of 140
An analyst is calculating the weighted harmonic mean P/E ratio of a 2-stock portfolio. Stocks
AAA and BBB have prices of $12 and $15, respectively, and EPS of $1 and $2, respectively.
Which of the following is the weighted harmonic mean P/E of the portfolio closest to?
A) 9
B) 9.75
C) 9.23
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.