Fsav4e SM Mod15

Module 15
Market-Based Valuation
DISCUSSION QUESTIONS
Q15-1.
The advantages of valuation using market multiples compared to valuation using

discounted cash flows or discounted residual operating income include the following:
Q15-2.
The disadvantages of valuation using market multiples compared to valuation using

discounted cash flows or discounted residual operating income include the following:
Q15-3.
It is quick, straightforward, and requires little data.

It is widely used in a variety of business contexts.
It does not necessarily require forecasts of future earnings or cash flows.
It does not have a rigorous theoretical model underlying it.

It requires an assumption of market efficiency regarding the comparable
companies.
It requires an assumption of market inefficiency regarding the target company.
There are no formal guidelines for choosing the correct companies to use as
comparables.
The residual operating income model follows:

Company value = NOA + Present value of Future ROPI.
If the ratio of company value to NOA is 1, then the expected present value of future
ROPI must be zero.
Solutions Manual, Module 15
Cambridge Business Publishers, 2015

15-1
Q15-4.
For the company-value-to-net-operating-assets ratio, the comparables should be

selected on the basis of expected future profitability (RNOA), expected future growth
(growth in NOA), and expected operating risk (variance of operating income).
For the price-to-book-value ratio, comparables should be selected using the above
factors as well as capital structure.
Q15-5.
When PE ratios are reported by data aggregators or quoted in publications (such as

Yahoo! and Google), earnings might be the past fiscal years earnings, trailing four
quarters earnings, or forecasted future earnings. Earnings might also be as reported
or adjusted for unusual or nonrecurring items. Consequently, it is important for us to
determine what version of earnings is used before drawing inferences.
Q15-6.
Recall that the residual income operating model yields the following formula for the
PE ratio:
PE [(1+re) /re] [1 + (Present value of expected changes in RI Dividend /
Earnings)]
If the company had a payout ratio of zero, the capitalization factor on current
earnings would be 11. This means a PE ratio of 11 implies that the market would
expect no growth in residual operating income. A PE ratio higher than 11 implies that
the market expects positive growth in residual operating income, and a PE ratio less
than 11 implies that the market expects negative growth in residual operating
income.
Q15-7.
This headline means that an analyst(s) from Goldman Sachs increased the price
target for Cisco Systems, based on an increased multiple of Ciscos earnings. This
analyst increased the multiple because she/he expected Cisco to show stronger
earnings growth in the future.

15-2
Financial Statement Analysis and Valuation, 4th Edition
MINI EXERCISES
M15-8. (15 minutes)
Using the industry average PB of 7.1, the estimated intrinsic value of Burger Kings equity is
$5,652 million, computed as 7.1 x $796 million.
This equates to $41.65 per share, computed as $5,652 million / 135.7 million.
M15-9. (15 minutes)

Using the industry average PB of 2.3, the estimated intrinsic value of Build-a-Bears equity is
$21.97 per share, computed as 2.3 x $9.55.
M15-10. (15 minutes)

Using the industry average PE of 14.25, the estimated intrinsic value for JAKKS Pacific is
$1,283 million, computed as 14.25 x $90 million.
This equates to $44.86 per share, computed as $1,283 million / 28.6 million.

Using the industry average PE ratio of 10.4, Motorolas intrinsic value per share is $6.45,
computed as 10.4 x $0.62.

Company A:
ROPI:
$8 = ($100 x 18%) ($100 x 10%)

PV of ROPI
$100 = $8 / (10% 2%)
Value of equity
$200 = $100 + $100
PB ratio
2.00
Company B:
ROPI:
$1 = ($100 x 11%) ($100 x 10%)

PV of ROPI
$12.5 = $1 / (10% 2%)
Value of equity
$112.5 = $100 + $12.5
PB ratio
1.13

15-3

Company A:
ROPI:
$8 = ($100 x 18%) ($100 x 10%)

PV of ROPI
$100 = $8 / (10% 2%)
Value of equity
$200 = $100 + $100
PB ratio
2.00
Company B:
ROPI:
$1 = ($100 x 11%) ($100 x 10%)

PV of ROPI
$16.7 = $1 / (10% 4%)
Value of equity
$116.7 = $100 + $16.7
PB ratio
1.17

Company A:
ROPI:
$3 = ($100 x 18%) ($100 x 15%)

PV of ROPI
$23.1 = $3 / (15% 2%)
Value of equity
$123.1 = $100 + $23.1
PB ratio
1.23
Company B:
ROPI:
$1 = ($100 x 11%) ($100 x 10%)

