Wednesday, October 26, 2011

Earnings Analysis

CFA Level 1 - Equity Investments

Earnings Per Share of a Stock Market Series
The earnings per share of a stock market series can be calculated as follows:

Formula 13.8

EPSstock market series = [(sales)(OM) - depreciation - interest](1-tax)

Sales = sales per share of the estimated series is determined through regression
OM = the operating margin is typically calculated as a percentage of sales
Depreciation = this is determined by either continuing the trend of the current depreciation or focusing on the expected capital expenditures and how that number relates to future dividends.
Interest = interest is determined by outstanding debt and the interest rate on that debt.

Example: Calculate the EPS of a stock market series
Assuming the following estimates for a stock market series, sales per share = $100.00, OM = 50%, depreciation of $20.00, interest of $2.00 and a corporate tax rate of 40%, calculate the forecasted EPS of the stock market series?

EPS = [($100.00)(50%) - $20.00 - $2.00](1-0.40) = $16.80 per share

The Expected Return of a Stock Market Series
Similar to determining the earnings multiplier of a stock, the earnings multiplier of a stock market series can be derived by the DDM.
Formula 13.9

Earnings multiplier

In addition to the EPS, the series' required rate of return, growth and dividend are needed.

Example: Calculate the expected P/E ratio of a stock market series
Next year's EPS for the series was determined to be $16.80. With a dividend of $4.00 for next year's dividend payout, calculate the stock series' earnings multiplier assuming 10% required return and 5% growth.

Earnings Multiplierstock mkt series = 4.00/16.80 = 4.7x

Estimate and Interpret the Earnings Multiplier of a Stock Market Series
To determine value of the earnings multiplier for a stock market series the following inputs must be determined:

2. Dividend
3. Future price
4. Required rate of return
5. Expected growth rate

 1. EPS
Next year's EPS must be forecasted to determine the earnings multiplier. 

2. Required Rate of Return
This return is derived from the CAPM model (Rseries = Rf + Bseries(Rmarket - Rf). If the required rate of return increases, the multiplier decreases.

3. Expected Growth Rate
The expected growth rate can be derived from both the retention rate (1-payout rate) and corporate ROE. (g = (retention rate)(ROE)). If the expected growth rate increases, the multiplier increases.

4. Dividend
To determine the dividend to be used in the DDM, last year's dividend must first be calculated as the dividend in the DDM is next year's dividend.  Given last year's corporate earnings as well as the corporate payout ratio, last year's dividend can be calculated. Using the growth rate derived above, next year's dividend can be determined. 

5.Future price
The future price for the company can be derived with next year's dividend divided by the difference in the company's required rate of return and its growth rate.

The Expected Rate of Return for a Stock Market Series
The expected return rate of return of a stock market series, including the dividend, is the relative change that is anticipated in the stock market series over a specified time period.

Formula 13.11

= End value of series + Dividend - Beg. value of serie
                                   Beg. value of series

Example: Calculate the expected rate of return for a stock market series
For a stock market series, it is estimated to have a dividend of $5.00 and an ending value of $25. If the current value of the stock market series is $15, calculate the expected return for the stock market series.


E(R) = ($25 + $5 - $15) = 1.0 or 100% return

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