Question

1.1)Critically evaluate the following statement made by a quantitative buy-side analyst: “It is not worth the time to develop detailed fundamentals-based forecasts of sales growth and profit margins to make earnings projections, or cash flow components to make projections of free cash flow. One can be almost as accurate, at virtually no cost, using the random walk model to forecast earnings and free cash flow.”

1.2)To forecast earnings and cash flows beyond three years, a sell-side analyst assumes that sales grow at the rate of inflation, capital expenditures are equal to depreciation, and that leverage, net profit margins, and working capital to sales ratios stay constant. Explain what pattern of return on equity is implied by these assumptions and whether this is reasonable.

1.3)“A company cannot grow faster than its sustainable growth rate.” Is this statement True or false? Explain your answer.

Answer 1

1.1 Research attempting to forecast earnings found that the random walk model where current year's earnings are the prediction for next year provides the best forecast of annual earnings.

The model assumes that past shocks to abnormal r0earnings persist forever but that future shocks are random or unpredictable the random walk model can be written as follows.

Forecasted AE1 = AE0

Forecasted AE1 is the forecast of next year's abnormal earnings and AE0 is current period abnormal earnings. Under the model, forecasted abnormal earnings for two years ahead are simpley abnormal earnings in year one or once again current abnormal earnings.

1.2 Return on equity is that company generates from each rupee of capital you invested in that business. Warren buffet uses a series of fundamental indicators to identifysolid companies worth investing it. Some of the key fundamental indicators used by stock analyst are return on equity, P/E Ratio, return on capital employed, free cash flow etc.

Retun on equity is a tool to measure how efficienefficiently the company manges investor money in the business to generate anprofit.

It is a ratio of net profit earned by the company to shareholder fund. It is called as mother of all ratios that can be measured from a company financial report.

1.3 False

The sustainable growth rate is the speed at which a company can expand either its level of profitability or its financial policies. Return on equity and the dividend pay out ratio determine the funds remaining in the firm and available to finance the firm growth. If a company wants to exceed its sustainable growth rate, it can increase its return on equity by improving its profitability, imcreasing its assets turnover or increasing leverage. Alternatively, it can reduce its dividend payout rate, therby increasing funds avaliable for reinvestment.