PV of ROPI
$12.5 = $1 / (10% 2%)
Value of equity
$112.5 = $100 + $12.5
PB ratio
1.13

Company A:
ROPI:
$1 = ($100 x 11%) ($100 x 10%)

PV of ROPI
$10 = $1 / (10% 0%)
Value of equity
$110 = $100 + $10
PB ratio
1.10
Company B:
ROPI:
$1 = ($100 x 11%) ($100 x 10%)

PV of ROPI
$10 = $1 / (10% 0%)
Value of equity
$50 = $100 + $10 $60
PB ratio
1.25

Fresh Del Monte is more similar to Chiquita in terms of profitability, growth, and risk. Thus, we
conclude it is a better comparable than Lancaster Colony for valuation using PB ratios.

15-4

Hillshire Brands is more similar to Hershey in terms of profitability (ROE) and risk (debt-toequity). Thus, we conclude that it is the better comparable to use for valuation using PE ratios.

a. Note to instructor: There is more than one reasonable answer to this question. The
important point is to select companies that are as similar as possible to PNRA on the basis
of profitability, growth, and risk.
One reasonable solution would be to eliminate BWLD and TXRH (both carry low ROE) and
SONC (high ROE) on the basis of profitability. Next, we see that BAGL has a low historical
growth rate. Finally, DNKN exhibits a high debt to equity ratio. Thus, this would leave THI,
PZZA and CMG as three good comparables for Panera.
b. The comparables have an average PB ratio of 9.91. Multiplying Paneras book value per
share of $27.18 by the 9.91 market multiple yields an estimate of its equity intrinsic value
per share of $269.35.
c. The comparables have an average PE ratio of 27.88. Multiplying Paneras earnings
estimate of $6.68 by the 27.88 market multiple yields an estimate of its equity intrinsic value
per share of $186.24.

ROE equals the current PB divided by the trailing PE. For the four following companies, the
ROE results are shown below.
Company
Apple (AAPL)
Outerwall (OUTR)
PPG Industries (PPG)
Hershey (HSY)
ROE
29.0%
27.9%
58.5%
57.8%
The market is most likely expecting future ROE to be highest for HSY. This is because it has
the highest PB ratio by far.

The forward PE ratio for PPG is substantially (over 100%) higher than its trailing PE ratio,
meaning the market likely expects its earnings to decline.

15-5
EXERCISES
E15-21. (20 minutes)
a. The price to net operating assets ratios for MDRX and MCK are 1.21 and 2.50, respectively.
b. The simple average of the two ratios is 1.86. Also, we could weight one of the two
companies more heavily if we believe its ratio is more relevant for valuing Cerner
Corporation.
Cerners estimated company intrinsic value is $2,760 million, using a 1.86 multiple on net
operating assets.
Cerners estimated equity intrinsic value is $4,110 million, computed as $2,760 million plus
nonoperating assets of $1,350 million.
Its estimated equity intrinsic value per share is $23.88, computed as $4,110 million / 172.1
million shares.

a. The price to book value ratios for MDRX and MCK are 1.26 and 3.01, respectively.
companies more heavily if we believe its ratio is more relevant for valuing Cerner.
Cerners estimated equity intrinsic value is $6,065 million, using a 2.14 multiple on book
value.
Cerners estimated equity intrinsic value per share is $35.24, computed as $6,065 million /
172.1 million shares.

15-6

a. The price to NOPAT ratios for KLA Tencor and Lam Research are 14.53 and 8.84,
respectively.
companies more heavily if we believe its ratio is more relevant for valuing Applied Materials.
Applied Materials estimated company intrinsic value is $18,599 million, using a 11.69
multiple.
Applied Materials estimated equity intrinsic value is $18,394 million, computed as $18,599
million minus debt of $205 million.
Its estimated equity intrinsic value per share is $13.63, computed $18,394 million / 1,350
million shares.

a. The price to net income ratios for KLA Tencor and Lam Research are 14.53 and 8.42,
respectively.
companies more heavily if we believe its ratio is more relevant for valuing Applied Materials.
Applied Materials estimated equity intrinsic value is $18,024 million, using an 11.48 multiple
on net income.
Applied Materials estimated equity intrinsic value per share is $13.35, computed as $18,024
million / 1,350 million shares.

a. Using the average forward PE ratio for MSI and ERIC of 14.75, the estimated intrinsic value
for Nokia is $2.95, computed as 14.75 x $0.20.
b. Nokias actual share price of $8.06 is significantly higher than the estimated intrinsic value of
$2.95 from part a. This result suggests that Nokias stock is overvalued, meaning the
market likely expects its earnings to increase in the future.

