1.   Even in a highly efficient market, financial analysts
     still serve several important functions.      First, they
...
submarines, then the enemy will take actions to alter
     those movements and make the forecasting model fail.

     Pick...
economy.   This forecast then provides assumptions that
     are used in constructing industry forecasts, which in
     tu...
ROA = 0.65 × 0.10 × 2.10

     =    .137 = 13.7%

     ROE = .137 × 3.0

     =    .411 = 41.1%

9.   a.   The price-earni...
e.   The payout ratio is:

        P/O = Dividends per share/Earnings per share

        For Augusta:

        P/O = $0.50...
competitors can be fraught with problems. In many
      industries, competitors’ lines of business do not
      precisely ...
24


                           23




         Fort McCoy Stock Price ($)
                           22


               ...
= 1.22%                  = 0

Financial
Leverage = Total Assets/Common Shareholder's Equity

= 245/159                = 29...
- (Fin Leverage × Interest Burden)] × (100%

     - Income Tax Rate)

     b.    i)   Asset turnover measures the ability ...
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1. Even in a highly efficient market, financial analysts ...

  1. 1. 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 consensus. 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 successful forecasting. 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
  2. 2. 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
  3. 3. 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 levels. 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) and ROE = ROA × (Assets/Equity) In the case of Afton:
  4. 4. 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 For Augusta: P/E = $30/$200,000/100,000 = 15.0 b. Book value per share is: BV = Stockholders equity/Average shares outstanding For Augusta: BV = $600,000/100,000 = $6.00 c. The price-book ratio is: P/B= Price/Book value per share For Augusta: P/B= $30/$6 = 5.0 d. The dividend yield is: D/P= Dividends per share/Price For Augusta: D/P= $0.50/$30 = .017 = 1.7%
  5. 5. e. The payout ratio is: P/O = Dividends per share/Earnings per share For Augusta: 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 different industries. 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
  6. 6. 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 markets. 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. 17.
  7. 7. 24 23 Fort McCoy Stock Price ($) 22 21 20 19 18 17 0 1 2 3 4 5 6 7 8 9 10 Day 18. Rel strength = [Fort McCoy price/S&P 500 price] × 100 Day 1 2 3 4 5 6 7 8 9 10 Rel Strgh 6.7 6.7 6.9 6.8 6.6 6.9 6.7 6.2 5.9 5.5 19. (From The CFA Candidate Study and Examination Program Review, 1991.) a. 1985 1989 Operating Margin = (Operating Income - Depreciation)/Sales = (38 - 3)/542 = (76 - 9)/979 = 6.46% = 6.84% Asset Turnover = Sales/Total Assets = 542/245 = 979/291 = 2.21x = 3.36x Interest Burden = Interest Expense/Total Assets = 3/245 = 0/291
  8. 8. = 1.22% = 0 Financial 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 = 11.94% 1989: = [((76 - 9)/979 × 979/291) - 0] × 291/220 × (1 - .5522) = [(6.84% × 3.36x) - 0] × 1.32x × .4478 = 13.58% Two alternative approaches are also correct: o [Op. Margin - (Int. Burden/Asset Turnover)] × Fin Leverage × Asset Turnover × (100% - Income Tax Rate) o [(Fin Leverage × Asset Turnover × Op. Margin)
  9. 9. - (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.

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