Question

please explain and show the formulas

Question 2-2 Parts (14+6= 20 marks) Part 1. Working as a junior analyst for mutual fund, you wonder if your fund should consider adding ABC Food, a large food chain, to your share portfolio. You obtain the following information from its latest financial statements and other sources: $ 100 Earnings: Book value of Equity: $1,000 Dividends: $ 80 You forecast that its earnings will grow by 10% next year and then by 5% per year infinitely. You also expect the dividend payout ratio (Dividends/Earnings) will remain constant and cost of equity will be 10% in the future. Required: a. Forecast ABC Food's dividends in each of the next three years. Use the discounted dividend model to find its value of equity. (5 marks) b. Suppose the clean surplus relationship holds for the company. Forecast ABC Food's abnormal earnings for the next three years. Use the discounted abnormal earnings model to find its value of equity. (9 marks) Part 2. In September 2012, the share price of Apple Inc. reached the record high of USD705. However, the price declined by 40% since then and was around 420 in March 2013. Financial analysts raised a few concerns about Apple's prospects, including increased competition in the industry, uncertainty after the passing away of Steve Jobs, and controversy of its tax practice Required: a. Use the discounted abnormal earnings model to provide THREE possible reasons for the decline in Apple's share price. Your answers must be related to the model, and no marks will be given to answers without explicit discussion on their links to the model. (3 marks) b. In March 2013, a financial analyst recommended investors to buy Apple's shares because "the forward P/E ratio for Apple is only 10, significantly below the historical average and current market average. Please discuss whether it is appropriate to buy a stock solely based on low P/E ratios. (3 marks)

Answer 1

Part 1a

Earnings = 100$

Book Value of Equity = 1000$

Dividends = 80$

growth in next year - 10%

Then onwards = 5% every year till infinity

D/E = Constant

Cost of Equity = 10%

ROE = Current EPS / Book value of equity = 100 / 1000 = 10%

Retention Ratio = 1 - Book value of equity / Earnings = 0.2 = 20%

Cost of Equity = 10% = discount rate

Too compute further we will need to plot a matrix for yearly distribution

As D/E is constant

EPS (n) = EPS (n-1) * (1 + growth Rate (n))^1

Payout Ratio ramains constant = 80%

dividend per share = 80% * EPS

Year	1	2	3
Growth Rate	10.00%	5.00%	5.00%
EPS	$110.00	$115.50	$121.28
Payout Ratio	80.00%	80.00%	80.00%
Dividends/Share	$88.00	$92.40	$97.02
Present Value	$80.00	$84.00	$88.20

Part 1b

Data Provided:

Year	1	2	3
Equity Book value	1000	1000	1000
ROE	10%	10%	10%
Normal Earning	100	100	100

From section 1a we identified the following data

Year	1	2	3
EPS	$110.00	$115.50	$121.28

So the Total abnormal earning is EPS - Normal earning

Year	1	2	3
Abnormal Earnings	$10.00	$15.50	$21.28

Discount Factor = =1/(1 +Cost of Equity)^(year)

Year	1	2	3
Discount Factor @10%	0.91	0.83	0.75

Hence the Present value = abnormal Value * Discount Factor

Year	1	2	3
Present Value	$9.09	$12.81	$15.98

net Present value = PV(1) + PV(2) + PV(3) = 37.89$

Book value = 1000$

Estimated value = 1037.89$

Part 2a

More details required like book value, cost of equity, growth, etc. to provide an apt conclusion.

Part 2b

Buying a stock solely based on a low P/E ratio is not correct. As a budding analyst, one should remember that PE ratio on its own is not a good way to value an investment. For a successful valuation, it should be considered alongside other metrics.

PE in a number of times is misleading because it looks only at earnings, ignoring the cash flow, and market capitalization/share price rather than enterprise value. The company's capital structure is completely ignored.

PE ratio is influenced by the market which in turn is influenced by emotions. So it's better to consider EV/EBITDA. for making the right call.