15-7

a. The important thing is to select firms that are as similar as possible to McCormick on the
dimensions of profitability, growth, and risk. On this basis, CAG and FLO are most
comparable.
b. TSN has had high recent earnings growth and low risk.
McCormick.
Thus, it is a poor match for

a. The important thing is to select firms that are as similar as possible to Kelloggs in terms of
expected growth and risk. General Mills and ConAgra are closer to Kelloggs on these
dimensions than are Bunge and Hormel.
b. Bunge exhibits overly low recent earnings and high expected growth, and Hormel exhibits
high expected growth and low debt to equity. Both are different from that exhibited by
Kellogg.

a. Instructor note: There is more than one reasonable answer to this question. The
important point is to select companies that are as similar as possible to Mens
Wearhouse on the basis of profitability, growth, and risk.
One reasonable solution would be to eliminate GES, JNY, and ANF on the basis of their
negative historical earnings growth rates. We also could eliminate ZUMZ and TLYS on the
basis of leverage. Only FRAN and SSI are eliminated due to the much higher or lower
accounting profitability. Thus, this would leave GCO, ASNA, and EXPR as three good
comparables for Mens Wearhouse.
b. The comparables have an average PB ratio of 2.64. Multiplying MWs book value of $1,096
million by the 2.64 market multiple yields an estimate of its equity intrinsic value of $2,893
million.
c. The comparables have an average PE ratio of 11.89. Multiplying MWs earnings estimate of
$117.2 million by the 11.89 market multiple yields an estimate of its equity intrinsic value of
$1,394 million.

15-8

important point is to select companies that are as similar as possible to Fossil, Inc.,
on the basis of profitability, growth, and risk.
One reasonable solution would be to eliminate ZQK, SKX, PERY and ANF on the basis of
their ROE. On the basis of earnings growth rates, we could eliminate GES, UNF, and
WWW. In reviewing, DECK, RL and GPS they do not need to be eliminated on the basis of
leverage. Thus, DECK, RL and GPS appear to be three good comparables for Fossil.
b. The comparables have an average PB ratio of 4.23. Multiplying Fossils equity value of
$2,894 million by the 4.23 market multiple yields an estimate of its equity intrinsic value of
$12,242 million.
c. The comparables have an average PE ratio of 14.70. Multiplying Fossils earnings estimate
of $399 million by the 14.70 market multiple yields an estimate of its equity intrinsic value of
$5,865 million.

a. The theoretically correct PE ratio for a firm with zero expected growth in residual income
equals the capitalization rate, which is ([1+r e] / re). Consequently, the PE for companies A
through E follows:
Company
Cost of equity capital
A..............................................................
6%
B..............................................................
9%
C.............................................................
12%
D.............................................................
15%
................................................................
E..............................................................
18%
PE
17.67
12.11
9.33
7.67
6.56
b. A company with a cost of capital of 10% and no expected growth in residual income would
have a PE ratio of 11. A company with a cost of capital of 2% and no expected growth in
residual income would have a PE of 52. Consequently, we could explain the range by
claiming that all companies had a cost of capital between 2% and 10%. However, 2%
seems implausibly low for a cost of capital, and 10% does not seem sufficiently high for a
risky company. Therefore, it appears that differences in expectations about future residual
income must explain a fair amount of the variation in PE ratios.

15-9

To determine ROE, we follow three steps:
First, for us to earn a minimum 12% return on investment (ROE), Googles market cap would
have to increase to $722.5 billion five years from nowcomputed from $409.98 billion x (1.12)5.
Second, for the market cap to be 3.0 times book value, book value must be $240.8 billion
computed as $722.5 billion / 3.0 times.
Third, for book value to increase from $87.31 billion to $240.8 billion in five years, ROE would
have to average approximately 22.5%solving for ROE from the following relation: $87.31
billion x (1 + ROE)5 = $240.8 billion.

One likely explanation for the relation between prices is that the companies with negative 5%
growth in net operating assets do not have growth opportunities and, thus, are not expected to
have increases in future residual operating income.
Another way to see this is to consider the companies with 34% growth in net operating assets.
These companies would appear to be expanding, thus, we can expect growth in future residual
operating income.

