Rio National Corp. is a U.S.-based company and the largest competitor in its industry. Tables 13.5 – 13.8 present financial statements and related information for the company.
Table 13.9 presents relevant industry and market data.
The portfolio manager of a large mutual fund comments to one of the fund’s analysts, Katrina Shaar: “We have been considering the purchase of Rio National Corp. equity shares, so I would like you to analyze the value of the company. To begin, based on
Rio National’s past performance, you can assume that the company will grow at the same rate as the industry.”
a. Calculate the value of a share of Rio National equity on December 31, 2012, using the constant-growth model and the capital asset pricing model.
b. Calculate the sustainable growth rate of Rio National on December 31, 2012. Use 2012 beginning-of-year balance sheet values.
a. 13% and $22.40
The value of a share of Rio National equity = $22.40,
k = rf + β [E(rM) – rf ] (Constant Growth model)
= 0.04 + 1.8 x (0.09 – 0.04)
= 0.13 or 13%
The share value (Gordon growth model):
P0 = D0 x (1 + g) / k – g
= $0.20 x (1 + 0.12) / 0.13 – 0.12
g = ROE × b
= ROE × Retention Rate
= ROE × (1 – Payout Ratio)
= (1 – Dividend / Net income) x Net income / Beginning equity
= (1 - $3.20) / $30.16 x $30.16 / $270.35
Here are four industries and four forecasts for the macro-economy. Choose the industry that you would expect to perform best in each scenario.
Industries: housing construction, health care, gold mining, steel production.
Deep recession: falling inflation, falling interest rates, falling GDP.
Superheated economy: rapidly rising GDP, increasing inflation and interest rates.
Healthy expansion: rising GDP, mild inflation, low unemployment.
Stagflation: falling GDP, high inflation.
Adams’s research report (see the previous problem) continued as follows: “With a business expansion already under way, the expected profit surge should lead to a much higher price for Universal Auto stock. We strongly recommend purchase.”
a. Discuss the business-cycle approach to investment timing. (Your answer should describe actions to be taken on both stocks and bonds at different points over a typical business cycle.)
b. Assuming Adams’s assertion is correct (that a business expansion is already under way), evaluate the timeliness of his recommendation to purchase Universal Auto, a cyclical stock, based on the business-cycle approach to investment timing.
Universal Auto is a large multinational corporation headquartered in the United States.
For segment reporting purposes, the company is engaged in two businesses: production of motor vehicles and information processing services.
The motor vehicle business is by far the larger of Universal’s two segments. It consists mainly of domestic United States passenger car production, but it also includes small truck manufacturing operations in the United States and passenger car production in other countries. This segment of Universal has had weak operating results for the past several years, including a large loss in 2012. Although the company does not reveal the operating results of its domestic passenger car segments, that part of Universal’s business is generally believed to be primarily responsible for the weak performance of its motor vehicle segment.
Idata, the information processing services segment of Universal, was started by Universal about 15 years ago. This business has shown strong, steady growth that has been entirely internal: No acquisitions have been made.
An excerpt from a research report on Universal prepared by Paul Adams, a CFA candidate, states: “Based on our assumption that Universal will be able to increase prices significantly on U.S. passenger cars in 2013, we project a multibillion-dollar profit improvement . . .”
As a securities analyst, you have been asked to review a valuation of a closely held business, Wigwam Autoparts Heaven, Inc. (WAH), prepared by the Red Rocks Group (RRG). You are to give an opinion on the valuation and support your opinion by analyzing each part of the valuation. WAH’s sole business is automotive parts retailing. The RRG valuation includes a section called “Analysis of the Retail Auto Parts Industry,” based completely on the data in Table 12.7 and the following additional information:
• WAH and its principal competitors each operated more than 150 stores at year-end 2010.
• The average number of stores operated per company engaged in the retail auto parts industry is 5.3.
• The major customer base for auto parts sold in retail stores consists of young owners of old vehicles. These owners do their own automotive maintenance out of economic necessity.
a. One of RRG’s conclusions is that the retail auto parts industry as a whole is in the maturity stage of the industry life cycle. Discuss three relevant items of data from Table 12.7 that support this conclusion.
b. Another RRG conclusion is that WAH and its principal competitors are in the consolidation stage of their life cycle. Cite three items from Table 12.7 that suggest this conclusion. How can WAH be in a consolidation stage while its industry is in a maturity stage?
Janet Ludlow’s firm requires all its analysts to use a two-stage DDM and the CAPM to value stocks. Using these measures, Ludlow has valued QuickBrush Company at $63 per share. She now must value SmileWhite Corporation.
a. Calculate the required rate of return for SmileWhite using the information in the following table:
b. Ludlow estimates the following EPS and dividend growth rates for SmileWhite:
First three years
12% per year
9% per year
Estimate the intrinsic value of SmileWhite using the table above and the two-stage DDM. Dividends per share in 2010 were $1.72.
c. Recommend QuickBrush or SmileWhite stock for purchase by comparing each company’s intrinsic value with its current market price.
d. Describe one strength of the two-stage DDM in comparison with the constant-growth DDM. Describe one weakness inherent in all DDMs.
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