Question

Arthur Cloff is an equity portfolio manager working for E-Tuff Investments (E-Tuff) - an asset management firm based in California, USA. Cloff was recently invited to a seminar by the California Investment Council (CIC) in collaboration with the Financial Institute of Portfolio Managers (FIPM). The seminar gathered equity analysts and portfolio managers from some of the leading asset management firms in the USA. Tom Mahard was the guest speaker at the event. After the seminar, Mahard held an informal discussion with Cloff and a few other portfolio managers on the current attractiveness of equity markets in different countries. He made the following comment:

“I have been assessing the equity markets in Europe, with a particular interest in Germany - using the Fed Model. I have gathered the following information about the major stock indexes in the continent:

1). The Euro-stock index forward P/E based on next year’s earnings estimates is 20.67. The yield on a similarly dated 10-year Euro Government bond is 5.64%.

2). The forward P/E for the German stock index based on next year’s earnings estimates is 15.22. Ten-year German Government bonds offer a yield of 7.85%.”

After listening to Mahard, Cloff decided to make an assessment of the U.S. equity market. Exhibit 1 displays some of the information he gathered for his analysis.

Exhibit 1. U.S. Equity Market Information

Moody’s A-rated corporate bond yields	6.7%
10-year T-bond yields	5.5%
5-year earnings growth rate forecast for the S&P 500 Index	11.5%
2-year earnings growth rate forecast for the S&P 500 Index	15.0%
Weight the market gives to 5-year earnings projections	0.10
Weight the market gives to 2-year earnings projections	0.065

Cloff then talked to Mahard about his evaluation of the U.S. market. At some point in their conversation, Mahard made the following comment regarding the Fed model:

“One of the drawbacks of the Fed Model is that the relationship between interest rates and earnings yields is not a linear one. This is a drawback most noticeable at low-interest rates.

However, by incorporating interest rates, the model adequately reflects the effects of inflation on the fair-value of the market.”

Cloff is evaluating T-Wires Enterprises (T-Wires), a small firm in the U.S. The company has experienced high growth and shifts in the use of financial leverage in the recent past. One of the reasons for its success is its ability to completely pass cost increases on to customers. Cloff is using the firm’s own historical P/E for valuation purposes. In his report, Cloff stated that the justified P/E for the firm would be inversely related to the inflation rate, and the higher the inflation, the greater effect there would be on the P/E multiple.

Although Cloff mostly uses the P/E ratio for comparisons between stocks, he also knows that the P/BV ratio can help in identifying excess return opportunities. Recently, when reviewing Masonry Corporation (MC), Cloff found out that the P/B ratio of the company increased considerably, whereas its P/E ratio narrowed by 23%. What’s more, the company’s stock price remained relatively constant over the same time period. Cloff wasn’t sure of the reason behind this scenario. justify your choice:

Question 1:

With respect to his evaluation of T-Wires, is Cloff is most accurate with respect to:

a) his use of the benchmark for valuation only.

b) his statement about the relationship between justified P/E and inflation only.

c) neither his use of the benchmark nor his statement about the relationship between justified P/E and inflation.

Question 2:

The difference in the P/BV and P/E ratios of MC is least likely because of:

a) share repurchases at a price higher than the book value of MC shares.

b) share repurchases at a price lower than the book value of MC shares.

c) a shift to a just-in-time inventory system.

Question 3:

Which of the following about the justified P/BV using the Gordon Growth model is most accurate?

a) If two stocks have the same P/BV ratio, they are equivalent in value regardless of the level of ROE for the two stocks, all else equal.

b) If the value of expected future residual earnings is positive, the justified P/BV will be greater than 1.

c) The most important determinant of the justified P/BV ratio is the relationship between ROE and r.

Answer 1

Q1. Option (c)

In using historical P/Es for comparisons, analysts should be alert to the impact on P/E levels of changes in a company’s business mix and leverage over time. Shifts in the use of financial leverage may impair comparability based on average own past P/E.

T-wires has experienced shift in the use of financial average in the recent past, hence own Historical P/E ratio should not be used as a relevant benchmark.

where ρ = real rate of return = Nominal Interest rate (r) - Inflation rate (i)

λ = percentage of inflation in costs that the company can pass through to earnings

If a company can pass through all inflation, so that λ = 1 (100 percent), then the P/E is equal to 1/ρ, i.e. the jusitified P/E becomes independent of Inflation rate. With complete cost pass-through for T-wires, the justified P/E should not be affected by inflation.

Q2. (b)

Buybacks reduce the number of shares outstanding and a company's total assets. A share decrease boosts EPS and lowers the P/E for more attractive value.

However, a major distortion of book value per share occurs due to a major share repurchase done above the current book value per share number. Buybacks improve the EPS (this narrowing P/E ratio), but lowered book value per share (thus boosting P/BV ratio). So, statement (a) is correct and can be one of the reasons for lowering P/E but increasing P/BV.

However, if the share repurchase is done at a price lower than the book value of equity, it will rather increase the book value per remaining share. Hence, both P/BV and P/E ratio will fall. Hence, statement (b) is the answer.

Q3. (b)

The expression for the justified P/B based on the most recent book value (B0) is

This equation clearly suggests that if two stocks have the same P/BV ratio, the one with the higher ROE is relatively undervalued, all else equal. Hence, (a) is incorrect.

The expression for the justified P/B based on the residual income valuation is:

The equation clearly indicates that if the present value of expected future residual earnings is positive,
the justified P/B is greater than 1. Hence, (b) is accurate.

As we can observe from the first P/BV equation, justified P/BV is a function of ROE, r as well as growth (g). Hence, statement (c) is incomplete and inaccurate.