Our first step is to compute current ROE by dividing PB by PE, which results in the Ps
cancelling out and we are left with EB, which is ROE. Then, we recognize that the PB ratio
should correlate with future ROE; thus, we can infer the direction of the change in earnings as
well as the level of future profitability. This results in the following matches.
PB
PE
ROE
Description
167%
E . 1.
High current profitability, earnings expected to decline but

profitability will remain high
1.5
12
12.5%
B . 2.
Average current profitability, profitability expected to remain

at the average
1.5
40
3.8%
C . 3.
Low current profitability, earnings expected to increase but

future profitability will be about average
15
27%
D . 4.
High current profitability, profitability will remain high
0.7
23%
A . 5.
High current profitability, earnings expected to decline

markedly and profitability will be low

15-10

Instructor note: There are alternative ways to solve for the missing values; solutions will
differ slightly due to rounding.
a. To find common shares outstanding, we divide market cap by stock price per sharesee
results below.
b. To find total book value of equity, multiply common shares outstanding (from a) by the book
value per sharesee results below.
c. To find EPS, we divide stock price per share by the trailing four quarters PE ratiosee
results below.
d. To find ROE, we divide EPS (from part c) by book value per sharesee results below.
Market
Cap ($ mil.)
Stock
Price
PB
Current
BV per
Share
Trailing
4Q PE
Book
Value*
EPS
$ 30,016
$35.39
1.89
$18.34
11.88
848
$ 15,552
$2.98
0.16
67,578
87.19
10.55
8.44
16.80
775
6,541
5.19
0.61
Citigroup
148,886
29.89
1.17
25.86
8.03
4,981
128,809
3.72
0.14
Coca-Cola
143,928
62.28
7.32
8.51
23.59
2,311
19,667
2.64
0.31
McDonalds
69,534
58.79
4.65
12.63
21.22
1,183
14,941
2.77
0.22
3M
60,261
84.49
5.49
15.35
17.24
713
10,945
4.90
0.32
Wal-Mart
191,630
47.85
3.04
15.57
15.90
4,005
62,358
3.01
0.19
Exxon Mobil
503,364
92.13
4.24
21.68
13.47
5,464
118,460
6.84
0.32
Company
Alcoa
Boeing
CSO
(sh)
*Students answers for Book Value and ROE may vary due to rounding.

15-11
ROE*
PROBLEMS
P15-35. (40 minutes)
a. Identification of comparables
Ticker
Market
Cap
($ mil.)
GIB
EPS 5-Year
PB
Historical
Current Growth Rate
-
EQIX
9,380
3.84
JCOM
2,310
XXIA
QNST
VOCS
ROE
(T 4Q)
Debt-toEquity
(Prior Q)
20.65% 15.99%
0.73
3.84%
1.61
3.20
11.60% 16.53%
0.35
933
1.87
60.34%
4.68%
0.40
294
1.24
-15.91% -18.89%
0.36
269
7.72%
2.93
Basis of Exclusion:
Financial
Profitability Growth
Risk
12.57
-24.05%
%
0.01
NTES
8,650
2.74
26.59% 24.86%
0.05
ULTI
4,740
25.41
47.25% 16.86%
0.04
DMD
498
1.01
9.50% -0.81%
0.10
DRIV
554
1.41
-17.73% -4.44%
0.75
To value a firm as a multiple of book value using comparable firms, the comparable firms
should be selected so that they have similar profitability, growth, and risk. In doing so, we
know we are not going to find perfect matches, but seek to exclude the firms that are most
different from our firm of interest. On this basis, we exclude 6 of the 9 firms, which leaves
JCOM, XXIA, and DMD to provide the basis for valuing GIB.
b. Estimate of equity intrinsic value

GIBs equity intrinsic value
$8,010 million
=
=
GIBs book value

$3,946 million
x
x
PB ratio
2.03
Continued next page

15-12
P15-35. concluded
c. Memorandum to superior
MEMORANDUM
TO:
FROM:
SUBJECT:
The body of the memorandum should make the following points:
I estimated GIBs intrinsic value at $8,010 million; computed as its book value of $3,946 million
times a PB market multiple of 2.03.
To value a firm as a multiple of book value using comparable firms, the comparable firms should be
selected so that they have similar profitability, growth, and risk. On this basis, I excluded 6 of the 9
firms, which leaves JCOM, XXIA, and DMD to provide the basis for valuing GIB. I have indicated
on the attached table the reasons for excluding the other firms.
If you wish, I can prepare models using other valuation techniques, including discounted cash flows
and discounted residual operating income. These models incorporate estimates of future cash
flows and earnings for GIB. If we have a good handle on GIBs future prospects, these models can
generate more dependable estimates of intrinsic value.
A cordial closing that indicates willingness to discuss the issue further would be appropriate.

