Equity research reports conclude with a stock recommendation. The investor reads the body of the report to be persuaded that the analysis in the report justifies the recommendation. She asks herself: is the report credible? Is it internally consistent? Is there an imperative for the recommendation? Does the report give me a feeling of security in following the recommendation?

Answer the following questions regarding the report.

1. Given the analyst?s forecasts provided in the report, what alternative valuation models (such as the dividend model, the free cash flow model, the P/E model, the P/B model, or the residual income model, etc.) may be used to value the Kmart?s common equity? Which model is used by the analyst in arriving at the BUY recommendation

2.

1. UsingReOImodelwithsimplenogrowthforecast,computethefollowingvaluationforK-martattheendofFY1999.
2. a)EquityIntrinsicValue=

b) Does the no growth forecast equity valuation justify a Buy recommendation? Explain your justification.

c) Is analysts? forecast of P/B ratio consistent with his/her own earnings forecast?

8 (Analyst report) Kmart Corp. March 1999 (NYSE: KM) Current Price per share: $17 Recommendation: BUY Kmart Corp is the second largest discount retailer in the United States and the world's third largest general merchandise retailer. It operates department stores in all 50 states in the United States and in Puerto Rico, the U.S. Virgin Islands, and Guam. Some pertinent data for 1999 fiscal year ending January 31 are below: Comprehensive Income $ 518 million Dividends 0 Common Equity (CSE) $5,979 million Net Debt (NFO) $2,706 million Cash flow from Operation $1,427 million Cash flow used for $ 795 million investment (CAPX) Forecast: we forecast the following earnings and book values per share for fiscal years ending January 31, 2000 and 2001, along with forecasts of P/B ratio and P/E ratio 1999A 2000E 2001E EPS 1.05 1.23 1.41 BPS 12.12 14.02 15.43 Shares outstanding 493.4 493.4 493.4 (in millions) Price-to-book ratio 1.40 1.36 1.38 Price-earnings ratio 16.2 17.1 20.0 We forecast eps to increase at 6% per year after 2001. We also forecast free cash flows to grow at 6% per year from 1999 onwards. Risk: we give Kmart a beta of 1.15 and a required return (of equity) of 12 percent per year. Recommendation: Our recommendation is based on the ability of the firm to grow its earnings and grow its P/E ratio. By 2001, we expect earnings to be fully flowing from its recent development of superstores in major metropolitan areas, and see no reason why Kmart's shares should not be trading at a P/E of 20, the current average earnings multiplier for US discount retailers. 9