1. Even in a highly efficient market, financial analysts ...
1. Even in a highly efficient market, financial analysts
still serve several important functions. First, they
identify the relevant characteristics of individual
securities or groups of securities (for example, betas,
unique risks, sensitivities to various pervasive
factors). Knowledge of these characteristics is
important in the construction of efficient portfolios.
Second, financial analysts attempt to identify mispriced
securities. While in a highly efficient market these
opportunities may be limited in number, situations will
still arise for skillful analysts to find profitable
(that is, net of all costs) mispricings.
Third, financial analysts can develop an understanding of
their clients' risk-return preferences. This enables
them to design portfolios that suit the investment
objectives of their clients.
2. Being able to accurately forecast a company’s next year’s
earnings does not necessarily imply an ability to discern
the performance of the company’s stock. If other analysts
also can accurately forecast the company’s earnings, then
the consensus forecast will likely be already imbedded in
the stock’s price. The analyst’s accuracy will only be
valuable when he or she has identified a situation where
his or her forecasts are materially different from the
consensus forecast. In that case, the analyst should
expect a strong relative risk-adjusted return on the
stock if his or her earnings forecast is above the
consensus and expect a weak relative risk-adjusted return
on the stock if his or her earnings forecast is below the
3. Predicting rainfall is essentially a game against nature.
However, nature is not an opponent attempting to defeat
the predictor. Thus, with careful analysis, one ought to
be able to develop a prediction model that consistently
and accurately forecasts rainfall. Further, the success
of the model will have no impact on nature. That is,
nature will take no action to counter the predictor's
Conversely, predicting the movements of enemy submarines
is a game against an opponent seeking to defeat the
predictor. To the extent that the predictor has initial
success in predicting the movements of enemy's
submarines, then the enemy will take actions to alter
those movements and make the forecasting model fail.
Picking mispriced stocks is considerably more like
predicting submarine movements than forecasting rainfall.
The investor picking mispriced stocks is competing
against opponents (other market participants) who will
take action to offset the success of the stock predictor.
4. The simplest answer would be that technical analysis can
add value. It may be that the tests used by efficient
markets proponents are too unsophisticated to capture the
subtle aspects of technical analysis employed by some
investors. Most tests debunking technical analysis focus
on simple technical patterns. In fact, in recent years,
numerous empirical studies have offered credence to
various forms of technical analysis (for example, studies
indicating that investors overreact to good or bad news).
Another answer could be that users of technical analysis
are simply fooling themselves into believing that it has
merit. Technical analysis proponents can be very
convincing in hindsight and their arguments may have
persuaded many investors to apply the techniques,
notwithstanding the strong body of evidence indicating
that technical analysis cannot produce superior returns.
5. Investors must overreact to certain types of information
if momentum and contrarian strategies are to be
successful. For example, momentum strategies rely on
investors reacting too favorably to good news or too
unfavorably to bad news, driving security prices away
from equilibrium in the direction of the news. However,
implicit in the concept of momentum strategies is that
investors will continue to react in the same direction
for a period of time sufficient to allow the momentum
investor to profit from long positions in “good news”
securities or short positions in “bad news” securities.
Contrarian strategies similarly rely on overreaction by
investors. However, it is assumed that investors must
ultimately reverse course and that prices of securities
for which good news has been reported will eventually
decline toward equilibrium. Conversely, prices of
securities for which bad news has been reported will
eventually increase toward equilibrium.
6. Top-down forecasting begins with a forecast of the
economy. This forecast then provides assumptions that
are used in constructing industry forecasts, which in
turn provide the basis for making company forecasts.
Bottom-up financial forecasting, on the other hand,
begins with individual company forecasts. These
forecasts are then aggregated to produce industry
forecasts, which in turn are aggregated to generate a
forecast of the overall economy.
The primary advantage of top-down forecasting is that it
creates a consistent set of assumptions to be used in
making lower level forecasts. As each level, the
forecasts are tied to the forecasts made at the preceding
higher level. The primary disadvantage of top-down
forecasting is that forecasting errors at higher levels
necessarily work their way into the forecasts at lower
The primary advantage of bottom-up forecasting is that it
permits more creative use of analysts' individual
forecasting insights. Analysts are not tied to rigid
economy and industry forecasts. The primary disadvantage
is that the analysts' individual company forecasts may
utilize inconsistent underlying assumptions about the
outlook for the economy and various industries.
7. The two companies must differ in terms of the amount of
leverage they employ. Because:
(Earnings/Assets) × (Assets/Equity) = ROE
and because the two firms have the same earnings and
assets, the amount of equity they have must differ. For
companies with positive ROA, their ROE is enhanced by
maintaining higher debt-equity ratios. Baldwin must have
a higher debt-equity ratio than Hudson.