15-13

a. Identification of comparables
Ticker
GIB
Market Cap Forward

($ mil.)
PE
EPS 5-Year
Historical
Growth Rate
ROE
(T 4Q)
Debt-toEquity
(Prior Q)
20.65%
15.99%
0.73
Basis of Exclusion:
Financial
Growth
Risk
EQIX
9,380
33.30
7.72%
3.84%
1.61
JCOM
2,310
13.31
11.60%
16.53%
0.35
XXIA
933
13.03
60.34%
0.40
QNST
294
14.40
-15.91%
0.36
VOCS
269
33.09
-24.05%
4.68%
18.89%
12.57%
NTES
8,650
9.86
26.59%
24.86%
0.05
4,740
67.40
47.25%
16.86%
0.04
DMD
498
26.43
9.50%
-0.81%
0.10
DRIV
554
29.06
-17.73%
-4.44%
0.75
ULTI
X
X
0.01
To value a firm as a multiple of PE using comparable firms, the comparable firms should be
selected so that they have similar growth and risk. In doing so, we know we are not going to
find perfect matches, but seek to exclude the firms that are most different from our firm of
interest. On this basis, we exclude 6 of the 9 firms, which leaves JCOM, XXIA, and DMD to
provide the basis for valuing GIB.
b. Estimate of equity intrinsic value
GIBs equity intrinsic value
$15,251 million
=
=
GIBs earnings estimate

$867 million
x
x
PE ratio
17.59
Continued next page

15-14
P15-36. concluded
c. Memorandum to superior
MEMORANDUM
TO:
FROM:
SUBJECT:
The body of the memorandum should make the following points:
I estimated GIBs intrinsic value at $15,251 million; computed as its earnings estimate of $867
million times a PE market multiple of 17.59.
To value a firm as a multiple of earnings using comparable firms, the comparable firms should be
selected so that they have similar growth and risk. On this basis, I excluded 6 of the 9 firms, which
leaves JCOM, XXIA, and DMD to provide the basis for valuing GIB. I have indicated on the
attached table the reasons for excluding the other firms.
If you wish, I can prepare models using other valuation techniques, including discounted cash flows
and discounted residual operating income. These models incorporate estimates of future cash
flows and earnings for GIB. If we have a good handle on GIBs future prospects, these models can
generate more dependable estimates of intrinsic value.
A cordial closing that indicates willingness to discuss the issue further would be appropriate.

a. The price to net operating assets ratios for Kohls and Wal-Mart are 3.7 and 2.4,
respectively.
b. A simple average of the two ratios from part a is 3.1. We could weight one of the two
companies more heavily if we believe its ratio is more relevant for valuing Target.
Targets estimated company intrinsic value is $79,521 million, using a 3.1 multiple from net
operating assets. Targets estimated equity intrinsic value is $69,412, and its estimated
equity intrinsic value per share is $81.
c. The price to book value ratios for Kohls and Wal-Mart are 4.0 and 3.2, respectively.
d. A simple average of the two ratios from part c is 3.6. We could weight one of the two
companies more heavily if we believe its ratio is more relevant for valuing Target. Targets
estimated equity intrinsic value is $56,279, using a 3.6 multiple on book value. Targets
estimated equity intrinsic value per share is $65.

15-15

a. The price to NOPAT ratios for Kohls and Wal-Mart are 20.1 and 17.8, respectively.
b. A simple average of the two ratios is 19.0. We could weight one of the two companies more
heavily if we believe its ratio is more relevant for valuing Target. Targets estimated
company intrinsic value is $60,021 million, using an 18.9 multiple. Targets estimated equity
intrinsic value is $49,912 and its estimated equity intrinsic value per share is $58.
c. The price to net income ratios for Kohls and Wal-Mart are 20.3 and 16.3, respectively.
d. A simple average of the two ratios is 18.3. We could weight one of the two companies more
heavily if we believe its ratio is more relevant for valuing Target. Targets estimated equity
intrinsic value is $51,002, using a 18.3 multiple on net income. Targets estimated equity
intrinsic value per share is $59.

important point is to select companies that are as similar as possible to Marinemax
on the basis of profitability, growth, and risk.
One reasonable solution would be to eliminate BC, JAKK and PII on the basis of profitability.
PII has a much higher historical growth rate than the others and we could eliminate it for that
reason (we might also eliminate CPRT and BC due to the earnings growth rate). JAKK and
POOL have higher leverage and should be eliminated. Thus, this leaves CPRT and CKH as
two good comparables for Marinemax.
b. The comparables have an average PB ratio of 3.34. Multiplying HZOs book value per share
of $9.31 by the 3.34 market multiple yields an estimate of HZOs equity intrinsic value per
share of $31.10.
c. The comparables have an average PE ratio of 18.91. Multiplying HZOs earnings estimate
of $0.58 by the 18.91 market multiple yields an estimate of HZOs equity intrinsic value per
share of $10.97.

