two)
Price / Sales per share – since the company is temporarily loss-making, the Price/Sales ratio is
suitable as it will indicate whether how the company is being valued relative to its past sale (historical
or time series) or other airlines in terms of sales (cross-sectional).

Price / Book value per share – it will be able to compare Lion Airways share price to the book value
of its assets. There will be a need to assess if the book value is a true reflection of assets if they were
to be liquidated.

Price / Cash flow EPS per share – although loss-making at EPS level, it should be investigated
whether the company is profitable at cash flow level. If yes, this could be an appropriate valuation
tool, and can be used for cross-country comparisons independent of accounting differences in e.g.
depreciation policies.