Exam 7: Valuation of the Individual Firm

The valuation models using price to sales, price to earnings, price to book value, price to cash flow, and price to dividends, assume that:

One way of calculating K_e is to use the Capital Asset Pricing model, as follows:

In the formula P₀ = D₁/(K_e - g), one limiting factor is that K_e must always be smaller than g.

For cyclical companies, the most accurate price-earnings ratio would be derived by dividing the current stock price by the latest 12 months earnings.

In general, young, rapidly expanding firms are more likely to carry higher P/E ratios than mature firms.

Security analysts following the Witczak Corporation use a simplified income-statement method of forecasting. Assume that current sales are $30 million, and are expected to grow by 10.5% in year 1 and 2. The after-tax profit margin is projected at 7% in year 1, and 7.2% in year 2. The number of shares outstanding is anticipated to be 450,000 for year 1, and 500,000 for year 2. Calculate the project earnings per share for the next two years.

Pacific Storage expects to have earnings per share of $5.25 in 2005, and $5.65 in 2006. The average price-earnings ratio for General industry is 10X (times). Pacific Storage has traditionally had a P/E ratio 12% higher than the industry, and in 2005 it is expected to be 15% higher than the industry. Calculate the expected price of Pacific's stock price in 2005 and 2006, based on expectations of EPS and P/E ratios.