8. We know that:
ROA = (Net income/EBIT) × (EBIT/Sales) × (Sales/Assets)
ROE = ROA × (Assets/Equity)
In the case of Afton:
ROA = 0.65 × 0.10 × 2.10
= .137 = 13.7%
ROE = .137 × 3.0
= .411 = 41.1%
9. a. The price-earnings ratio is:
P/E = Price/Earnings/Average shares outstanding
P/E = $30/$200,000/100,000
b. Book value per share is:
BV = Stockholders equity/Average shares outstanding
BV = $600,000/100,000
c. The price-book ratio is:
P/B= Price/Book value per share
d. The dividend yield is:
D/P= Dividends per share/Price
= .017 = 1.7%
e. The payout ratio is:
P/O = Dividends per share/Earnings per share
P/O = $0.50/$2
= .250 = 25.0%
10. It is not true that reported earnings numbers are always
(or even often) directly comparable across corporations.
Generally accepted accounting principles permit
considerable latitude in reporting on various corporate
activities. Examples include depreciation and inventory
valuation. As a result it is possible for companies in
the same line of business with the same revenues and
costs to report radically different earnings. The
problem is even more acute when comparing firms in
11. Unique student answer. Students should apply the
relationship illustrated in Figure 22.1.
12. Company A’s earnings should not be assumed to grow faster
than Company B’s despite the former company’s higher ROE.
Referring back to Equation (17.51b) whereby g = r (1 −
p), the sustainable earnings growth rate of a company is
a function of both the company’s ROE and its payout
ratio. If a company with a high ROE also paid out a large
proportion of its earnings, then the company’s earnings
might not grow faster than a company with a lower ROE but
also a lower payout ratio.
13. Ratio analysis is often more useful than simply examining
absolute financial statement numbers because those
numbers display more meaning when they are considered
relative to one another. For example, a growing firm will
generally increase the amount of its debt outstanding.
Such increases are expected and appropriate. However,
when that debt relative to total assets or stockholders’
equity increases significantly, a red flag is raised for
analysts. They will want to know the reasons for, and
ramifications of, such an increase in leverage.
14. Comparisons of one company’s ratios with those of its
competitors can be fraught with problems. In many
industries, competitors’ lines of business do not
precisely match up. For example, in the general retail
merchandise industry, Sears might be compared to J.C.
Penney or Federated Department Stores. However, Sears has
a very large credit card operation compared to its
competitors. This business has a significant effect on
Sears’ balance sheet and income statement and makes
comparisons of those financial statements with its
competitors problematic. Further, even very similar
companies may use different accounting procedures. The
result is often an apples and oranges situation that
diminishes the value of peer comparisons.
15. The insider trading data reported in the Official Summary
is publicly available. If this information were truly
valuable, then in a highly efficient market investors
should be expected to incorporate it in the price of the
affected stocks as soon as it becomes available. Yet
certain studies indicate that abnormal profits can be
earned by trading on this insider trading data for an
extended period of time after the information is
initially available to the public. This finding is
inconsistent with the semistrong-form view of efficient
16. Most importantly, technical analysts believe that
information is not received by all investors
simultaneously. Information is believed to move
gradually across various segments of the investment
community over time. As a result stock prices do not
reflect immediately and fully all relevant information
(as would occur in a perfectly efficient market).
Rather, stock prices gradually react in predictable ways
to a drawn out process of information dissemination.
= 1.22% = 0
Leverage = Total Assets/Common Shareholder's Equity
= 245/159 = 291/220
= 1.54x = 1.32x
Tax Rate = Income Taxes/Pre-Tax Income
= 13/32 = 37/67
= 40.63% = 55.22%
The recommended formula is:
Return on Equity (ROE) = [(Op. Margin × Asset Turnover)
- Int. Burden] × Fin Leverage
× (100% - Income Tax Rate)
1985: = [((38 - 3)/542 × 542/245) - 3/245] × 245/159 ×
(1 - .4063)
= [(6.46% × 2.21x) - 1.22%] × 1.54x × .5937
1989: = [((76 - 9)/979 × 979/291) - 0] × 291/220 ×
(1 - .5522)
= [(6.84% × 3.36x) - 0] × 1.32x × .4478
Two alternative approaches are also correct:
o [Op. Margin - (Int. Burden/Asset Turnover)] × Fin
× Asset Turnover × (100% - Income Tax Rate)
o [(Fin Leverage × Asset Turnover × Op. Margin)
- (Fin Leverage × Interest Burden)] × (100%
- Income Tax Rate)
b. i) Asset turnover measures the ability of a company
to minimize the level of assets (current and
fixed) to support its level of sales. The asset
turnover increased substantially over the period
thus contributing to an increase in the ROE.
ii) Financial leverage measures the amount of financing outside of
equity including short and long-term debt. Financial leverage declined over the period
thus adversely affected the ROE. Since asset turnover rose substantially more than
financial leverage declined, the net effect was an increase in ROE.