Copyright © 2012. McGraw-Hill Higher Education. All rights reserved.

Ebook pages 286-309 | Printed page 1 of 19

210

Chapter Seven

Valuation and Active Investing

Passive investors accept market prices as fair value. Fundamental investors, in contrast, are active investors. They see that
price is what you pay, value is what you get. They understand that the primary risk in investing is the risk of paying too much
(or selling for too little). The fundamentalist actively challenges the market price: Is it indeed a fair price? This might be
done as a defensive investor concerned with overpaying or as an investor seeking to exploit mispricing.
This chapter leads you into active investing, with the price-to-book (P/B) and price-earnings (P/E) valuation models of
Chapters 5 and 6 as the tools. These models are skeletal—more tools will be added as the book proceeds—but they are
sufficient to demonstrate the approach. How do we apply these models in active investing? How do we use these models to
challenge the market price?
211

The Analyst’s Checklist

Penman, Stephen. Financial Statement Analysis and Security Valuation, McGraw-Hill Higher Education, 2012. ProQuest Ebook Central, [Link]
Created from bham on 2025-10-27 16:24:06.
Copyright © 2012. McGraw-Hill Higher Education. All rights reserved. Ebook pages 286-309 | Printed page 2 of 19

After reading this chapter you should understand:

• How the fundamental investor operates.
• Why it is unnecessary to calculate “intrinsic value.”
• Why growth rates in a valuation are speculative.
• That we really do not know the cost of capital.
• How the investor applies the principle of “separate what you what you know from speculation” in practice.
• How the investor challenges the market price.
• How the investor ascertains the growth forecast implicit in the market price.
• How the investor understands the expected return from investing at a given price.
After reading this chapter you should be able to:
• Reverse engineer the market price to ascertain the market’s earnings forecast.
• Plot the future earnings growth path that is implicit in the market price.
• Calculate the expected return from buying at the current market price.
• Evaluate the current level of a stock market index like the S&P 500.
• Challenge the market price of a stock.
• Take the first steps in engaging in active investing.

HOW THE FUNDAMENTAL INVESTOR OPERATES

To answer these questions, we must put ourselves in the mind-set of the active investor. That means discarding some
common misconceptions.

Common Misconceptions About Valuation

Standard valuation methods often proceed with the pretense that we know the inputs to a valuation model. Indeed, valuation
models lend themselves to “playing with mirrors.” The fundamentalist does not play that game. Fundamental investors strive
for honesty, at all points understanding what is known and what is uncertain.
The following points highlight some common misconceptions about valuation and warn of pitfalls to avoid in handling
valuation models. For illustration, we will work with the residual earnings valuation model of Chapter 5. For a two-year-
ahead forecast,

The idea of “intrinsic value” is not useful. Even though valuation models seemingly produce a number for “value” as the
output of the valuation process, it is not helpful to think of the notion of true “intrinsic value.” Deferring to Graham and
Dodd, the fathers of fundamental analysis,
He [the investor] is concerned with the intrinsic value of the security and more particularly with the discovery of the discrepancies
between intrinsic value and price. We must recognize, however, that intrinsic value is an elusive concept. In general terms it is
understood to be that value which is justified by the facts, e.g., the assets, earnings, dividends, definite prospects—as distinct, let
us say, from market quotations established by artificial manipulation or distorted by psychological excesses. But it is a great
mistake to imagine that intrinsic value is as definite and as determinable as is the market price.

—Benjamin Graham and David Dodd, Security Analysis (New York: McGraw-Hill Book Company, 1934), p. 17.

212
With intrinsic value being inherently uncertain, the idea of discovering true intrinsic value is doubtful or even misguided.
This may come as a surprise, because the models tell us to plug in numbers on the right-hand side to deliver an intrinsic
value (V) on the left-hand side. A valuation model does not deliver a certain intrinsic value because the inputs themselves are
uncertain. Forecasts (for two years in the equation 7.1 model above) are estimates. But the two other inputs, the required
return, ρ, and the long-term growth rate, g, are also uncertain.
We do not know the required return. Standard valuation practices pretend we know the required return because it is
supplied by an asset pricing model such as the capital asset pricing model (CAPM). But, as the appendix to Chapter 3 made
clear, estimates of the required return from these models are highly uncertain, particularly the estimate of the “market risk
Penman, Stephen. Financial Statement Analysis and Security Valuation, McGraw-Hill Higher Education, 2012. ProQuest Ebook Central, [Link]
Created from bham on 2025-10-27 16:24:06.
Copyright © 2012. McGraw-Hill Higher Education. All rights reserved. Ebook pages 286-309 | Printed page 3 of 19

premium,” which is anyone’s guess. The value from a valuation model is quite sensitive to the required return used, yet we
really don’t know what the required return is. It is quite disappointing that, after 60 years of dedicated endeavor, modern
finance has not come up with a way for determining the required return. You and I may have our own required return for
investing—our own hurdle rate—and we can certainly use that in the model. But the idea that the required return can
objectively be determined is fiction. Using the CAPM is largely playing with mirrors.
We do not know the long-term growth rate. Benjamin Graham had the following to say about valuation models:

The concept of future prospects and particularly of continued growth in the future invites the application of formulas out of higher
mathematics to establish the present value of the favored issue. But the combination of precise formulas with highly imprecise
assumptions can be used to establish, or rather justify, practically any value one wishes, however high, for a really outstanding
issue.

—Benjamin Graham, The Intelligent Investor, 4th rev. ed. (New York: Harper and Row, 1973), pp. 315–316.

