FI 413 Study Guide - Final Guide: Cash Flow, Demand Curve, Transaction Cost
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International Research Journal of Applied Finance ISSN 2229 â 6891
Vol. VI Issue â 8 August, 2015 Case Study Series
A Stock Valuation Case: An Application of the âMethod of Comparablesâ for Macyâs Shares
Halil D. Kaya* ,Julia S. Kwok
Abstract
The primary focus of this case is the application of the âMethod of Comparablesâ in the estimation of the value of a security. An investment decision will be made based on the comparison of the selling price and the estimated value. A security will be good for purchase if the estimated value is higher than the market price. This method utilizes basic financial ratios that are commonly provided by financial web sites. First, using Yahoo Finance website, the pricing, sales, book value of equity and shares outstanding data are collected for both the target firm and the competitor firms. Then, the pricing multiples (i.e. price earnings ratio, price to sales ratio and price to book ratio) of the competitors are calculated. After that, those multiples along with the target firmâs earnings, sales, book value and shares outstanding data are used to estimate target firmâs share value. The case also examines the impact of treating ânegativesâ in the data. Students will learn that replacing negative earnings with zeros tend to induce less bias in target firmâs value estimation than excluding the ânegativeâ data altogether.
Introduction
March 14, 2015 was a sunny day. Mary took advantage of the nice weather to have lunch at the Mall. On her way back to work, she walked by Susanâs investment office. Susan was Maryâs college roommate. They both liked shopping together to find new fashionable clothes. Looking at her watch, Mary realized she had half an hour to spend. She thought she would drop by and say hello to Susan.
The Performance of Macyâs
âHi, Susan, how are you?â How is your business?â said Mary. Susan was a recent finance graduate. Susan replied, âI am doing fine. Thank you. After so many years, the market is still recovering from the mortgage crisis; many investors have been buying back stocks that they have sold during the crisis. What are you up to?â âI want to start my investment in securities, too. I have a couple thousand dollars, would Macyâs be a good stock to invest in now? That was our favorite store to shop among all of the department stores,â Mary exclaimed. She added, âAlso, I read from Motleyâs Foolâs article on Macyâs today about its earnings per share growth for the last 16 quartersâ (Zahid Waheed, 2014).
In response to Maryâs questions, Susan checked the monthly adjusted returns of Macyâs in Yahoo Finance. She found that, since March 2010, Macyâs stock price had an average annual increase of 23.5% over the last 5 years. The stock rose from $19.98 to $57.38. Susan then told Mary that Macyâs was indeed a growing stock. She added that its success could be attributed to the omni-channel integration, e-commerce and magic selling strategies which allowed merging of sales channels, online shopping and better customer care. Since investment strategy 101 is to buy low, and sell high, given Macyâs stock price had been going up, Susan was not sure whether Macyâs was currently overvalued or undervalued by the market.
The Method of Comparables
Susan remembered her class lecture on the two types of valuation of stocks, namely absolute and relative evaluation. The absolute evaluation focuses on finding the intrinsic value of the security based on fundamentals. That involves more complicated models of discounting cash flows from dividends, operations and residual income.
On the other hand, relative evaluation is quick and easy to use. It assumes two similar securities should sell for one price in an efficient market, i.e. âLaw of One Price.â So an analyst can estimate its stock price by multiplying target companyâs specific earnings, sales and equity value data by the earning, sales and equity âper shareâ financial multiples of its competitors.
Since Mary was not familiarized with financial models, Susan decided to use the easy-toperform-and-analyze âComparables Methodâ to estimate the relative value of Macyâs stock.
The Financial Data
Dillards, JC Penney and Nordstrom were selected as competitors of Macyâs as they were all in retail department store business. Susan would need some financial data regarding these companies. She went to SECâs (i.e. Securities and Exchange Commission) website and downloaded these companiesâ most recent balance sheet and income statement data. Out of those statements, she knew that she would need the EPS (i.e. earnings per share), the sales number, the number of outstanding shares, and the book value of equity. She also knew that she would need the current share price for each company. After some work, she had found all the necessary information to run the analysis. Below were the data that she had gathered:
All data are in US$ except for the number of outstanding shares. The share price as of March 15, 2014 is shown in the first column. The âEarnings per shareâ is shown in the second column. The third column reports the book value of equity. The last column shows the number of outstanding shares.
| Firm | P ($) | EPS ($) | Sales ($) | BV of equity ($) | # of shares |
| Macy's | 58.58 | 3.93 | 27,931 mil. | 6,249 mil. | 378.3 mil. |
| Dillard's | 90.61 | 7.10 | 6,532 mil. | 1,992 mil. | 45.6 mil. |
| JC Penney | 8.71 | -5.57 | 11,859 mil. | 3,087 mil. | 249.3 mil. |
| Nordstrom | 61.33 | 3.77 | 12,166 mil. | 2,080 mil. | 194.5 mil. |
The Decision
Susan thinks that the following steps would be necessary to perform the analysis:
1.Based on the data above, calculate Sales per share, BV of equity/share values of all firms. Note that EPS is directly given.
2.Calculate P/E, P/Sales, and P/B for all of Macyâs competitors based on the data obtained.
3.Find the average of the P/E, P/Sales, and P/B multiples for the three competitors.
4.Multiply those averages calculated in step 3 with Macyâs EPS, Sales per share, and BV of equity/share values, respectively to get three value estimates for Macyâs shares.
