Question #113

The weighted harmonic mean is 1/[(12/27)(1/12) + (15/27)(2/15)] = 27/3 = 9.00 The weighted harmonic mean of the individual stocks P/Es is the best measure of the P/E for a portfolio of stocks. (Module 22.4, LOS 22.r) At the end of 2x09, Dustin Pedroia, CFA, is writing a report to help advise on a potential corporate takeover. Iliot Inc. is up for sale, and Pedroia's client is considering buying 100% of the share capital. Pedroia has decided to include two free cash flow valuations in his report for the client. An extract of the most recent cash flow statement, which he intends to use as a base for his first FCF calculation, appears below: Cash Flow Statement (extract) for the Year Ended 31st December 2x09 U.S. $ millions Cash flow from operating activities 130 Extracts from the Financial Statements for 2x09 also show the following: Financial Statement Extracts 2x08 $m 2x09 $m Fixed assets (at cost) 270.0 320.0 Less: Accumulated depreciation 112.0 138.0 Inventory 65.2 71.0 Accounts receivable 94.2 96.7 Accounts payable 74.0 79.0 There have been no sales or impairments of fixed assets during the year and net borrowing for 2x09 raised $14 million. For his first valuation, Pedroia will make a simple assumption that free cash flow to equity will grow at 5% per annum indefinitely in order to reach his valuation. The resulting value will be labelled "Best Case Scenario" in the report. In addition, the client has passed Pedroia their own forecasts for the performance of Iliot over the next five years, and he also intends to use these forecasts to come up with an alternative valuation, which he will label "FCF Valuation Using Forecasted Cash Flows." Details of the forecasted flows are as follows: Free Cash Flow to Equity Forecasts: Iliot Inc. 2x10 $65 million 2x11 $68 million 2x12 $72 million 2x13 $75 million Pedroia will discount the flows at a cost of equity of 12%, and that the 2x10 free cash flow will occur in one year from now. In order to calculate a terminal value at the end of 2x13, Pedroia intends to use an estimate of Iliot's P/E ratio and earnings. He estimates Iliot's trailing P/E ratio at the end of 2x13 to be 28 using a linear regression model based on risk, growth, and dividend payout, and forecasts 2x13 earnings to be $70 million. Pedroia also wishes to include a note on Iliot's normalized earnings in his final report. He intends to initially calculate a normalized EPS figure for 2x09. To do this he will use the method of average return on equity method. In order to assist with this task he notes down various information for Iliot from the last three years: Iliot Historical Data 2x07 2x08 2x09 Earnings per share $2.80 $2.50 $2.85 Book value per share $16.20 $15.80 $16.40 Return on equity 14.8% 15.4% 18.0% Pedroia intends to conclude his report with a note to the client that he himself owns a small number of Iliot shares. He purchased the shares after implementing a stock screen system of selection, whereby he decided to only purchase shares if they passed the following criteria: P/E less than 10 Market Cap greater than $0.5 billion EBITDA-to-free cash flow ratio less than 12 PEG ratio greater than 1.2 He implemented his stock screen system in mid 2x06. Before implementing the system, Pedroia back tested it using 2x05 year-end ratios published by his favorite analyst's journal in April 2x06. Using those ratios, results showed that if he had bought stocks at the end of 2x05, which passed his screen, he would have made abnormal positive profits.