Mark Cannan is updating research reports on two well-established consumer companies before first quarter 2011 eamings reports are released. His supervisor, Shatolyn Ritter, has asked Cannan to use market-based vahuations when updating the reports Delite Beverage is a manufacturer and distributor of soft drinks and recently acquired a major water bottling compary in order to offer a broader product line. The acquisition will have a You Fix It is a United States retail distributor of products for home improvement, primarily for those consumers who choose to do the work themselves. The home improvement industry is cyclical; the industry was adversely affected by the recent downturn in the economy, the level of foreclosures, and slow home sales. Although sales and earnings at You Fix It weakened, same store sales are beginning to improve as consumers undertake more home improvement projects. Poor performing stores were closed, resulting in significant restructuring charges in 2010 significant impact on Delite's future results used in the valuation of Delite and You Fix It The data used by Cannan in his analysis is summarized in Exhibit 1. Before approving Cannan's work, Ritter wants to discuss the calculations and choices of ratios &Exhibit 1. Select Financial Data for Delite Beverage and You Fix It 2010 Eamings per share (EPS) 2011 estimated EPS Book value per share end of year Current share price Sales (billions) Free cash flow per share Shares outstanding end of year Delite BeverageYou Fix It $3.44 $3.50 $62.05 $65.50 $32.13 $2.68 2,322,034,000 se $1.99 $1.64 37.23 $67.44 $0.21 1,638,821,000 Cannan advises Ritter that he is considering three different approaches to value the shares of You Fix It 1. Approach 1 Price-to-book (P/B) ratio 2. Approach 2 Price-to-earnings (P/E) ratio using trailing earnings 3. Approach 3 Price-to-eamings ratio using normalized eamings Cannan tells Ritter that he calculated the price-to-sales ratio (P/S) for You Fix It, but chose not to use it in the valuation of the shares. Cannan, states to Ritter that it is more appropriate to use the P/E ratio rather than the P/S ratio because 1. Reason 1 Earnings are more stable than sales 2. Reason 2 Eanings are less easily manipulated than sales. 3. Reason 3 The P/E ratio reflects financial leverage whereas the P/S ratio does not Cannan also informs Ritter that he did not use a price-to-cash flow multiple in valuing the shares of Delite or You Fix It. The reason is that he could not identify a cash flow measure that would both account for working capital and non-cash revenues, and also be after interest expense and thus not be mismatched with share price. Ritter advises Cannan that such a cash flow measure does exist Ritter provides Cannan with financial data on three close competitors as well as the overall beverage sector, which includes other competitors, in Exhibit 2. She asks Cannan to determine, based on the price-to-eamings growth (PEG) ratio, whether Delite shares are overvalued, fairly valued, or undervalued Exhibit 2. Beverage Sector Data Forward P/E Earnings Growth Delite Fresh Iced Tea Company Nonutter Soda Tasty Root Beer Beverage sector average 16.59 15.64 44.10 16.40 12.41% 9.52% 11.94% 20% 10.80% After providing Ritter his answer, Cannan is concemed about the inclusion of Tasty Root Beer in the comparables analysis. Specifically, Cannan asks Ritter: "I feel we should mitigate the effect of large outliers, but not the impact of small outliers (ie. those close to zero), when calculating the beverage sector P/E. What measure of central tendency would you suggest we use to address this concern? Ritter requests that Cannan incorporate their discussion points before submitting the reports for final approval. 17. Based on the information in Exhibit 1, the most appropriate price-to-eamings ratio to use in the valuation of Delitc is closest to: A 18.71 B. 1904. C. 24.44. 18. Based upon the information in Exhibit 1, the price-to-sales ratio for You Fix It is closest to: A 0.28. B. 0.55 C. 0.90 19. Which valuation approach would be most appropriate in valuing shares of You Fix It? A Approach 1 B. Approach2 C. Approach 3 20. Cannan's preference to use the P/E ratio over the P/S ratio is best supported by A Reason 1 B. Reason 2 C. Reason 3 21. The cash flow measure that Ritter would most likely recommend to address Cannan's concem 18: A. Free cash flow to equity. B. Eamings plus non-cash charges C. eamings before interest, tax, depreciation, and amortization 22. Based upon the information in Exhibits 1 and 2, Cannan would most likely conclude that Delite's shares are: A Overvalued. B. Undervalued. C. Fairly valued. 23. The measure of central tendency that Ritter will most Ilikely recommend is the: A Median. B. Harmonic mean C. Arithmetic mean