Solution assignment 4 1.

In fundamental analysis, the intrinsic value of a stock is its justified price; that is, it is the price justified by investors' evaluations of a company's fundamental financial variables. It is also thought of as an estimated value or a formula value. A stocks intrinsic value can be estimated by using the dividend discount model or the earnings multiplier model. 2. The three variables that affect the P/E ratio are: (a) The dividend payout ratio (direct relation) (b) The required rate of return (inverse relation) (c) The expected growth rate in dividends (direct relation). (a) Earnings and dividends are directly related; therefore, an increase in the expected growth rate of earnings would equate with an increase in g, which is directly related to the P/E (the typical assumption is that the payout ratio is constant; therefore, g is the expected growth rate in both dividends and earnings). (b) A decline in the expected payout will lead to a decline in the P/E. (c) An increase in the risk-free rate of return will result in a rise in k and, therefore, a decline in the P/E. (d) An increase in the risk premium will result in a rise in k and, therefore, a decline in the P/E. (e) A decrease in the required rate of return will increase the P/E. 3. Beta reflects the relative systematic risk for a stock. Other things being equal, the higher the beta, the higher the risk, and the higher the required rate of return. Investors will want to know about a stocks beta in order to estimate the volatility of the stocks returns. If a rise in the market is expected, investors would prefer, other things being equal, stocks with higher betas. Likewise, with an expected market decline, lower betas would be preferred if stocks are to be held.

COMPUTATIONAL PROBLEMS . For 2008, as an illustration, the calculations for parts (a), (b) and (c) are: (a) 100(721/8256) = 8.73% (b) 100(289/8256) = 3.50% (c) 289/51.92 = $5.57 The same values for 2004-2007 are: Year (a) (b) (c) 2004 9.6% 4.2% $4.65 2005 9.0 4.3 5.12 2006 8.6 3.9 5.16 2007 8.3 2.6 4.47 (d): 1, 2, 3, 4 and 5 are calculated for 2008, and are summarized for 2004-2007 below. (1) (2) (3) (4) (5) 2315 / 1342 = 1.72 (736 / 2804) (100) = 26.2%, as a percentage 1872 / 51.92 = $36.06 100 (Net Income after tax/Common Equity) = 100(289 / 1872) = 15.4% (289 / 4310)100 = 6.7% Year 2004 2005 2006 2007 (1) 2.05 1.86 2.11 1.86 (2) 14.9% 13.8 18.4 29.3 (3) $26.46 29.62 32.57 32.88 (4) 17.6% 17.3 15.8 13.6 (5) 9.0% 8.6 8.2 5.7

The 2008 calculations are shown for (6) - (11), and summarized for the other years. (6) 4310 / 1872 = 2.30 NOTE: 2.30 X ROA of 6.7% = 15.4%, the ROE (7) (289 / 8256)100 = 3.5%, as a percentage (8) 8256 / 4310 = 1.92 (9) 535 + 139 = $674 mn. (10) (289 / 674)100 = 42.9% (11) (674 / 8256)100 = 8.2% Year (6) (7) (8) (9) (10) (11) 2004 1.94 4.2% 2.13 $483mn 48.0% 8.8% 2005 2.01 4.3 2.00 509 50.3 8.5 2006 1.93 3.9 2.13 523 48.8 7.9

2007

2.37

2.6

2.16

570

38.8

6.8

(e) Examining the figures for the years 2004-2008 from parts (a) to (d), ROE declined through 2007, although it recovered somewhat in 2008. The same is true of ROA. Leverage has increased. Operating efficiency declined through 2007 before turning up in 2008. Operating income/net revenue has been deteriorating, as has net profits/revenue. The current ratio has deteriorated. In summary, it would appear that GF underwent some deterioration between 2004 and 2008, with some (but not complete) improvement in 2008. Examining the and ROA in 2008, we can see that GF had recovered some ground, but still compared unfavorably to 2004 and 2005.

ROE