Graham was skeptical about valuation formulas in general but, in this quote, the focus is on long-term growth rates, the g in
the continuing value of valuation formulas—“continued growth” as he called it. We do not know the long-term growth rate,
or can estimate it only with considerable uncertainty. Graham recognized the scheme of the sell-side investment banker who
can choose almost any growth rate (and a required return) to justify the “due diligence” valuation he wants for floating
shares. But buy-side fundamental investors acknowledge that the long-term growth rate is highly uncertain, so they do not
“assume” long-term growth rates. They do not play that game.
A valuation model is nominally a device for giving us some certainty about the correct value, but you can see from these
points that the model can actually serve to compound our uncertainty: Garbage in, garbage out. You might then well ask how
useful valuation models are in getting a value, V, to challenge the market price, P. The next point below answers this
question and shows how the fundamental investor indeed plays the game and how she plays with valuation models to do so.
Investing is a game against other investors. Equity investing is not a game against nature, but a game against other
investors. So it serves little purpose to use a valuation model to discover the “true” intrinsic value, as if it existed somewhere
out there. Rather, valuation models should be used to understand how an investor thinks differently from other investors in
the market. Thus, the right question to ask of a model is not what the “right” value is but rather whether the model can help
the investor understand the perceptions of other investors embedded in the market price—so those perceptions can be
challenged. The investor is “negotiating with Mr. Market” (in Benjamin Graham’s words) and, in those negotiations, the
onus is not on the investor to produce a valuation, but
213
rather to understand Mr. Market’s valuation, in order to accept it or reject his asking price. As a valuation is based on
forecasts, valuation models are appropriately applied to understand Mr. Market’s forecasts: What forecasts are behind Mr.
Market’s price? Are those forecasts reasonable?
This view of the investing game leads us directly to our application of valuation models to active investing. But first, let’s
review some fundamentalist principles laid down in Chapter 1.

Applying Fundamental Principles

Chapter 1 gave 12 commonsense principles that guide the investor. We pick up three of them here:

1. Don’t mix what you know with speculation.

2. Anchor a valuation on what you know rather than speculation.
3. Beware of paying too much for growth.
The first point is behind the criticism of standard valuation approaches: Don’t build speculation about the required return
or a growth rate into a valuation. We really don’t know these numbers, so don’t mix them with what we do know. Use
valuation models to challenge the market price with value based on what we do know.
The second point tells us to anchor a valuation on what we know. Identify the value indicated by what we know—“value
justified by the facts” in Graham’s words—and then go about adding value for speculation:

This breaks a valuation down into component (1) that is relatively “hard” and component (2) that is “soft” in the sense that
it is far more speculative. As we will see, what we know comes from analysis of information, particularly financial statement
information. The fundamental investor asks: What is the value implied by the fundamentals (before I go about adding value
for speculative growth)?
The third point says that speculation centers on growth. That is clear from the valuation model in equation 7.1: We know
book value—it’s on the face on the balance sheet—and we may have relatively firm information about forward earnings or
Penman, Stephen. Financial Statement Analysis and Security Valuation, McGraw-Hill Higher Education, 2012. ProQuest Ebook Central, [Link]
Created from bham on 2025-10-27 16:24:06.
Copyright © 2012. McGraw-Hill Higher Education. All rights reserved. Ebook pages 286-309 | Printed page 4 of 19

even earnings two years ahead. So we can determine a value implied by these numbers. But it is the growth rate, g, where
our uncertainty lies. Indeed, we have stressed in prior chapters that it is the continuing value (containing the growth rate)
about which we are most uncertain. It is easy to plug in a speculative growth number into a valuation model like 7.1 and
overpay for growth. Chapter 1 gave a history of markets being over-excited about growth in boom times and too pessimistic
in depressed times.
The fundamentalist understands that he must challenge the market’s speculation and that speculation concerns growth. He
does this by anchoring on what he knows. It is here that valuation models come into play and realize their potential. So let’s
play the game—the game against other investors—using our valuation models.

CHALLENGING SPECULATION IN THE MARKET PRICE

We will find that our financial statement analysis of the next part of this text will typically give us near-term forecasts to
which we can anchor along with book value. That leaves us two unknowns in the valuation model, the growth rate and the
required return. As the game
214
is against other investors, active investing does not plug in numbers for ρ and g and pretend to get an “intrinsic value,” but
turns the valuation model around and asks what are the growth rate or expected return that is implicit in the market price.
The exercise is called reverse engineering: Rather than inserting inputs into a valuation formula to get a V, set V equal to P
and ask what inputs explain the current market price, P.
We first illustrate with the simple example that introduced the valuation models in the last two chapters. The simple
residual earnings valuation model took the form,

Book value is $100 and forward residual earnings is forward earnings of $12.36 minus a charge against book value at 10
percent: RE1 = $12.36 # (0.10 × 100) = $2.36. Following standard valuation procedures, we set a growth rate for residual
earnings of 3 percent to yield a $133.71 value. But now let’s apply the model in reverse-engineering mode. Suppose your
personal hurdle rate for this investment is 10 percent, and suppose that the equity traded at $133.71. Then, setting value equal
to price in reverse-engineering mode,