5.The average of the three estimates would then be Susanâs best estimate of Macyâs value per share.
answer # 1-5 please
You recently graduated from Suffolk University, and your job search led you to J&J Bagel, Inc. As you are finishing your employment paperwork, Jerry Chen, one of the co-owners of J&J Bagel, informs you about the companyâs new 401(k) plan. A 401(k) is a type of retirement plan, offered by many companies.
A 401(k) is tax deferred, which means that any deposits you make into the plan are deducted from your current income, so no current taxes are paid on these deposits. For example, if your annual salary is $30,000 and you contribute $1,500 to the 401(k) plan, you will pay taxes only on the $28,500 in income. No taxes will be due on any capital gains or plan income while you are invested in the plan, but you will pay taxes when you withdraw the money at retirement. You can contribute up to 15 percent of your salary to the plan. As is common, J&J Bagel has a 5 percent match program. This means that the company will match your contribution dollar-for-dollar up to 5 percent of your salary, but you must contribute to get the match. In other words, if you contribute 5 percent of your $30,000 salary (which is $1,500) towards the 401(k) plan, J&J Bagel will match your contribution by adding another $1,500 to your plan, so that $3,000 in total will be contributed to your 401(k) plan.
The 401(k) plan has several options for investments, most of which are mutual funds. As you know, a mutual fund is a portfolio of assets. When you purchase shares in a mutual fund, you are actually purchasing partial ownership of the fundâs assets, similar to purchasing shares of stock in a company. The return of the fund is the weighted average of the return of the assets owned by the fund, minus expenses. The largest expense is typically the management fee paid to the fund managers, who make all of the investment decisions for the fund. J&J Bagel uses Imperium Financial Services as its 401(k) plan administrator.
Jerry Chen then explains the following retirement investment options available for employees:
Company Stock. One option is stock in J&J Bagel. The company is currently privately held. The price you would pay for the stock is based on an annual appraisal, less a 20 percent discount. When you are interviewed by the owners, John Benson and Jerry Chen, they informed you that the company stock was expected to be publically sold in three to five years. If you needed to sell the stock before it became publicly traded, the company would buy it back at the then-current appraised value.
Imperium S&P 500 Index Fund. This mutual fund tracks the S&P 500 Index. Stocks in the fund are weighted exactly the same as they are in the S&P 500 Index. This means that the fundâs return is approximately the return of the S&P 500 Index, minus expenses. With an index fund, the manager is not required to research stocks and make investment decisions, so fund expenses are usually low. The Imperium S&P 500 Index Fund charges expenses of 0.20 percent of assets per year.1
Imperium Small-Cap Fund. This fund primarily invests in small capitalization stocks. As such, the returns of the fund are more volatile. The fund can also invest 10 percent of its assets in companies based outside of the U.S. This fund charges 1.7 percent of assets in expenses per year.
Imperium Large-Cap Fund. This fund invests primarily in large capitalization stocks of companies based in the U.S. The fund is managed by Jenna King and has outperformed the market in six out of the last eight years. The fund charges 1.5 percent in expenses.
Imperium Bond Fund. This fund invests in long-term corporate bonds issued by U.S. companies. The fund is restricted to investments in bonds with investment grade credit rating. This fund charges 1.4 percent in expenses.
Imperium Money Market Fund. This fund invests in short-term, high credit quality debt instruments, which include Treasury Bills. As such, the return on money market funds is only slightly higher than the return on Treasury Bills. Because of the credit quality and short-term nature of the investments, there is only a very slight risk of negative return. The fund charges 0.60 percent in expenses.
*1 The return on a mutual fund after accounting for management expenses is calculated as follows. If a fund charges 2 percent in expenses and it is expected to yield a 10 percent return before expenses, then the return on this fund after expenses will be (1 + 0.10)Ã(1 â 0.02) â 1 = 0.078 or 7.8 percent*
QUESTIONS
1. advantages/disadvantages do the mutual funds offer compared to company stock for your retirement investing?
2. One can assess investment risk by looking forward to how assets are expected to react to a particular set of circumstances or âstates of economyâ. Use the following set of assumptions for the coming year to compute the expected rates of return (before expenses) and the standard deviations for the mutual funds described above.
| Probability | S&P 500 index fund | Small-cap fund | large-cap fund | Bondfund | moneymarketfund | |
|---|---|---|---|---|---|---|
| Recession | 20% | -12% | -30% | -10% | 18% | 2% |
| Near Recession | 10% | -8% | -20% | -6% | 14% | 3% |
| Normal | 30% | 12% | 22% | 12% | 8% | 4% |
| Near Boom | 20% | 22% | 38% | 15% | -1% | 5% |
| Boom | 20% | 26% | 54% | 20% | -6% | 6% |
3. Given the expected returns calculated for each of the mutual funds above, estimate the betas of these funds. Assume a risk-free rate of 4 percent and the expected market return equal to the expected return on the S&P 500 Index.
4. If you decide to invest your money equally in the Small-Cap and Bond funds, what would your portfolioâs expected return and risk level (standard deviation and beta) be? (Hint: Adjust mutual fund returns for management expenses as explained in footnote 1.
5. What would happen if you were to put 70 percent of your portfolio in the Small-Cap fund and 30 percent in the S&P 500 Index fund? Would this combination be better for you?
6. The returns of the Imperium Small-Cap Fund are the most volatile of all the mutual funds offered in the 401(k) plan. Why would you ever want to invest in this fund? When you examine the expenses of the mutual funds, you will notice that this fund also has the highest expenses. Will this affect your decision to invest in this fund?
