managerial finance
The evaluation of equity research report involves three main stages;
- Inquire what the analyst depends on to make a recommendation. What a
strategy the analyst is using. Whether it is an effective basis for evaluating the
value of the stock or not. - Inquire if the recommendations adhere to the analysis; in particular based on
the formulated forecast - Inquire if the analysis is reasonably consistent. In addition, assess whether
‘good analysis” have been violated or not.
The task of the analysts is developing forecasts so as to make inferences regarding the
valuation based on the forecasts. Some analysts are excellent when it comes to
forecasting; however they are not competent to convert the forecast to a given valuation
as well as a recommendation. On the other hand, other analysts are excellent at collecting
data about an organization, but not good at converting such data for forecasting purposes.
Moreover, other analysts feel strong regarding a recommendation. However, they do not
support such a recommendation with detailed data forecasting or collection (Ohlson,
2005).
In most cases, it always appropriate to inquire about the strategy based on the
analyst’s perspective in obtaining a valuation. A bad equity research report will not
provide a comprehensible answer to this issue. With respect to Kmart scenario,
- What is the analyst using to make a recommendation?
The forecast of the price-earnings ratio (P/E) is imperative to a recommendation.
However, there is no clear strategy behind it. The analyst submits average price earnings
ratio like she views other discount, retailers. One wonders whether such average multiple
is acceptable. The analysts have simply initiated the technique of comparable, something
that is not encouraged in stock valuation as it is risky. In addition, the analyst fails to
demonstrate how one gets the right profit earnings ratio or if she comprehends what P/E
is all about. In the analyst’s estimates, it is clear that profit earnings ratio is inconsistent
with other forecasts (Easton, 2003).
- Does the recommendation adhere to the analysis?
The present cost is USD 17 per share. According to the analyst’s 2001, Eps forecast of
USD 1.41 with a projected profit earnings ratio of 20 gives a projected 2001 cost of USD
28.20. Therefore, the stock return projected for two years based on the current costs of
$17 is;
Estimated stock return= (28.20-17.0)/17.0
= 65.9%
As such, the return for two years at 12% p.a is 25.4 percent. Thus, this forecast does
undeniably mean a BUY. However, is this analysis logic?
- Is the analysis reasonably consistent?
a) The analyst estimates 2001 profit earnings ratio of 20, which generates an
estimated cost of $28.20 while estimating a Price-to-book (P/B) ratio that yields an
estimated cost of $21.30. These costs are different. The $21.30 cost indicates an
estimated return of 25.3% that is needed for the 2 year return. A HOLD is implied.
Estimated return = (21.30-17.0)/17.0
25.3%
b) The Bps estimates are not correct if compared with Eps projections (Ohlson, &
Juettner-Nauroth, 2005). It should be that; Bps (2000) = Bps (1999) + Eps (2000) – DPS
(2000). Because there are no dividends and shares outstanding demonstrates an estimated
stock concerns or even re-acquirements;
Bps (2000) = 12.12 + 1.23 = 13.35 while
Bps (2001) = 13.35 + 1.41 = 14.76
In the event that the estimated Price-to-book ratio in 2001 is used, the cost in 2001 is
about $20.37. This cost demonstrates a SELL.
c) The analyst estimates earnings to increase at 6 percent annually after 2001. As a
matter of fact when earning are estimated to increase at a lower rate compared to the
required return, the earnings yield is higher than required return, and the price-earnings
ratio is below the required return. The perception is that, if an organization is to increase
its earnings below the required return on cost, the cost will be less per every dollar of
earnings compared to if it was to increase at the required return. In that view, the required
return is roughly 12 percent; the E/P ought to be higher than the required return while
price earnings ratio must be below 9.33. As a result, the analyst estimate of price-
earnings ratio at 20 is inconsistent with earnings estimates.
d) The recommendation is inconsistent based on the projection of free cash flow
increasing at 6 percent;
V E 1999 = ( 2000 free cash flow/ {required return-growth in FCF})-Debit
= ({632×1.06})/12%-6%)-2,706
= $8,459 or $17.14 /share (for 493.4 million shares)
With the present costs of $17, this analysis demonstrates a HOLD. The cost capital of 12
percent is assumed here for purposes of simplicity. As such, cost capital for operations
out to be forecasted.
e) The analysis of estimated earnings indicated a SELL.
2- Year yield= (1.23+1.141)/17.00
=15.53%
There are no dividends for reinvestment; this is because this is below the required 2-year
return of about 25.4 percent. Therefore, implying a SELL. Increasing more years of
earning at 6 percent cannot change this justification. However, the justification can only
change in the event that forecasted change in premium is integrated with the costs in
2001 from the estimated price-earnings ratio of 20, although not with the estimated 2001
price-to-book ratio.
By and large, Kmart share is selling at $17, however, based on the valuation the stock
price is lower. In that case, analyst’s recommendation to BUY is not correct since one
pays more compared to actual cost. Regardless of the analyst’s suggestion to BUY the
shares, the valuation indicated a SELL for Kmart shares (Penman, 2005).
References
Easton, P (2003). “Does the PEG Ratio Rank Stocks According to the Market’s Expected
Rate of Return on Equity Capital?” Notre-Dame University,
Ohlson, J& Juettner-Nauroth, B. (2005). “Expected EPS and EPS Growth as
Determinants of Value,” Review of Accounting Studies 10.
Ohlson, J. (2005). “On Accounting-Based Valuation Formulae” Review of Accounting
Studies 10.
Penman, S. (2005). Discussion of ‘On Accounting-Based Valuation Formulae’ and
‘Expected EPS and EPS Growth as Determinants of Value’,” Review of
Accounting Studies 10.
