# Question

Michelle Delatorre, the professional tennis player first introduced in the Integrative Problem in Chapter, has returned to your office at Balik and Kiefer to ask some questions about stock valuation and selection. Ms. Delatorre intends to retain your services as her investment adviser and manager, but she wants to “dabble” in the stock market with a small amount of the winnings she earned in tournaments last year. She has posed some questions relating to stock valuation and selection that she would like help answering.

a. What is the difference between evaluating stocks using fundamental analysis and technical analysis?

b. What is a business cycle? What does it mean when we say that the economy is in an expansion? What does it mean when we say that the economy is in a contraction?

c. What approaches can we use to forecast business cycles? Is it difficult to predict business cycles? Why?

d. How are business cycles affected by the monetary policy carried out by the Federal Reserve and by the fiscal policy followed by the government?

e. Why is it necessary to evaluate the industry within which a company operates before making an investment decision? What factors should an investor examine when conducting an industry analysis?

f. How can knowledge of the industry life cycle concept aid an individual with his or her investment decisions?

g. What is the primary reason an investor needs to examine the financial position of a firm?

h. Describe the three valuation techniques discussed in this chapter and indicate when it is appropriate to use each one.

i. Ms. Delatorre has been following a company (Omega Optical) that was recommended by one of her fellow tennis players. The more she investigates the company, the greater her interest becomes. Right now, she does not know how to estimate the value of Omega Optical’s stock. Ms. Delatorre has collected quite a bit of information about the company through her own analysis. The results of her investigations have yielded the following information:

EBIT............... $110,000

Net income .............. $ 60,060

Marginal tax rate ........... 35%

Invested capital ........... $550,000

Before-tax cost of debt, rd ......... 8.0%

Cost of equity, rs ............ 18%

Debt/assets ratio ............ 40%

Shares outstanding .......... 40,000

Current dividend per share, D0 ...... 0

In addition to this information, Ms. Delatorre has given you some analysts’ forecasts that she has gathered from various investment information subscriptions she receives. The consensus of the experts is that Omega will initiate its first dividend payment five years from today, when it pays each investor $4 per share. In the following year, the dividend payment will increase by 25 percent, then the growth in dividends will decrease by 2 percent per year until it stabilizes at the constant, or normal, growth of 5 percent. In other words, dividend growth in Year 6 will be 25 percent, it will decrease to 23 percent in Year 7, it will decrease to 21 percent in Year 8, and so on, until Year 16, when dividend growth settles at 5 percent for the remaining life of the firm.

(1) Using the dividend discount model, compute the value of Omega’s common stock.

(2) Ms. Delatorre’s cache of information indicates that the average P/E ratio for firms with operations similar to Omega’s is 25. Using the P/E valuation approach, what would be the estimate for the price of the stock?

(3) Compute Omega’s EVA. According to this computation, is Omega a good investment? Why?

j. Explain why the results you found in part (i) are not the same for each computation. What do you believe the value for the stock should be?

k. Describe some measures used by technical analysts that might be helpful to Ms. Delatorre’s effort to value Omega’s stock.

l. If you had to summarize the advice of the experts contained in Table and give Ms. Delatorre three pieces of general advice about investing, what would you tell her?

m. Describe the concept of informational efficiency in the financial markets. If the markets are efficient, of what use is investment analysis? What investment advice would you give Ms. Delatorre about investing in an efficient market?

a. What is the difference between evaluating stocks using fundamental analysis and technical analysis?

b. What is a business cycle? What does it mean when we say that the economy is in an expansion? What does it mean when we say that the economy is in a contraction?

c. What approaches can we use to forecast business cycles? Is it difficult to predict business cycles? Why?

d. How are business cycles affected by the monetary policy carried out by the Federal Reserve and by the fiscal policy followed by the government?

e. Why is it necessary to evaluate the industry within which a company operates before making an investment decision? What factors should an investor examine when conducting an industry analysis?

f. How can knowledge of the industry life cycle concept aid an individual with his or her investment decisions?

g. What is the primary reason an investor needs to examine the financial position of a firm?

h. Describe the three valuation techniques discussed in this chapter and indicate when it is appropriate to use each one.

i. Ms. Delatorre has been following a company (Omega Optical) that was recommended by one of her fellow tennis players. The more she investigates the company, the greater her interest becomes. Right now, she does not know how to estimate the value of Omega Optical’s stock. Ms. Delatorre has collected quite a bit of information about the company through her own analysis. The results of her investigations have yielded the following information:

EBIT............... $110,000

Net income .............. $ 60,060

Marginal tax rate ........... 35%

Invested capital ........... $550,000

Before-tax cost of debt, rd ......... 8.0%

Cost of equity, rs ............ 18%

Debt/assets ratio ............ 40%

Shares outstanding .......... 40,000

Current dividend per share, D0 ...... 0

In addition to this information, Ms. Delatorre has given you some analysts’ forecasts that she has gathered from various investment information subscriptions she receives. The consensus of the experts is that Omega will initiate its first dividend payment five years from today, when it pays each investor $4 per share. In the following year, the dividend payment will increase by 25 percent, then the growth in dividends will decrease by 2 percent per year until it stabilizes at the constant, or normal, growth of 5 percent. In other words, dividend growth in Year 6 will be 25 percent, it will decrease to 23 percent in Year 7, it will decrease to 21 percent in Year 8, and so on, until Year 16, when dividend growth settles at 5 percent for the remaining life of the firm.

(1) Using the dividend discount model, compute the value of Omega’s common stock.

(2) Ms. Delatorre’s cache of information indicates that the average P/E ratio for firms with operations similar to Omega’s is 25. Using the P/E valuation approach, what would be the estimate for the price of the stock?

(3) Compute Omega’s EVA. According to this computation, is Omega a good investment? Why?

j. Explain why the results you found in part (i) are not the same for each computation. What do you believe the value for the stock should be?

k. Describe some measures used by technical analysts that might be helpful to Ms. Delatorre’s effort to value Omega’s stock.

l. If you had to summarize the advice of the experts contained in Table and give Ms. Delatorre three pieces of general advice about investing, what would you tell her?

m. Describe the concept of informational efficiency in the financial markets. If the markets are efficient, of what use is investment analysis? What investment advice would you give Ms. Delatorre about investing in an efficient market?

## Answer to relevant Questions

Use the model in File C17 to solve this problem. Refer back to Problem 17-11.Rework parts (a) through (d) using the computerized model, but make the following changes. Consider each change to be independent of the others; ...Thomas has a five-stock portfolio that has a market value equal to $400,000. The portfolio’s beta is 1.5. Thomas is considering selling a particular stock to help pay some university expenses. The stock is valued at ...What would happen to the standard of living in the United States if people lost faith in our financial markets? Why?What does it mean to maximize the value of a corporation?The current risk-free rate of return, rRF, is 4 percent and the market risk pre-mium, RPM, is 5 percent. If the beta coefficient associated with a firm's stock is 2.0, what should be the stock's required rate of return?Post your question

0