15-16

Preliminary computation: PB ratio = 2.95; PB* = PB 1 = 1.95
a. Solve for implied growth rate
Assumed parameters
ROE
Discount rate, re
Implied parameter
Growth rate, (re + [PB* re] - ROE) / PB*
18.0%
8.0%
2.9%
b. Solve for implied discount rate

Assumed parameters
ROE
Growth rate, g
Implied parameter
Discount rate, (ROE + [PB* g]) / (1+PB*)
18.0%
3.0%
8.1%
c. Solve for implied future ROE

Assumed parameters
Discount rate, re
Growth rate, g
Implied parameter
ROE, (PB* [re g]) + re
8.0%
3.0%
17.8%
d. Recall that this valuation model assumes a constant ROE and a growth rate in perpetuity. In
case a, the implied growth rate is 2.9% (this is growth in residual income, not income). In
case b, the implied discount rate seems plausible. In case c, the ROE is what Wolverine
has achieved recently. Thus, the market expectations underlying the observed PB ratio
seem reasonable.

15-17

Preliminary computation: PB ratio = 1.78; PB* = PB - 1 = 0.78
a. Solve for implied growth rate
Assumed parameters
ROE
Discount rate, re
Implied parameter
Growth rate, (re + [PB* re] ROE) / PB*
11.0%
9.0%
6.4%
b. Solve for implied discount rate

Assumed parameters
ROE
Growth rate, g
Implied parameter
11.0%
4.0%
7.9%
c. Solve for implied future ROE

Assumed parameters
Discount rate, re
Growth rate, g
Implied parameter
9.0%
4.0%
12.9%
d. Recall that this valuation model assumes a constant ROE and a growth rate in perpetuity. In
case a, the implied growth rate is 6.4% (this is growth in residual income, not income), which
might be difficult to sustain. In case b, the implied discount rate seems reasonable. In case
c, the ROE is higher than what CVS has achieved recently. Thus, the market expectations
underlying the observed PB ratio might be difficult to obtain. It is possible that investors are
assuming that CVSs acquisition of Caremark will substantially improve its performance
going forward.

15-18

Preliminary computations
PB ratio observed = 4.69; PB* = PB 1 = 3.69
Case 1: Solve for implied growth rate
Assumed parameters
ROE
Discount rate, re
Implied parameter
15.0%
10.0%
Case 2: Solve for implied discount rate

Assumed parameters
ROE
Growth rate, g
Implied parameter
15.0%
8.0%
Case 3: Solve for implied future ROE

Assumed parameters
Discount rate, re
Growth rate, g
Implied parameter
10.0%
8.0%
8.6%
9.5%
17.4%
a. Case 1: The growth rate implied is 8.6%.

b. Case 2: The discount rate implied is 9.5%.
c. Case 3: The future ROE rate implied is 17.4%.
d. Recall that this valuation model assumes a constant ROE and a growth rate in perpetuity.
Googles ROE and growth have been high in recent years, but it is unlikely that these can be
sustained over very long horizons. It is more likely that Googles valuation is explained by
several more years of hyper-growth, likely followed by a reversion to economy-wide norms.

15-19

a. This analyst mentions considering a PE multiple to value Disney.
b. The price target for Disney is $85; and, at the date of this report, Disneys stock price was
$71.05.
An investor would realize a 19.6% return if the company actually achieved the target within
12 months.
c. This analyst estimates Disneys earnings by considering expected sales growth including
separate analysis by major segment. The analyst also considers expected margins in each
of these segments in determining their contribution to Disneys earnings. After determining
an estimated earnings per share, the analyst applies a PE multiple to obtain a price target of
$85. This analyst believes the multiple is justified after consideration of Disneys business
and competitive environment historically and relative to peers.
d. The analyst appears to have spent effort learning about Disneys business and competitive
environment. An analysis of recent financial information has been conducted, followed by
the preparation of forecasts focusing on growth in sales and the associated profit margins.
These steps mirror those shown in our study of financial statement analysis. Without an
understanding of the differing elements of Disneys product lines (theme parks,
broadcasting, and retail stores) one could misconstrue the growth that has been recently
occurring for the company and the effects of the overall economy.

