Question

The earnings factory

(1). According to many analysts, The Earnings Factory is a ‘darling’ of the ASX. Its current market price is $15 per share and its book value is $5 per share. Analysts forecast that the firm’s book value will grow by 10% per year indefinitely, and the cost of equity is 15%. Given these facts, what is the market’s expectation of the firm’s long-term average ROE?

(2). Given the information in part a, what will be The Earnings Factory’s share price if the market revises its expectations of long-term average ROE to 20%?

(3). Analysts reassess The Earnings Factory’s future performance as follows: growth in book value increases to 12% per year, but the ROE of the incremental book value is only 15%. What is the impact on the market-to-book ratio?

Answer 1

1)

(P/B) = 1+[( ROE - r)/(r - g)]

P = current price per share = $15

B = book value per share = $5

ROE = Firm's long term Average ROE

r = cost of equity = 15% = 0.15

g = growth rate of book value per share = 10% = 0.10

substituting these values in

(P/B) = 1+[( ROE - r)/(r - g)]

(15/5) = 1+[( ROE - 0.15)/(0.15 - 0.10)]

3 = 1+ [( ROE - 0.15)/0.05]

ROE = ((3-1)*0.05) + 0.15 = 0.25 = 25%

2)

If ROE = 20%

using the same formula as above

(P/B) = 1+[( ROE - r)/(r - g)]

P = (1+[( ROE - r)/(r - g)])*B

P = (1+[( 0.20 - 0.15)/(0.15 - 0.10)])*5

P = (1 + 1)*5 = $10

Price = $10

3)

as ROE of incremental growth value = 15% = Cost of equity

There is no increase in value