One can now solve for g. For a price of $133.71, g = 1.03 or a 3 percent growth rate (of course). If the price were $147.2, g
= 1.05, or a 5 percent growth rate: Given the current book value and a forecast of earnings one year ahead, the market is
forecasting a 5 percent long-term growth rate for residual earnings. This is the market’s implied residual earnings growth
rate.
Rather than guessing at a growth rate, we have reverse engineered to understand Mr. Market’s growth rate. To do this we
have first “anchored on what we know,” as in equation 7.2. We know the book value and we have good information (say)
about forward earnings, so we anchor on these two numbers. But rather than adding our own speculation about growth, we
turn the problem around and use the anchoring numbers to discover Mr. Market’s growth forecast.
Alternatively, we can reverse engineer to discover the market’s implied expected return. Specifying a growth rate of 3
percent,

The solution is ER = 1.10, a 10 percent return (of course). This is given by a simple formula,

This formula is referred to as the weighted-average expected return formula because it is a weighted average of the
forward return on common equity (ROCE) and the growth rate, with the book-to-price supplying the weights. 1 (The book-to-
price is simply the reciprocal
215

Penman, Stephen. Financial Statement Analysis and Security Valuation, McGraw-Hill Higher Education, 2012. ProQuest Ebook Central, [Link]
Created from bham on 2025-10-27 16:24:06.
Copyright © 2012. McGraw-Hill Higher Education. All rights reserved. Ebook pages 286-309 | Printed page 5 of 19

of the price-to-book, of course.) With a book-to-price of $100/$133.71 = 0.748 and a forward ROCE of $12.36/$100 = 12.36
percent,

ER = [0.748 × 12.36%] + [0.252 × 3%] = 10.0%

Note, importantly, that ER is not the required return but the expected return from buying shares at the current market
price. If the market price is $147.2, then the expected return from buying at the current market price (with the same 3 percent
growth rate) is 9.36 percent. That makes sense: With a higher price for the same expectations, one will get a lower expected
return.
You can see that the active investor has two ways to challenge the market price.
First, understand the market’s growth forecast and then ask if that growth rate is justified, too high, or too low. You will
have to do more analysis to be secure in your answer, and the financial statement analysis of the next part of the text is set up
to deal with the question. But appreciate that the onus is not on you, the investor, to come up with a growth rate (or a
valuation), but just to accept or reject the market’s growth rate as reasonable. After identifying the market’s forecast of
growth, you might conclude that (with the help of the analysis to come) the implied growth rate is difficult to achieve. So
you would conclude that buying the stock runs the risk of paying too much. You don’t know the intrinsic value, but you do
not have to; all you need to do is assess the risk of overpaying. You might also see an opportunity to earn superior returns
when the implied growth rate seems low.
Second, the investor might assess the risk of paying too much (or the opportunity provided by a cheap stock) by
calculating the expected return to buying at the market price. If the stock is expensive (the price is high), the expected return
will be low; if the stock is cheap, the expected return will be high.
The two methods provide an enhanced screening to the simple screening analysis of Chapter 3 that we judged as too
simple: Rather than screen stocks on P/E or P/B, screen them on their implied growth rates or their expected returns. We will
get to refinements later in the book, but you see the basic idea.
But there is a problem. To get the implied growth rate, we had to input a required return, and to get an expected return we
have to input a growth rate. But we have concluded that both the required return and the growth rate are something we are
typically quite unsure about. One can always input one’s own hurdle rate or a ceiling growth rate—the GDP growth rate, for
example—but this problem needs to be dealt with. We will deal with this later in the book after more tools are on the table.
For the moment we proceed with some real-life examples.

Reverse Engineering the S&P 500

In May 2011, the S&P 500 stock index traded at 1357 on a book value of 588 and thus a price-to-book of 2.3. S&P forward
earnings for the index (supplied on Standard and Poor’s Web site) was 98.76, thus forward ROCE was 98.76/588 = 16.8
percent. What long-term growth rate was the market forecasting for the S&P 500 firms at the 1357 level for the index? The
10-year risk-free Treasury rate at the time was 3.3 percent and the consensus estimate of the market risk premium was 5.7
percent. So set the required return at 3.3% + 5.7% = 9%, then reverse engineer. By pricing at 2.3 times book value, the
market was pricing a dollar of book value as follows:

(The numerator is the residual earnings for a dollar of book value.) The solution for g is 1.03, a 3 percent grow rate. If one
expects residual earnings to grow in the long run at the historical GDP growth rate of 4 percent, then one would conclude
that the S&P 500 is underpriced.
216

Penman, Stephen. Financial Statement Analysis and Security Valuation, McGraw-Hill Higher Education, 2012. ProQuest Ebook Central, [Link]
Created from bham on 2025-10-27 16:24:06.
Copyright © 2012. McGraw-Hill Higher Education. All rights reserved. Ebook pages 286-309 | Printed page 6 of 19

FIGURE 7.1 Price-to-Book Ratio (P/B) and Implied Residual Earnings Growth Rates for the S&P 500, 1982–2008.
The measures are at the end of December of each year. The implied growth rate is indicated on the left axis, and the P/B on the right axis.
Implied residual earnings growth rates are calculated by reverse engineering the end-of-year S&P 500 index with a required return of 9 percent
and forward earnings measured with analysts’ consensus of forward earnings forecasts for the following year.

Sources: The S&P 500 index is from Standard and Poor’s Web site; book value is from the COMPUSTAT data through WRDS; and analysts’ forecasts
are from IBES, supplied through WRDS.

One might question the 4 percent GDP rate as an appropriate benchmark. However, the average growth rate for this
reverse-engineering exercise on the index typically does approximate the average GDP growth rate, though with some
variation. Figure 7.1 plots the price-to-book ratio for the S&P 500 at year-end from 1982–2008, along with implied growth
rates. The calculation of implied growth rates is the same as above, but now with forward ROCE based on analysts’
consensus earnings forecasts for the index. The implied growth rates range from #11.2 percent in 1982 to 8.0 percent in
2001, but the average is 4.2 percent, much like the typical GDP growth rate. The implied growth rates deviate from the
average 4.2 percent—particularly during the bubble of the 1990s—but revert back to the mean. The 4 percent rate seems to
be a good measure for central tendency.
Would this analysis detect when the market is underpricing or overpricing growth? If it does, it would predict future
returns. Figure 7.2 suggests so. That figure plots the same implied growth rates as in Figure 7.1, but now with an overlay of
returns for the S&P 500 over the following year. It appears that the implied growth rates predict returns on the index,

FIGURE 7.2 Implied Growth Rates and Year-ahead Returns for the S&P 500, 1982–2008.
Implied growth rates are indicated on the left axis and year-ahead returns on the right axis.

217

Penman, Stephen. Financial Statement Analysis and Security Valuation, McGraw-Hill Higher Education, 2012. ProQuest Ebook Central, [Link]
Created from bham on 2025-10-27 16:24:06.
Copyright © 2012. McGraw-Hill Higher Education. All rights reserved. Ebook pages 286-309 | Printed page 7 of 19

FIGURE 7.3 Expected Year-Ahead Returns and Actual Year-Ahead Returns for the S&P 500, 1982–2008.
Expected returns are inferred from the level of the index at the end of December of each year using book value at that date and analysts’
consensus forward earnings forecasts for the following year, along with a GDP growth rate of 4 percent. The actual return is the return for the
index for the next calendar year. The expected return is indicated on the left axis, and the actual return on the right axis.

Sources: The S&P 500 index and dividends for the index are from the Standard and Poor’s Web site; book value is from the COMPUSTAT data through
WRDS; and analysts’ forecasts are from IBES, supplied through WRDS.

with higher growth rates predicting lower subsequent returns and vice versa. The correlation is #0.25, and the correlations
with returns for two years ahead and three years ahead are #0.26 and #0.33, respectively. 2 It appears that challenging the
market’s growth forecast would have paid off during this period.
If one accepts the GDP rate as the expected long-term growth rate, the alternative method of reverse engineering to the
expected return can be applied. With a price-to-book of 2.3, the book-to-price for the index in May 2011 was 0.435.
Applying the weighted-average expected return formula in equation 7.3,

If the investor has a hurdle rate of 9 percent for buying equities, then an investment in the S&P 500 would seem reasonable.
Is this measure of expected return a good predictor of actual returns earned? Figure 7.3 suggests so. The figure plots the
implied expected return (ER) on the index with a GDP growth rate of 4 percent. The implied expected returns predict the
actual year-ahead returns in the figure; the correlation is 0.29. The average expected return over the years, 1982–2008 is 8.8
percent, close to the 9 percent. The period included the 1990s bubble years when, due to high prices, the expected return was
low (6.8 percent in 1998 and 6.6 percent 1999, for example). The low expected return in those years was a warning of the
actual poor returns that were to follow.
218
The pictures do give some encouragement for active investing. They also deliver a warning to passive investors who just
buy the market portfolio, perhaps with an index fund or an exchange traded fund (ETF) tied to a market index. Beware: you
may be overpaying.
We have to be careful of mechanical schemes, here as always. They are a good first cut but use limited information. Risk
can change as economies go into recession or into a financial crisis. At times an investor might require a higher or lower
return because of changes in market uncertainty. In these illustrations, with a 9 percent return benchmark at all points, we
have not allowed for changing risk. More needs to be flushed out, including a fundamental analysis of risk.

Challenging the Price of a Stock

In May 2011, Google, Inc. was trading at $535 per share, or 3.7 times book value of $143.92 per share at the end of its 2010
fiscal year. Analysts were forecasting a consensus estimate of $33.94 EPS for 2011 and $39.55 for 2012. If we were fairly
confident about these near-term forecasts we could break down the valuation into two parts following equation 7.2:

Penman, Stephen. Financial Statement Analysis and Security Valuation, McGraw-Hill Higher Education, 2012. ProQuest Ebook Central, [Link]
Created from bham on 2025-10-27 16:24:06.
Copyright © 2012. McGraw-Hill Higher Education. All rights reserved. Ebook pages 286-309 | Printed page 8 of 19

The residual earnings model provides us with the anchoring value (without growth):

You see that component (1) is simply the valuation in model 7.1 without growth (that is, with g set to 1.0). The value from
growth is now in component (2). Accordingly, component (1) is referred to as the no-growth valuation. To anchor on two
years of forecasts, we must be fairly confident in our predictions; otherwise only one year, the forward year, is used (as in the
S&P 500 example). The financial statement analysis in the next part of the book yields these forecasts.
A pro forma that delivers Google’s no-growth valuation is laid out in Exhibit 7.1. Your hurdle rate is 10 percent. This is,
of course, the Case 2 valuation of Chapter 5 where residual earnings after two years is forecasted to continue at the same
level (that is, with no growth).
With no value recognized for speculative growth, we account for $359.54 of the $535 in market value, made up of
$143.92 in book value and $17.77 + $197.85 = $215.62 from the short-term forecasts. Thus the amount of the market price
unexplained by the accounting is $175.46. That is the value that the market is placing on speculative growth.
Figure 7.4 shows how we have deconstructed the market price into three components: (1) book value, (2) value from short-
term earnings, and (3) the speculative value the market places on subsequent growth. These are building blocks that help us
understand our uncertainty. The three blocks parse out uncertainty into what we know for sure—book value—what we know
with some confidence—value from short-term forecasts—and what we are quite uncertain about—value from long-term
growth prospects. It is the latter where our serious uncertainty lies. It is the latter where we risk overpaying for growth. The
diagram confronts us: Do we want to pay $175.46 for risky growth?
219

EXHIBIT 7.1 No-Growth Valuation for Google, Inc.

A 10 percent required return is used for calculating residual earnings.

2010A 2011E 2012E

EPS 33.94 39.55

DPS 0.00 0.00
BPS 143.92 177.86 217.41
Residual earnings (10% charge) 19.548 21.764
Growth in residual earnings 11.3%
Growth in EPS 16.5%

We are now in a position to ask Mr. Market for his growth rate. The answer comes quickly by bringing growth back into
our valuation, substituting price for value, and reverse engineering:

With value set to Google’s market price of $535, we can infer the market’s long-term growth rate: The implied growth rate
for Google after 2012 is 4.7 percent per year.
This growth rate is the residual earnings growth rate, a little difficult to get our minds around. But we can convert the
growth rate to an implied earnings growth rate by reverse engineering the residual earnings calculation:

Penman, Stephen. Financial Statement Analysis and Security Valuation, McGraw-Hill Higher Education, 2012. ProQuest Ebook Central, [Link]
Created from bham on 2025-10-27 16:24:06.
Copyright © 2012. McGraw-Hill Higher Education. All rights reserved. Ebook pages 286-309 | Printed page 9 of 19

Earnings forecastt = (Book valuet-1 × Required return) + Residual earningst (7.4)

FIGURE 7.4 Building Blocks for the Market’s Valuation for Google, Inc., May 2011.
The no-growth value is the sum of the first two components, $359.54, and the speculative value for growth is the third component, $175.46.

220

FIGURE 7.5 EPS Growth Path for 2012–2018, Implied by the Market Price of $535 for Google, Inc.

Google’s residual earnings two years ahead (2012) is $21.764 per share in Exhibit 7.1, so the residual earnings forecasted for
the third year ahead (2013) at a growth rate of 4.7 percent is $22.787. Thus, with a per-share book value of $217.41
forecasted for the end of 2012 (in Exhibit 7.1), the forecast of EPS for 2013 is $44.53 and the forecasted growth rate over
2012 EPS is 12.6 percent. Extrapolating in the same way to subsequent years, one develops the earnings growth path that the
market is forecasting, displayed in Figure 7.5. The growth path divides the BUY zone and the SELL zone: If an analyst sees
growth at a higher rate than this path, then issue a BUY recommendation; if lower, issue a SELL recommendation.
The 4.7 percent residual earnings growth rate is an average rate for the long term. Modifications permit the more realistic
picture of a declining growth rate over time. The 4.7 percent rate looks something like the GDP growth rate, perhaps a little
higher. Exhibit 7.1 shows Google growing residual earnings at 11.3 percent in 2012, indicating that the firm might be able to
maintain a growth rate above 4.7 percent for some years. On the other hand, one might expect that all firms will look like the
average firm in the very long run, with growth at the GDP growth rate. This accepts the view that exceptional growth, like
Google’s, is ultimately eroded away. With a 2012 growth rate of 11.3 percent, reversion to a long-term GDP growth rate of
(say) 4 percent is given by weighting the two with weights that sum to one:

Growth rate for 2013 = (0.8 × 11.3%) + (0.2 × 4.0%) = 9.84%

Penman, Stephen. Financial Statement Analysis and Security Valuation, McGraw-Hill Higher Education, 2012. ProQuest Ebook Central, [Link]
Created from bham on 2025-10-27 16:24:06.
Copyright © 2012. McGraw-Hill Higher Education. All rights reserved. Ebook pages 286-309 | Printed page 10 of 19

(and so on, recursively, for years after 2013). The 2013 growth rate is lower than the 11.3 percent for 2012 because it is on a
path to decline to 4 percent in the long run. Applying the weights to subsequent years, the forecasted growth rate for 2014 is
8.67 percent, declining to 4 percent eventually. So we establish a fade pattern for growth with the growth path depicted in
Figure 7.6. This path yields a value of $570.32. The figure compares this fade pattern to a path with weights of (0.9, 0.1)
which yields a value of $657.84. The weights are somewhat arbitrary but are a device for experimenting in challenging the
market price of $535. What does our information indicate will be the most likely path for Google? You can see that it is a
question of how long above-average growth can be sustained. That is the issue of sustainable competitive advantage, but
now we have some concreteness by bringing numbers to the evaluation of sustained competitive advantage.
221

FIGURE 7.6 Residual Earnings Growth Paths for Google, Inc., for Alternative Weights Applied to Short-term and
Long-term Growth Rates.
The (0.684, 0.316) weights are those implied by the market price of $535.

We can make that challenge to the market price directly by “backing out” the weights implicit in the market price. The
implicit weights are (0.684, 0.316), and they imply the third growth path in Figure 7.6 that has the growth rate decaying to 4
percent much faster. The path can be converted to an EPS growth path as in Figure 7.2. This is the path that the market sees
Google following as it reverts to the GDP growth rate in the long run. Can this path be justified? Or does the analyst see
Google maintaining competitive advantage and superior growth for much longer? Is $535 too much or too little to pay for
growth?
You can see that we have challenged the market price with this analysis. But we have challenged the price by challenging
the market’s forecast of the growth path. We have more work to do, to establish the anchoring no-growth value and to get a
handle on the question as to whether the market’s growth forecast is justified. But we now have a scheme to play the game
against other investors, that is, to engage in active investing.
The alternative scheme is to apply the weighted average return formula to estimate the expected return to buying Google
at the current market price. Exercise E7.11 asks you to do that.

