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CFA Level II Chartered Financial Analyst Questions 130–134 (page: 48)

Zi Wang is a senior buy-side equity analyst with Shandong Securities. Wang must review the work of several of his junior colleagues before investment recommendations go to the Shandong portfolio managers. One recommendation from a junior analyst is given in Exhibit 1.



This same junior analyst e-mailed Wang, saying "I'm in a meeting and hate to bother you. I don't have my calculator or computer with me. We have a British stock with a current £4.00 dividend that is expected to grow at 40% per year for two years and then forever after at 6%, If we assume a required return of 12%, what is the value of this stock?"
in a few minutes, Wang e-mails him back: "The British stock is worth £110.42"
The junior analyst sends back a second e-mail. "Thanks. If we can buy this stock for £90, what rate of return would we get? Assume the same dividend pattern as in my first e-mail."
Wang replies to the second e-mail: "I used trial and error and found an expected rate of return for the British stock of 12%."

One of Shandong's portfolio managers asks Wang to clarify the PVGO (present value of growth opportunities) concept for him. Wang tells him, "PVGO is the part of a stock's total value that comes from future growth opportunities. PVGO is conventionally estimated as the market value per share minus the book value per share."

The Shandong portfolio manager quickly follows up with two more requests. He says, "I need a couple of favors. First, could you describe the sustainable growth rate concept for us? We've been arguing about it among ourselves. And, second, could you review some highlighted phrases from a research report we received from one of our investment bankers? We aren't sure that the analyst who wrote this report is very competent." The highlighted phrases are:

Phrase 1: When calculating the justified P/E ratios based on a constant growth model like the Gordon model, the forward P/E should be greater than the trailing P/E.
Phrase 2: A free cash flow approach might be preferable when the company's cash flows differ substantially from dividends or the investor takes a control perspective.

Phrase 3: When the required rate of return increases, the value of a share of stock should decrease even if the stock's dividend has a negative growth rate.

Is Wang's description of PVGO most likely correct?

Zi Wang is a senior buy-side equity analyst with Shandong Securities. Wang must review the work of several of his junior colleagues before investment recommendations go to the Shandong portfolio managers. One recommendation from a junior analyst is given in Exhibit 1.



This same junior analyst e-mailed Wang, saying "I'm in a meeting and hate to bother you. I don't have my calculator or computer with me. We have a British stock with a current £4.00 dividend that is expected to grow at 40% per year for two years and then forever after at 6%, If we assume a required return of 12%, what is the value of this stock?"

in a few minutes, Wang e-mails him back: "The British stock is worth £110.42"
The junior analyst sends back a second e-mail. "Thanks. If we can buy this stock for £90, what rate of return would we get? Assume the same dividend pattern as in my first e-mail."

Wang replies to the second e-mail: "I used trial and error and found an expected rate of return for the British stock of 12%."

One of Shandong's portfolio managers asks Wang to clarify the PVGO (present value of growth opportunities) concept for him. Wang tells him, "PVGO is the part of a stock's total value that comes from future growth opportunities. PVGO is conventionally estimated as the market value per share minus the book value per share."
The Shandong portfolio manager quickly follows up with two more requests. He says, "I need a couple of favors. First, could you describe the sustainable growth rate concept for us? We've been arguing about it among ourselves. And, second, could you review some highlighted phrases from a research report we received from one of our investment bankers? We aren't sure that the analyst who wrote this report is very competent." The highlighted phrases are:

Phrase 1: When calculating the justified P/E ratios based on a constant growth model like the Gordon model, the forward P/E should be greater than the trailing P/E.

Phrase 2: A free cash flow approach might be preferable when the company's cash flows differ substantially from dividends or the investor takes a control perspective.
Phrase 3: When the required rate of return increases, the value of a share of stock should decrease even if the stock's dividend has a negative growth rate.

