Reference no: EM13902028
MARKET MULTIPLES AND REVERSE-ENGINEERING SHARE PRICES. In 2000, Enron enjoyed remarkable success in the capital markets. During that year, Enron's shares increased in value by 89 percent, while the S&P 500 index fell by 9 percent. At the end of 2000, Enron's shares were trading at roughly $83 per share and all of the sell-side analysts following Enron recommended the shares as a "buy" or a "strong buy." With 752.2 million shares outstanding, Enron had a market capitalization of $62,530 million and was one of the largest firms (in terms of market capital) in the United States. At year-end 2000, Enron's book value of common shareholders' equity was $11,470 million.
At year-end 2000, Enron posted earnings per share of $1.19. Among sell-side analysts following Enron, the consensus forecast for earnings per share was $1.31 per share for 2001 and $1.44 per share for 2002, with 10 percent earnings growth expected from 2003-2005. At the time, Enron was paying dividends equivalent to roughly 40 percent of earnings and was expected to maintain that payout policy.
At year-end 2000, Enron had a market beta of 1.7. The risk-free rate of return was 4.3 percent, and the market risk premium was 5.0 percent.
[Note: The data provided in this problem, and the inferences you draw from them, do not depend on foresight of Enron's declaring bankruptcy by the end of 2001.]
Required
a. Use the CAPM to compute the required rate of return on common equity capital for Enron.
b. Use year-end 2000 data to compute the following ratios for Enron:
i. Market-to-book
ii. Price-earnings (using 2000 earnings per share)
iii. Forward price-earnings (using consensus forecast earnings per share for 2001).
c. Reverse-engineer Enron's $83 share price to solve for the implied expected return on Enron shares at year-end 2000. Do the reverse engineering under the following assumptions:
i. Enron's market price equals value.
ii. The consensus analysts' earnings-per-share forecasts through 2005 are reliable proxies for market expectations.
iii. Enron will maintain a 40 percent dividend payout rate.
iv. Beyond 2005, Enron's long-run earnings growth rate will be 3.0 percent.
d. What do these analyses suggest about investing in Enron's shares at a price of $83?
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: Use the CAPM to compute the required rate of return on common equity capital for Enron. What do these analyses suggest about investing in Enron's shares at a price of $83?
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