Chapter 3

With Solutions
Exercise 1.
An analyst decides to value Firm A on the basis of multiples of two comparable firms,
Firm B and Firm C. Firm B trades at 16 times trailing earnings and C trades at 12 time
trailing earnings. Firm A’s last reported EPS was $2.34.
Carry out the valuation. What reservations do you have about this valuation?
Apply the average multiple for B and C to Firm A’s earnings:
14 x 2.34 = $32.76 per share
The valuation is suspect: If Firms B and C are mispriced in the market, one will get the
wrong valuation for A.
Exercise 2.
Contrarian investors buy stocks with low P/E and P/B ratios; they judge that low
multiples indicate that prices are too low and will increase. Why is this practice suspect?
A firm might have a low multiple for very good reasons. Indeed a low multiple firm
could be overpriced. A multiple compares price to just one piece of information and
ignores other information relevant to pricing. One ignores information at one’s peril.
Exercise 3
In September 2003, IBM traded at $89 per share with a total market capitalization of its
equity of $153.97 billion. It reports $14 billion of debt, and sales for its latest year were
$81.2 billion.
Calculate the price-to-sales ratio.
Price-to-sales ratios must be unlevered for leverage does not affect sales. That is, they
must be enterprise value -- the value of the assets without regard to financing by debt or
equity--relative to sales:
P/S = ($153.97 + 14)/81.2
= 2.07
Exercise 4.
An analyst forecasts that a stock’s dividends per share will be $2.00 in the coming year,
and further expects dividends to grow at a rate of 3% per year indefinitely after that.
Investors require a return of at least 9% for the stock.
Value this stock.
Because dividends are expected to grow at a constant rate, the dividend discount model
can be used:
V0E 
= $33.33
0.09  0.03