How should Wang describe sustainable growth? "The sustainable growth rate is the rate of dividend and earnings growth that can be sustained for a given return on equity assuming that:

Zi Wang is a senior buy-side equity analyst with Shandong Securities. Wang must review the work of several of his junior colleagues before investment recommendations go to the Shandong portfolio managers. One recommendation from a junior analyst is given in Exhibit 1.




This same junior analyst e-mailed Wang, saying "I'm in a meeting and hate to bother you. I don't have my calculator or computer with me. We have a British stock with a current £4.00 dividend that is expected to grow at 40% per year for two years and then forever after at 6%, If we assume a required return of 12%, what is the value of this stock?"
in a few minutes, Wang e-mails him back: "The British stock is worth £110.42"
The junior analyst sends back a second e-mail. "Thanks. If we can buy this stock for £90, what rate of return would we get? Assume the same dividend pattern as in my first e-mail."
Wang replies to the second e-mail: "I used trial and error and found an expected rate of return for the British stock of 12%."

One of Shandong's portfolio managers asks Wang to clarify the PVGO (present value of growth opportunities) concept for him. Wang tells him, "PVGO is the part of a stock's total value that comes from future growth opportunities. PVGO is conventionally estimated as the market value per share minus the book value per share."

The Shandong portfolio manager quickly follows up with two more requests. He says, "I need a couple of favors. First, could you describe the sustainable growth rate concept for us? We've been arguing about it among ourselves. And, second, could you review some highlighted phrases from a research report we received from one of our investment bankers? We aren't sure that the analyst who wrote this report is very competent." The highlighted phrases are:

Phrase 1: When calculating the justified P/E ratios based on a constant growth model like the Gordon model, the forward P/E should be greater than the trailing P/E.
Phrase 2: A free cash flow approach might be preferable when the company's cash flows differ substantially from dividends or the investor takes a control perspective.

Phrase 3: When the required rate of return increases, the value of a share of stock should decrease even if the stock's dividend has a negative growth rate.

Which of the three phrases in the investment banker's report is least likely to be correct?

Yummy Doughnuts (YD) sells a variety of doughnuts and other related items through both company-owned locations and franchise locations. YD has experienced significant growth over the past five years. However, barriers to entry are low and competition is increasing.
Linda Haas, CFA, follows YD for Gibraltar Capital. Gibraltar Capital prides itself on its thorough fundamental analysis of investment opportunities. The company uses a bottom-up approach to the investment process. Haas's security selection process utilizes residual income models to determine a stock's intrinsic value. Haas obtains YD's 2008 financial statements shown in Exhibit 1. In addition, Haas provides supporting information about YD's financials and other related material found in Exhibit 2.







Haas makes the following statements during her YD presentation to the investment committee.

Statement 1: Based on ROE mean reversion, YD's continuing residual income is assumed to decline to zero over time.
Statement 2: The residual income model states that if YD's ROE equals its equity cost of capital, then YD's intrinsic value will equal its book value per share.

Based on Exhibits 1 and 2, YD's adjusted net operating profits after taxes (NOPAT) is closest to

Yummy Doughnuts (YD) sells a variety of doughnuts and other related items through both company-owned locations and franchise locations. YD has experienced significant growth over the past five years. However, barriers to entry are low and competition is increasing.
Linda Haas, CFA, follows YD for Gibraltar Capital. Gibraltar Capital prides itself on its thorough fundamental analysis of investment opportunities. The company uses a bottom-up approach to the investment process. Haas's security selection process utilizes residual income models to determine a stock's intrinsic value. Haas obtains YD's 2008 financial statements shown in Exhibit 1. In addition, Haas provides supporting information about YD's financials and other related material found in Exhibit 2.






Haas makes the following statements during her YD presentation to the investment committee.

Statement 1: Based on ROE mean reversion, YD's continuing residual income is assumed to decline to zero over time.
Statement 2: The residual income model states that if YD's ROE equals its equity cost of capital, then YD's intrinsic value will equal its book value per share.

Based on Exhibits 1 and 2, YD's weighted average cost of capital (WACC) is closest to: