Equity Valuation and Portfolio Management

QUESTIONS

1. Firm D and Firm E have the same performance characteristics. They both have a P/E of 20× and they also have the same cost of capital, return on equity, etc. The only difference is that Firm E's economic book value is $25 billion and Firm D's economic book value is $25 million. Explain why, in the language of the FFM, Firm E's P/E is more likely to decline than Firm D's.
2. Firm F is an excellent firm with superior management and a long history of steady earnings. After a long period of expansion, the Firm F has run out of opportunities to expand by building out new businesses. Toward what values are its TV, FV, and P/E likely to converge?
3. Why is it hard for CEOs of large successful companies to maintain the firm's P/E?
4. What is a reasonable level for the long-term P/E of a market under the following assumptions: economic book value = $500 billion, roe = 15%, cap rate = 9%, return on new investments = 18%, total investment in new businesses = $20 billion per year for the next 10 years? How does the projected P/E change if the cap rate is 8% or 10%? How does the projected P/E change if total investment is (a) $20 billion per year for 20 years? (b) $300 billion per year for 20 years? (c) $400 billion per year for 20 years?
5. Explain the long term decline in value of an investment in Firm A or Firm B in terms of the FFM.

¹ For further discussion see Zvi Bodie, Alex Kane, and Alan Marcus, Investments (New York: McGraw-Hill/Irwin, 2010) and Myron J. Gordon, The Investment Financing ...