15-20
DISCUSSION POINTS
D15-44. (35 minutes)
a. The price to net operating assets ratios for Ralph Lauren and Gap are 3.45 and 5.70,
respectively.
b. The simple average of the two ratios is 4.58. You could weight one of the two companies
more heavily if you believe its ratio is more relevant for valuing Guess.
Guess estimated intrinsic company value is $3,508 million, using a 4.58 multiple on net
operating assets.
Guess estimated equity intrinsic value is $3,829 million, and its estimated equity intrinsic
value per share is $44.84.
c. The price to book value ratios for Ralph Lauren Gap are 2.73 and 5.27, respectively.
d. The simple average of the two ratios is 4.00. You could weight one of the two companies
Guess estimated equity intrinsic value is $4,348 million, using a 4.00 multiple on book
value. Guess estimated equity intrinsic value per share is $50.91.

a. The price to NOPAT ratios for Ralph Lauren and Gap are 12.00 and 12.55, respectively.
b. The simple average of the two ratios is 12.28. You could weight one of the two companies
Guess estimated company intrinsic value is $2,260 million, using a 12.28 multiple.
Guess estimated equity intrinsic value is $2,581 million and its estimated equity intrinsic
value per share is $30.22.
c. The price to net income ratios for Ralph Lauren and Gap are 13.77 and 13.45, respectively.
d. The simple average of the two ratios is 13.61. You could weight one of the two companies
more heavily if you think its ratio is more relevant for valuing Guess.
Guess estimated equity intrinsic value is $2,463 million, using a 13.61 multiple on net
income. Guess estimated equity intrinsic value per share is $28.84.

15-21

a. Guess and Ralph Lauren have similar operating profitability, which implies a good
profitability match. Gap has much higher RNOA.
Guess is much similarly leveraged to Ralph Lauren while GAP has much higher leverage,
which implies Gap would be a poor financial risk match.
Finally, we have no data on the growth of the firms, so we do not know how well matched
they are on that dimension.
b.
TO:
________, Senior Analyst
FROM:
DATE:
SUBJECT:
Further considerations when applying valuation multiples
Using the method of comparables, with Ralph Lauren and Gap as the reference firms, I estimated
Guess equity intrinsic value per share to be between $28 and $51.
To value a firm as a multiple of book value using comparable firms, the comparable firms should
be selected so that they have similar profitability, growth and risk. To value a firm as a multiple of
earnings the firms should have similar growth and risk. Ralph Lauren has similar RNOA and
leverage to Guess, but Gap is more highly leveraged and we have no data on their growth.
If you would like, I can prepare models using other valuation techniques, including discounted
cash flows and discounted residual operating income. These models incorporate estimates of
future cash flows and earnings for Guess. If we have a good handle on Guess future prospects,
these models may generate more dependable estimates of intrinsic value.
c. There are a range of possible answers to this question. However, one should definitely
eliminate APO due to negative expected growth and HD, CAB, and DDS whose expected
growth rates exceed 15%.
If you are comfortable with the analysts forecast of 4.3%
earnings growth for Guess, then it would also make sense to eliminate HBI, TJX, ZQK and
ANF with growth rates over 10%. FL and MW have very low leverage, so they might be
eliminated. This leaves only PERY and KSS.
Continued next page

15-22
D15-46. concluded
d.
PB ratio observed = 2.32; PB* = PB 1 = 1.32
Case 1: Solve for implied growth rate
Assumed parameters
ROE
Discount rate, re
Implied parameter
Case 2: Solve for implied discount rate
Assumed parameters
ROE
Growth rate, g
Implied parameter
Case 3: Solve for implied future ROE
Assumed parameters
Discount rate, re
Growth rate, g
Implied parameter
14%
11%
8.7%
14%
5%
8.9%
11%
5%
18.9%
a. Case 1: See table; the implied growth rate is 8.7%.

b. Case 2: See table; the implied discount rate is 8.9%.
c. Case 3: See table; the implied ROE is 18.9%.
Remember that this valuation model assumes constant ROE and a growth rate in perpetuity.
In case 1, the growth rate of 8.7% (remember this is growth in residual income, not income)
implies that Guess has many investment opportunities. In case 2, the discount rate seems
implausibly low given for the current market and Guess beta of 1.74. In case 3, the ROE is
much higher than Guess current ROE. These findings, however, do not imply that Guess is
irrationally priced. More careful modeling of its future profitability, growth, and risk is
required to draw such a conclusion.