Reverse Engineering with the Abnormal Earnings Growth Model

The illustration above applies the residual earnings model of Chapter 5. The analysis can be done alternatively with the
abnormal earnings growth (AEG) model of Chapter 6. For two years of forecasts,

Parsing out the model into its no-growth and growth components,

Penman, Stephen. Financial Statement Analysis and Security Valuation, McGraw-Hill Higher Education, 2012. ProQuest Ebook Central, [Link]
Created from bham on 2025-10-27 16:24:06.
Copyright © 2012. McGraw-Hill Higher Education. All rights reserved. Ebook pages 286-309 | Printed page 11 of 19

222
The implied growth rate is found by solving for g in equation 7.5. That refers to growth in AEG, but that is readily
converted to an earnings growth by reverse engineering the AEG calculation:

With these earnings forecasts, one can plot the market’s EPS growth path, as in Figure 7.5.

BUILD YOUR OWN ACTIVE INVESTING TOOL

In Chapters 5 and 6 you were encouraged to build a spreadsheet engine that delivers a value from inputs of book values,
earnings forecasts, growth rates, and the required return. It is a short step to adapt those spreadsheets for active investing.
This can be done in two ways. First, set up a program to solve directly for implied growth rates, with current price as an
input. The weighted average expected return formula 7.3 governs the template for the implied expected return. Or, second,
use the spreadsheets you have already developed and just experiment with growth rates or required returns that yield a value
equal to the current market price. In both cases you will have to add the feature that converts residual earnings growth rates
or AEG growth rates to earnings forecasts, following formulas 7.4 and 7.6. If you can work with graphic functions, you
might display plots like those in Figures 7.5 and 7.6.

The Web Connection

Find the following on the Web page for this chapter:

• Further examples of reverse engineering.
• Consensus estimates of the market risk premium from surveys of analysts, academics, and investors.
• More discussion of the difficulties in applying asset pricing models like the CAPM.
• More help in building spreadsheets for active investing.

Summary
A valuation model is a useful tool, but the investors must understand how to operate the tool effectively. Valuation models
can be used naively, yielding valuations that are just the product of speculative inputs. Rather than being a tool for
challenging speculation, they can build in speculation.
This chapter has shown how to handle valuation models in active investing. A valuation model cannot deliver a reliable
intrinsic value. But that does not matter, for active investing does not require us to discover intrinsic value. All that is
required is to accept or reject the market valuation. For that, the tools of reverse engineering come into play, with valuation
models used to infer the market’s growth forecast that then can be challenged. Alternatively, with a forecast of growth, one
can apply the valuation model to estimate the expected return to buying a stock at the current market price.
There is more to be done to develop a full toolbox for active investing. Most important, we need to analyze the
information that anchors us in challenging the market price and the growth rate implicit in that price. That is the subject of
the next part of the book.3
223

Key Concepts

Penman, Stephen. Financial Statement Analysis and Security Valuation, McGraw-Hill Higher Education, 2012. ProQuest Ebook Central, [Link]
Created from bham on 2025-10-27 16:24:06.
Copyright © 2012. McGraw-Hill Higher Education. All rights reserved. Ebook pages 286-309 | Printed page 12 of 19

fade pattern is the pattern a characteristic takes in evolving from the present or near future to the very long term.
implied earnings growth rate is the forecast of earnings growth rate that is embedded in the market price.
implied expected return is the expected rate of return from buying at the current market price.
implied residual earnings growth rate is the forecast of the growth rate in residual earnings that is embedded in the
market price.
no-growth valuation is a valuation based on current and near-term accounting numbers with no growth expected.
reverse engineering is the process of inferring information from the current market price by running valuation formulas
backward.

The Analyst’s Toolkit

Analysis Tools Page

Reverse engineering 214

—for implied growth rates 214
—for expected returns 214
Weighted-average expected return 214
No-growth value 218
Valuation building blocks 219
Implied earnings growth path 220
BUY/SELL zones 220
Fade patterns 220

Key Measures Page

Implied expected return 214

Implied earnings growth rate 220
Implied AEG growth rate 221
Implied residual earnings growth rate 214
Value of speculative growth 218

Acronyms to Remember

AEG abnormal earnings growth

B/P book-to-price ratio
EPS earnings per share
ER expected return
ETF exchange traded fund
DPS dividends per share
GDP gross domestic product
P/E price/earnings ratio
P/B price-to-book ratio
RE residual earnings
ROCE return on common equity

Penman, Stephen. Financial Statement Analysis and Security Valuation, McGraw-Hill Higher Education, 2012. ProQuest Ebook Central, [Link]
Created from bham on 2025-10-27 16:24:06.
Copyright © 2012. McGraw-Hill Higher Education. All rights reserved. Ebook pages 286-309 | Printed page 13 of 19

A Continuing Case: Kimberly-Clark Corporation

A Self-Study Exercise

In the Kimberly-Clark (KMB) case for Chapters 5 and 6, you were asked to convert analysts’ consensus earnings
forecasts to a valuation. The issue of the appropriate long-term growth rate arose, and it was suggested that you use the
4 percent GDP growth rate. The continuing case now asks you to go into reverse-engineering mode to understand the
market’s forecast and to challenge the price. You do not have the full toolkit to do this at this stage, but you will see that
you are starting to get a handle on the problem.

