Multiple Case Scenario

Erin Price is a financial analyst currently hired at Postet Automobiles, a renowned luxury automobile manufacturer. Price and her team are currently in the process of valuing Postet, as an imminent merger is anticipated by the market between Postet and a competing manufacturer. In a meeting to discuss current company performance and its effect on company value, Price made the following observation:

Due to the cyclical nature of Postet, the trailing earnings per share has been considered an inappropriate measure of determining company performance. This is explained by the Molodovsky effect, which states that trailing earnings per share is typically positive in the bust stage of the cycle and negative in the boom stage of the cycle.

Postet is contemplating the purchase of a spare parts manufacturing entity in the hopes of driving down production costs. A number of these entities are located in Houston, Texas. Price has identified three suitable factories in the highlighted area. Financial information relevant to these factories is presented in Exhibit 1:

Exhibit 1

	Micro	Milli	Macro
EPS	$18	$15	$20
DPS	$5	$3	$7
Required Return	15%	17%	15%
Return on Equity	20%	18%	22%
Forward P/E (Market)	50X	30X	48X
Stage of Life Cycle	Growth	Unknown	Unknown

For the purposes of predicting a justifiable P/E, Price is running a cross-sectional regression of the relevant variables. The most recent regression yielded an R2 of 22%. However, prior regressions had yielded a significantly higher R2 .

Question

The observation made by Price is most likely:

• A.

  incorrect, regarding explanation of the Molodovsky effect.

• B.

  incorrect, regarding the cyclical nature of Postet.

• C.

  incorrect, regarding the appropriateness of the performance measure.

Question

Using the growth rate information provided in Exhibit 1, what is the most likely deduction to be made about the three spare parts entities?

• A.

  Millis shareholders would rather have a stake in either Micro or Macro, than in Milli.

• B.

  Macro is in the mature stage of the industry life cycle.

• C.

  All three companies are in the growth phase of the industry life cycle.

Question

Using the information provided in Exhibit 1, which firm will most likely have the lowest justified trailing P/E ratio?

• A.

  Micro

• B.

  Milli

• C.

  Macro

Question

Which of the following is not a limitation of running a cross-sectional regression for the basis of predicting P/E?

• A.

  The regression does not take into account the duration differentials in growth.

• B.

  The presence of multicollinearity between independent variables.

• C.

  The recent regression run by Price yielded insufficient explanatory power.

Question

Using the information provided in the vignette, which firm is most likely undervalued?

• A.

  Micro

• B.

  Milli

• C.

  Macro

Question

Assuming expected growth rates of Micro, Milli, and Macro are 7%. 9% and 12% respectively and using the market forward P/E Ratios, the firm with the most attractive PEG ratio is most likely:

• A.

  Micro

• B.

  Milli

• C.

  Macro