Question

In 2000, Enron enjoyed remarkable success in the capital markets. During that year, Enron’s shares increased in value by 89%, while the S&P 500 index fell by 9%. At the end of 2000, Enron’s shares were trading at roughly $83 per share, and all of the sell-side analysts following Enron recommended the shares as a ‘‘buy’’ or a ‘‘strong buy.’’ With 752.2 million shares outstanding, Enron had a market capitalization of $62,530 million and was one of the largest firms Enron had a market capitalization of $62,530 million and was one of the largest firms (in terms of market capital) in the United States. At year-end 2000, Enron’s book value of common shareholders’ equity was $11,470 million. At year-end 2000, Enron posted earnings per share of $1.19. Among sell-side analysts following Enron, the consensus forecast for earnings per share was $1.31 per share for 2001 and $1.44 per share for 2002, with 10% earnings growth expected from 2003 to 2005. At the time, Enron was paying dividends equivalent to roughly 40% of earnings and was expected to maintain that payout policy. At year-end 2000, Enron had a market beta of 1.7. The risk-free rate of return was 4.3%, and the market risk premium was 5.0%. (Note: The data provided in this problem, and the inferences you draw from them, do not depend on foresight of Enron’s declaring bankruptcy by the end of 2001.)

Reverse engineer Enron’s $83 share price to solve for the implied expected return on
Enron shares at year-end 2000. Do the reverse engineering under the following
assumptions:
(1) Enron’s market price equals value.
(2) The consensus analysts’ earnings-per-share forecasts through 2005 are reliable proxies
for market expectations.
(3) Enron will maintain a 40% dividend payout rate.
(4) Beyond 2005, Enron’s long-run earnings growth rate will be 3.0%.

Please include details on how the reverse engineering numbers are calculated.

Answer 1

ANSWER:

Reverse Engineering:  For our first pass, we assume that at year-end 2000,

1.      Enron's market price equals value.

2.      The consensus analysts' earnings-per-share forecasts through 2005 are reliable proxies for market expectations.

3.      Enron will maintain a 40 percent dividend payout rate.

4.      Beyond 2005, Enron's long-run earnings growth rate will be 3.0 percent and the CAPM discount rate is appropriate.

These first-pass assumptions yield a value of $10.60 per share, much lower than Enron's $83 share price.  The computations (using the residual income model specified using per share amounts) are as follows:

				Year +1	Year +2	Year +3	Year +4	Year +5	Long Run
EPS				$1.31	$1.44	$1.59	$1.74	$1.92	$1.98
BVps (Lagged)			$15.25	$16.02	$16.87	$17.80	$18.83	$19.96
Normal EPS			$1.95	$2.05	$2.16	$2.28	$2.41	$2.56
Abnormal EPS			($0.64)	($0.61)	($0.57)	($0.53)	($0.49)	($0.58)
Present Value Factors		0.887	0.786	0.697	0.618	0.548
PV of Abnormal EPS		($0.57)	($0.48)	($0.40)	($0.33)	($0.27)
Sum of PV of Abnormal EPS		($2.05)
Continuing Value			($3.24)
BV per Share			$15.25
PV of Abnormal EPS and BV per   Share:	$9.96
Times:  Midyear Adjustment:	1.064
Value per Share:			$10.60

To solve for the implied expected return on Enron shares, we re-run the above computations to iterate and solve for the rate of return that equates our value estimate to Enron's $83 share price. Starting with the risk free-rate of return of 4.3, it does not take much iteration to achieve convergence.  Enron's shares are priced to yield a 4.413 percent rate of return, as shown in the following computations:

				Year +1	Year +2	Year +3	Year +4	Year +5	Long Run
EPS				$1.31	$1.44	$1.59	$1.74	$1.92	$1.98
BVps (Lagged)			$15.25	$16.02	$16.87	$17.80	$18.83	$19.96
Normal EPS				$0.67	$0.71	$0.74	$0.79	$0.83	$0.88
Abnormal EPS			$0.64	$0.73	$0.84	$0.96	$1.09	$1.09
Present Value Factors			0.958	0.917	0.878	0.841	0.806
PV of Abnormal EPS			$0.61	$0.67	$0.74	$0.81	$0.88
Sum of PV of Abnormal EPS		$3.70
Continuing Value			$62.39
BV per Share				$15.25
PV of Abnormal EPS and BV per Share:	$81.34
Times: Midyear Adjustment:		1.022
Value per Share:			$83.13