ACTIVE INVESTING
In the earlier editions of the case you embraced analysts’ five-year earnings growth rate. These growth rates are
notoriously imprecise, so discard them. They are not something on which you can anchor. Work now with the EPS
earnings estimates for 2011 and 2012, $4.98 and $5.35 respectively. The stock traded at $65.24 when these forecasts
were made. Suppose
224
your hurdle rate for investing in KMB is 8 percent and that you are reasonably comfortable with using the two years of
forecasts.

Understanding Your Uncertainty

Assemble a building-block diagram for KMB like the one in Figure 7.4. What part are you most uncertain about? What
price is the market putting on growth?

Reverse Engineering
Calculate the no-growth value for KMB. Now estimate the growth after 2012 that is forecasted by the market price. Plot
the forecasted EPS growth rate, as in Figure 7.5. You probably will work with the residual earnings valuation model,
but you might also try your hand at applying the abnormal earnings growth model, as in equations 7.5 and 7.5a. You
might also experiment with different fade rates, with the growth rate fading to a (very) long-term rate of 4 percent, as in
Figure 7.6.
Now reverse engineer the expected return from buying KMB at $65.24 per share. The weighted-average expected
return formula is the tool. Set the growth rate initially at the GDP growth rate, but also look at the expected return for
different growth rates. Ask, for example, what the expected return would be if KMB delivered no growth. What would
be the expected return with 5 percent growth?
Suppose your hurdle rate is 8 percent and that you refuse to pay for residual earnings growth in excess of 3 percent.
Would you buy this stock?

Using Spreadsheet Tools

You can build a spreadsheet program that conducts the reverse-engineering exercise. If you have built spreadsheets for
the P/B and P/E valuation models, you might just run with those programs, experimenting with different inputs to
discover growth rates and expected returns that yield the market price.

Concept Questions

C7.1. Why is a fundamental investor suspicious about a required return estimated from the capital asset pricing model
(CAPM)?
C7.2. Why do valuation models lend themselves to “playing with mirrors”?
C7.3. “Investing is not a game against nature, but a game against other investors.” What does this statement mean?
What does it imply about how to conduct equity investing?
C7.4. Benjamin Graham was concerned about “the concept of future prospects and particularly of continued growth in
the future.” Why was he concerned?
C7.5. Growth is risky. Explain.
C7.6. A firm currently has a growth rate for residual earnings of 16 percent. Would you expect that growth rate to be
higher, lower, or about the same in five years time?

Penman, Stephen. Financial Statement Analysis and Security Valuation, McGraw-Hill Higher Education, 2012. ProQuest Ebook Central, [Link]
Created from bham on 2025-10-27 16:24:06.
Copyright © 2012. McGraw-Hill Higher Education. All rights reserved. Ebook pages 286-309 | Printed page 14 of 19

C7.7. Why would you expect an abnormally high growth to fade toward average growth for the economy in the long
run?
C7.8. A firm currently has a growth rate for residual earnings of 16 percent, but investors agree that the very long-term
growth rate should be the GDP growth rate of 4 percent. What determines the speed by which the 16 percent rate
fades to the 4 percent rate over time?
C7.9. A high P/E stock typically is one with high earnings growth expectations. Would you also expect that stock to be
high risk? Are CAPM betas higher for high P/E stocks?
225
C7.10. A share is trading at $16.34. The no-growth value is $12.92. What do you infer from this comparison?
C7.11. A share trades at a P/B ratio of 0.8. The no-growth value indicates a P/B of 1.2. What do you infer from this
comparison?

Exercises

Drill Exercises

E7.1. Reverse Engineering Growth Rates (Easy)

a. A share traded at $26 at the end of 2012 with a price-to-book ratio of 2.0. Analysts were forecasting earnings
per share of $2.60 for 2013. Your required return for equity is 10 percent. What is the growth rate for
residual earnings that the market expects beyond 2013?
b. A firm with a book value of $27.40 per share at the end of 2012 is expected to earn an EPS of $4.11 in 2013.
Your required return for investing in the shares of this firm is 9 percent. What is the expected growth rate for
residual earnings after 2013 that is implied by a market price of $54?
(This exercise and Exercise E7.2 can be worked together.)

E7.2. Reverse Engineering Expected Returns (Easy)

a. A share traded at $26 at the end of 2012 with a price-to-book ratio of 2.0. Analysts were forecasting earnings
per share of $2.60 for 2013. If you expect no growth in residual earnings after 2013, what is the expected
return from buying this stock?
b. A firm with a book value of $27.40 per share at the end of 2012 is expected to earn an EPS of $4.11 in 2013.
If you expect subsequent growth in residual earnings to be at a rate of 4 percent per year, what is the
expected return from buying this stock at a market price of $54 per share?
E7.3. Reverse Engineering Earnings Forecasts (Easy)
The equity of a firm trades at 2.6 times book value of $239.0 million at the end of 2012 and your required return
is 9 percent. The forward earnings forecast for 2013 is $33.46 million and the firm pays no dividends.
a. What is the growth rate for residual earnings after 2013 that is implied by the market price?
b. What is the forecast of earnings for 2014 that is implicit in the market price?
E7.4. Expected Returns for Different Growth Rates (Easy)
A firm whose shares are trading at 2.2 times book value is forecasted to earn a return on book value of 15 percent
next year. Calculate the expected return to buying this stock for the following forecasts of residual earnings
growth after the forward year: 3 percent, 4 percent, and 6 percent. What is the expected return if no growth is
expected?

