Question

Question 2: On November 1, 2019. Mr. Daniel Kim, an individual stock investor, pays attention to the news that Dongguk Corp, may report earnings surprise thanks to the booming demand for natural gas pipe associated with rising shale gas production in the US. In order to make an investment judgement through a price multiple comparison method, Mr. Kim chooses to deploy PER (Price-Earnings Ratio) computed as following: PER per share stock price of Dongguk Corp. (November 1, 2019) / expected per share net income for the fiscal year of 2019 For comparison purpose, Mr. Kim selects 5 firms that belong to the same industry as Dongguk Corp. that are also similar in firm size, and calculates the average PER using above formula. As a result, Mr. Kim gets a multiple of 15 for Dongguk Corp, whereas the average multiple of those five firms is 12. Based on this multiple comparison, Mr. Kim concluded that the stock market overprices the shares of Dongguk Corp. and gives up investment in Dongguk Corp. shares. Requirement 1: If you are a financial analyst, what is your investment advice to Mr. Daniel Kim? (12 points) Requirement 2: The method of price multiple comparison, as explained above, has implementation problems as well as conceptual problems. Indicate one for each of implementation and conceptual problems. (13 points)

booming demand for natural gas pipe associated with rising shale gas production in the US In order to make an investment judgement through a price multiple comparison method, Mr. NG&OUs Kim chooses to deploy PER (Price-Earnings Ratio) computed as following PER per share stock price of Dongguk Corp. November 1, 2019) / expected per share net income for the fiscal year of 2019 For comparison purpose, Mr. Kim selects 5 firms that belong to the same industry as Dongguk Corp. that are also similar in firm size, and calculates the average PER using above formula. As a result, Mr. Kim gets a multiple of 15 for Dongguk Corp, whereas the average multiple of those five firms is 12. Based this multiple comparison, Mr. Kim concluded that the stock market overprices the shares of Dongguk Corp. and gives up investment in Dongguk Corp. shares. Requirement 1: If you are a financial analyst, what is your investment advice to Mr. Daniel Kim? (12 points) Requirement 2 The method of price multiple comparison, as explained above, has Indicate one for each of implementation problems as well as conceptual problems. implementation and conceptual problems. (13 points) Question 3: An analyst presents you with the following pro forma (in millions of US $) that He asks you to value the 1,380 gives his forecast of earnings and dividends for 2020-2024. million shares outstanding at the end of 2019, when common shareholder's equity (book Use a required rate of return (cost of equity) of value of net asset) stood at $4,310 million. 10% per annum in your calculations. 2024E 2023B 629.0 367.0 2022B 599.0 349.0 2021E 2020B 660.4 385.4 570.0 160.0 388.0 115.0 Earnings Dividends Requirement 1: Forecast book value of net assets, return on common equity (ROCE), and residual earnings for each of the years 2020-2024. (10 points)

Answer 1

Requirement 1:

A PER is generally once of the accepted measures used to compare between various comparable (in this case, belonging to the same industry) investment opportunities. Generally, PER is calculated based on the per share stock price divided by the 12 months earnings per share (EPS), which ideally is the trailing twelve months EPS. Trailing Twelve Months EPS is calculated based on previous 12 months earnings / weighted average number of equity shares.

In the present case, Daniel has opted to make a decision based on PER which is based on stock price and expected 12 months future earnings. However, since Daniel uses market prices as at 1st November 2019 and considers expected net income for the fiscal year 2019, the PER may still give results close to actuals since the results of almost 3 quarters to Sept 2019 must already be based on actuals and only 1 quarter results would be an estimate.

A PER of 15 for Dongguk Corp. in comparison to average PER of 12 for the industry would definitely indicate that Dongguk Corp is an over priced investment and as such, Daniel should give us investment in Dongguk Corp and take up investment in other company with lower PE. However, considering the fact that the booming demand for natural gas pipe associated with rising shale gas production in the US, may bring significant improvements in the net income of Dongguk in the years to come, Daniel should also base his investment decision considering the industry PER comparison for the coming 1 to 2 years, as investments would give returns not based on historical performance but based on future earnings.

Requirement 2:

Implementation problem: The methodology used by Daniel has significant implementation problem since to get a reliable estimate of net income for the fiscal year is a risky proposition, it has limitations in terms of assumptions, opinions, estimates etc.

Conceptual problem: Making investment decisions only based on PER may at times prove to be wrong. A PER is a ratio. While PER of 15 may look that the stock is over priced as compared to industry, it also indicates that investors has more confidence on this stock and are even willing to pay 15 times as compared to 12 times for other companies. This is almost contradicting the decision to ignore the stick based on high PER. Further, PER does not give any information on the quality of earnings, size of earnings, riskiness of the businesses in terms of its Asset Liability position or the Balance Sheet position.