Tut4_sol
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E6.9. Residual Earnings and Abnormal Earnings Growth: IBM The pro forma for the forecast is as follows:2002 2003 2004 2005 2006 2007Eps 4.32 5.03 5.58 6.20 6.88 Dps 0.60 0.67 0.74 0.83 0.92 Bps 13.85 17.57 21.93 26.77 32.14 38.10Reinvested dividends at 12% 0.072 0.080 0.089 0.100 Cum-dividend earnings 5.102 5.660 6.289 6.980 Normal earnings 4.838 5.634 6.250 6.944Abnormal earnings growth 0.264 0.026 0.039 0.036Residual earnings 2.658 2.922 2.948 2.987 3.023Change in residual earnings 0.264 0.026 0.039 0.036The answers to parts a, b and c of the question are in the last three lines of the pro forma.E6.12. Challenging the Level of the S&P 500 with Analysts’ ForecastsThe required return = risk free rate + risk premium = 5% + 5% = 10%To develop the pro forma for the implied growth rate, first apply the forward P/E ratio to get an earnings forecast for 2006, then convert the PEG ratio to an earnings forecast for 2007:Forward P/E = Price/Earnings 2006Treat the 1271 as dollars to get earnings in dollars:$1,271/Earnings 2006 = 15Thus Earnings 2006 = $84.73 PEG = 2007/for Rate GrowthE P Forward = 1.47Thus, for a forward P/E of 15, the 2007 growth rate for 2007 earnings is 10.2%.Thus, 2007 earnings forecasted is $84.73 × 1.102 = $93.37a. The pro forma to calculate abnormal earnings growth (AEG) is as follows:2003 2004Earnings 84.73 93.37 Dividends (payout = 27%) 22.88 Reinvested dividends (at 10%) 2.288 Cum-dividend earnings 95.658 Normal earnings ($84.73 x 1.10) 93.203 AEG 2.455b. If cum-dividend earnings are expected to grow at the required rate of return, 10%, after 2006, the P/E should be normal: P/E =10.01= 10At this P/E, the index should be $84.73 × 10 = 847.3The normal P/E is appropriate if (cum-dividend) earnings are expected to grow at a rate equal to the required return, 10%. The P/E based on analysts forecast (15) is higher than this because the market sees earnings growing at a higher rate. Is this assessment reasonable?c. Applying the abnormal earnings growth (AEG) pricing model with the long-term growth rate for AEG of 4%:⎥⎦⎤⎢⎣⎡-+=04.110.1455.273.8410.01V= 1256d. The S&P 500 index is appropriately priced (approximately) at 1271. This will not always be the case. The estimated level can different from the actual level for a number of reasons:1. Analysts’ forecasts are too optimistic relative to how the rest of the market sees it.2. The market agrees with analysts’ forecasts for 2006 and 2007, but sees the long -term growth rate at less than 4%.3. The market requires a higher or lower required return than 10%.4. The market is mispriced.With respect to point 1, sell-side analysts’ forecasts are o ften overly optimistic, particularly two-year ahead forecasts on which the AEG is calculated.This exercise is dangerous when both the market and analysts are too optimistic (as in the bubble). Then you have to challenge the price with your own forecasts. Notice that the next exercise works with actual earnings numbers, not analysts’ forecasts.E6.14. Inferring Implied EPS Growth Rates: Kimberly-Clark CorporationPrice, March 2005 $64.81 a.18.24 3.641.6064.81 P/E Trailing =+=17.01 3.8164.81P/E Forward ==12.24 0.0891.089P/E trailing Normal ==11.24 0.0891P/E forward Normal ==b.Calculate AEG for 2006: 2004 2005 2006Eps 3.64 3.81 4.14 Dps1.60 1.80 1.96 Dividends reinvested at 8.9% 0.1602 Cum-dividend earnings 4.3002Normal eps (3.81 x 1.089) 4.1491 Abnormal earnings growth (AEG)0.151110.1511 64.81 = 3.81 + 0.089 1.089 - g P ⎡⎤=⎢⎥⎣⎦()rate growth 1.2% 1.012 =gc. 2005 2006 2007 2008 2009 2010Eps 3.81 4.14 Dps 1.80 1.96 2.14 2.33 2.54 2.77 AEG 0.1511 0.1529 0.1547 0.1566 0.1585 (growing at 1.2%)Reinvested dividends (0.1744) (0.1905) (0.2074) (0.2261) (at 8.9%) Normal earnings 4.5085 4.8863 5.2822 5.6970 Eps4.48704.85055.23145.6294Eps growth rate 8.66% 8.38% 8.10% 7.85% 7.61%Note: Normal earnings are the earnings in the prior year growing at 8.9%. So, for 2008, normal earnings = $4.487 x 1.089 = 4.8863. d.The market was pricing approximately the same growth rates as forecasted by analysts. Put another way, the market was pricing KMB based on consensus analysts’ forecasts. e.Yes, as analysts were forecasting the same growth rates as those implied in the market price, they are saying that the market price is reasonable. The 2.6 rating – a HOLD – has integrity.(If you are following the Continuing Case in the text, some of this material will be familiar to you.)。