15-23

a. The numerator of this ratio is impacted primarily by assets that are recorded below market
value and also by assets that are not recorded by accounting such as intangibles or items
created through R&D. The denominator being R&D expense provides the clue that this ratio
is seeking to measure the valuation of items by the market created through R&D efforts
which are not included on the balance sheet. In industries for which R&D plays a significant
role, determining their value is an important element of valuation as the current accounting
standards do not allow these items to be recorded as assets.
b. Of the companies you are currently following the obvious candidate is Pfizer as they are
primarily a research oriented pharmaceutical company whose value will be greatly affected
by the success of their R&D efforts. The other company that would be engaging a large
amount of R&D is Procter & Gamble as they attempt to create new products or expand
existing product lines.
c.
TO:
FROM:
DATE:
____, Senior Analyst
SUBJECT:
Considerations when applying industry-based multiples
Using the method of comparables with the suggested multiple of (Price Book) / R&D Expense
must be done with caution. The choice of comparable companies will be key and should be done
to match types of products as closely as possible. For example, when looking at Pfizer, companies
researching drugs specific to certain applications may be valued differently than those seeking
drugs with broad usage.
Another element of the use of this ratio is that it implies that all differences between price and book
arise due to the R&D efforts. However, if a companys accounting is conservative, there will be a
difference not attributable to the R&D. This must be considered when using this multiple. To value
a firm using multiples, the comparable firms should be selected so that they have similar
profitability, growth and risk.
If you would like, I can prepare models using other valuation techniques, including discounted
cash flows and discounted residual operating income. These models incorporate estimates of
future cash flows and earnings for the companies. If we have a good handle on their future
prospects, these models may generate more dependable estimates of intrinsic value.

15-24

a. This analyst is applying an EBITDA multiple to estimate the enterprise value of Marriott.
b. The price target for Marriott is $43; and, at the date of this report, the Marriotts stock price
was $54.23.
An investor would realize a 20.7% negative return if the company actually achieved the
target within 12 months.
c. This analyst estimates Marriotts earnings for 2013 and 2014 to be $2.01 and $2.29 per
share, respectively. The analyst applies a 13.0 EBITDA multiple to obtain a price target of
$43. This analyst believes the higher than average, but lower than historical, multiple is
justified because of Marriotts international operations.
d. One alternative is to apply a RevPAR multiple using the data disclosed in the MD&A section.
The analyst references this industry based multiple which looks at revenue per available
room. This data could be obtained for Marriotts competitors, and then the RevPAR multiple
could be used to value Marriott.

15-25

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Module 15

The advantages of valuation using market multiples compared to valuation using

The disadvantages of valuation using market multiples compared to valuation using

It is quick, straightforward, and requires little data.

It does not have a rigorous theoretical model underlying it.

The residual operating income model follows:

Solutions Manual, Module 15

Cambridge Business Publishers, 2015

For the company-value-to-net-operating-assets ratio, the comparables should be

When PE ratios are reported by data aggregators or quoted in publications (such as

Cambridge Business Publishers, 2015

Financial Statement Analysis and Valuation, 4th Edition

M15-9. (15 minutes)

M15-10. (15 minutes)

M15-11. (15 minutes)

M15-12. (20 minutes)

$8 = ($100 x 18%) ($100 x 10%)

$1 = ($100 x 11%) ($100 x 10%)

Solutions Manual, Module 15

Cambridge Business Publishers, 2015

M15-13. (20 minutes)

$8 = ($100 x 18%) ($100 x 10%)

$1 = ($100 x 11%) ($100 x 10%)

M15-14. (20 minutes)

$3 = ($100 x 18%) ($100 x 15%)

$1 = ($100 x 11%) ($100 x 10%)

M15-15. (20 minutes)

$1 = ($100 x 11%) ($100 x 10%)

$1 = ($100 x 11%) ($100 x 10%)

M15-16. (15 minutes)

Cambridge Business Publishers, 2015

Financial Statement Analysis and Valuation, 4th Edition

M15-17. (15 minutes)

M15-18. (20 minutes)

M15-19. (20 minutes)

M15-20. (15 minutes)

Solutions Manual, Module 15

Cambridge Business Publishers, 2015

E15-22. (20 minutes)

Cambridge Business Publishers, 2015

Financial Statement Analysis and Valuation, 4th Edition

E15-23. (20 minutes)

E15-24. (20 minutes)

E15-25. (20 minutes)

Solutions Manual, Module 15

Cambridge Business Publishers, 2015

E15-26. (15 minutes)

Thus, it is a poor match for

E15-27. (15 minutes)

E15-28. (20 minutes)

Cambridge Business Publishers, 2015

Financial Statement Analysis and Valuation, 4th Edition

E15-29. (20 minutes)

E15-30. (25 minutes)

Solutions Manual, Module 15

Cambridge Business Publishers, 2015

E15-31. (20 minutes)

E15-32. (20 minutes)

E15-33. (25 minutes)

High current profitability, earnings expected to decline but

Average current profitability, profitability expected to remain

Low current profitability, earnings expected to increase but

High current profitability, profitability will remain high