Doing practice exams from Schweser and came across this stumper: Question is from Schweser “Sample Exams” book, Exam 1, AM, #94 Saunders is analyzing B Inc., and industrial conglomerate. Saunders is estimating the intrinsic value for B Inc. by forecasting the company’s earnings per share and earnings multiplier. Each of the following attributes of Barco will increase the company’s earnings multiplier EXCEPT: A.) B Inc. has never had a restructuring charge in it’s history. B.) B Inc.'s earnings move in tandem with overall economic growth. C.) B Inc consistently generates free cash flows. D.) B Inc’s dividend has been increasing for the last 30 years. Can someone explain how each of these A-D are related to increasing B Inc’s earnings multiplier? I read the answer at the back of the book, but it’s not very clear.
I am stumped, but i will take a stab at it. c? A - If it has never taken a restructuring charge, it could be an indication of high quality earnings i.e no expenses hidden as restructuring charges B. if earnings move in tandem with economic growth, it should probably be important in estimating growth.D. D. Since sustainable growth = roe * (1 dividend payout ratio) i think D should be important
For choice D Dividend has been continuously increasing. So RR – Retention Ratio has been falling. Since g=ROE*RR and assuming a constant ROE (for the time being) – g is falling. P/E = K/(rce-g) So g is falling, rce is constant. So denominator is increasing. Numerator is also increasing. so lets take some numbers to identify direction of movement of P/E 1. Div payout = 30%, ROE = 15%, rce = 15% g=10.5% P/E = .3 / .045 = 6.67 2. Div Payout = 35% g = 9.75% P/E = .35 / .0525 = 6.67 k = 40% g = 9% .4/.06 = 6.67 So it keeps being constant, consistently. The P/E is always a constant Not sure if this is a good example, though. I would think Earnings moving in tandem with economic growth could be the answer. B So when economy is in a peak, Earnings increase. When economy is in a trough – earnings decrease so it is a cyclical company, moving with the economy. So P/E would not be consistently increasing. So based on that, I would think B is my choice. Company having free cash flows FCF = CFO - Cap Ex. So it has positive free cash flows to plow back, after spending on its capital expenditure requirements. Means there is enough left for growth. never taken a restructuring charge. so basically a company that has good fundamentals. I am going out on a big long limb here. What’s the answer?
Earnings multiplier is a rubbish term for the P/E, or the rating of the company. A) is a good thing - high quality earnings C) is a good thing - we like fcf D) is a good thing - we like rising divis. B) is not a good thing - we prefer stability over cyclicality.
I dont understand A and B A) never had restructuring cost in the history, could be an indicator that it might need restructuring in the future B) ???
Remember the effects of a restructuring charge - in the year it is taken, it kills you, but in future years, it boosts net income. So if a restructuring charge has been taken in the past, then earnings will be artificially boosted. I think they called it “big bath” incentives for management, or something wonderfully yankee. B - if earnings move with the overall econony, by definition they are cyclical. If one company has stable earnings growth, and one is cyclical, all other things being equal - which would you rather own?
Answer was B.) “Since the company’s earnings are cyclical, earnings multiplier is reduced vs. a company with a stable earnings profile.” Thanks for the help, it makes a bit more sense now.
B I think because of the cyclicality factor, and the fact that P/E would drop instead of increasing if the EPS part of the ratio increased.