of 140
Alpha Software (AS) recently reported annual earnings per share (EPS) of $1.75, which
included an extraordinary loss of $0.19 and an expense of $0.10 related to acquisition costs
during the accounting period, neither of which are expected to recur. Given that the most
recent share price is $65.00, what is a useful AS's trailing price to earnings (P/E) for valuation
purposes?
A) 44.52.
B) 37.14.
C) 31.86.
Lucas Davenport, CFA, has been assigned the task of doing a valuation analysis of Sanford Systems Inc.
Sanford is currently trading at $15 per share. Exhibit 1 and Exhibit 2 present a summary of Sanford's financial
statements for 2007 and 2008.
Davenport has previously completed a FCFE valuation, which yielded a value of $11.18 per share based on
FCFE per common share in 2008 of $0.85.
Exhibit 1: Sanford Systems Balance Sheets as of 12/31/2008 (in US$ millions)
2007
2008
Cash and equivalents
$325
450
Accounts receivable
850
870
Inventory
1,000
1,050
Total current assets
$2,175
$2,370
Gross fixed assets
13,600
15,900
Accumulated depreciation
2,300
2,900
Net fixed assets
11,300
13,000
Total assets
$13,475
$15,370
Accounts payable
$1,500
$1,520
Notes payable
300
550
Accrued taxes and expenses
Total current liabilities
$1,800
$2,070
Long-term debt
$5,575
$6,111
Common stock
100
100
Additional paid-in capital
Retained earnings
6,000
7,089
Total shareholders' equity
$6,100
$7,189
Total liabilities and shareholders' equity
$13,475
$15,370
Exhibit 2: Sanford Systems Income Statements for 2007 and 2008 (in US$ millions)
2007
2008
Total revenues
$12,000
$13,100
Operating costs and expenses
9,400
9,600
EBITDA
$2,600
$3,500
Depreciation and amortization
500
600
EBIT
$2,100
$2,900
Interest expense
500
585
Income before taxes
$1,600
$2,315
Taxes (40%)
640
926
Net income
$960
$1,389
Dividends
$280
$300
Change in retained earnings
$680
$1,089
EPS
$1.92
$2.78
DPS
$0.56
$0.60
# of shares outstanding (millions)
500
500
Davenport determines that the company follows IFRS rules, and compiles the following industry price-to-
adjusted (per share) CFO data, where adjusted CFO is equal to cash flow from operations from the statement
of cash flows plus after-tax cash interest expense.
Exhibit 3: Industry Data
Trailing
P/Adjusted CFO per share
Beta
Consensus 5-Year
Earnings Growth
Industry Median
2.0x
1.20
9.9%
Sanford
1.25
9.2%
Davenport would also like to make international price multiple comparisons and is contemplating using one
or more of the following ratios: price-to-sales, price-to-earnings, price-to-book, price-to-adjusted cash flow
from operations, and enterprise value-to-EBITDA.
Davenport decides to use a single-stage residual income model to estimate the value of Sanford, in addition
to the FCFE framework he used earlier. He estimates Sanford's long-term perpetual growth rate in residual
income at 5 percent, its return on equity to be 20 percent going forward, weighted average cost of capital to
be 10.4 percent based on the target debt-to-asset ratio, and the required return on equity to be 14 percent.
Finally, Davenport solves the following equation for T, given the other inputs (where the index is the S&P
500), and determines that T = 3.6.