E7.5. Reverse Engineering with the Abnormal Earnings Growth Model (Medium)
Analysts forecast forward earnings of $2.11 per share and a forecast of $2.67 for two years ahead. The firm pays
no dividends. The required return is 9 percent.
a. What is the long-term growth rate in abnormal earnings growth (AEG) implied by a market price of $105.69?
b. What is the market’s forecast of EPS for three years ahead?
226
Applications

E7.6. Reverse Engineering Growth Rates: Dell, Inc. (Easy)

In September 2008, Dell’s shares traded at $20.50 each. In its last annual report, Dell had reported book value of
$3,735 million with 2,060 million shares outstanding. Analysts were forecasting earnings per share of $1.47 for
fiscal year 2009 and $1.77 for 2010. Dell pays no dividends.
Given the analysts’ forecasts, what was the market’s forecast of the residual earnings growth rate after 2010?

Penman, Stephen. Financial Statement Analysis and Security Valuation, McGraw-Hill Higher Education, 2012. ProQuest Ebook Central, [Link]
Created from bham on 2025-10-27 16:24:06.
Copyright © 2012. McGraw-Hill Higher Education. All rights reserved. Ebook pages 286-309 | Printed page 15 of 19

E7.7. Building Blocks for a Valuation: General Electric (Medium)

General Electric Co. (GE) reported a per-share book value of $10.47 in its balance sheet on December 31, 2004.
In early 2005, analysts were forecasting consensus earnings per share of $1.71 for 2005 and $1.96 for 2006.
a. Calculate the value per share in early 2005 with a forecast that residual earnings will grow at a long-term
GDP growth rate of 4 percent after 2006.
b. GE traded at $36 per share in early 2005. Construct a building-block diagram, like that in Figure 7.4,
displaying the components of this $36 price that are attributable to book value, short-term earnings
expectations, and speculation about long-term growth.
c. What is the forecast of the residual earnings growth rate after 2006 that is implied by the $36 market price?

Real World Connection

See Exercises E5.11, E6.10, and E11.8 on General Electric.

E7.8. The S&P 500 During Boom and Bust (Easy)

a. At the end of 2008, after the S&P 500 had returned #37.0 percent for the year during the financial crisis, the
S&P 500 index stood at 903. Analysts were forecasting forward earnings of 73.0 on book value at the end of
2008 of 451. If the required return for investing in equities is 9 percent, what is the growth forecast that is
implicit in the index price of 903? How does this number compare with the average implied growth rates for
the index in Figure 7.1?
b. Repeat the exercise at the end on 1999 when the index stood at 1,469 with a book value of 294. Forward
earnings’ estimates at the time were 50.1.
E7.9. The Market’s Forecast of Nike’s Growth Rate (Easy)
The shares of Nike, Inc., traded at $74 after its financial statements for fiscal year 2010 were published. The
balance sheet reported book value per share of $20.15. Analysts were forecasting EPS of $4.29 for 2011 and
$4.78 for 2012. A dividend of $1.16 was indicated for 2011. Your required return is 9 percent.
a. What is the forecast of the residual earnings growth rate after 2012 that is implicit in the market price?
b. What is the market’s forecast of EPS for 2013 and 2014?

Real World Connection

Other exercises on Nike are in E2.14, E5.13, E6.7, E9.12, E14.17, E16.11, E16.13, and E19.5.

E7.10. Expected Return from buying Novartis (Easy)

Novartis, the pharmaceutical firm, traded at a price-to-book ratio of 2.1 in May 2011. It is forecasted to have a
return on common equity (ROCE) of 19 percent for 2011. What is the expected return from buying a Novartis
share if you forecast that residual earnings will grow at 4 percent per year in the future?
227
E7.11. The Expected Return to Buying a Google Share (Medium)

Exhibit 7.1 lays out a pro forma for Google, Inc., as of May 2011. Refer to the exhibit to answer the following
questions:
a. Working with EPS forecasts for just one year ahead (2011), calculate the expected return to buying Google
with a forecast of a 4 percent growth rate for residual earnings after the forward year. What is the expected
return for a 5 percent growth rate and a 6 percent growth rate? What is the expected return if no growth is
expected?
b. Now repeat the exercise with two years of EPS forecasts (2011 and 2012) with the forecasted growth rates
being for the third year (2013) onwards.

Real World Connection

Minicases M7.2 and M19.1 also deal with Google.

E7.12. Growth for a Hot Stock: Netflix (Easy)

Netflix delivers movies for home entertainment, initially via efficient mail distribution but with prospects of
dominating the new technology of electronic delivery. With the failure of Blockbuster and other traditional retail
outlets, Netflix was a market favorite in 2011, trading at $157 per share and a forward P/E of 42. Analysts were
forecasting EPS of $3.71 for 2011 and $4.84 for 2012 on a book value per share at the end of 2010 of $5.50. The
Penman, Stephen. Financial Statement Analysis and Security Valuation, McGraw-Hill Higher Education, 2012. ProQuest Ebook Central, [Link]
Created from bham on 2025-10-27 16:24:06.
Copyright © 2012. McGraw-Hill Higher Education. All rights reserved. Ebook pages 286-309 | Printed page 16 of 19

firm pays no dividends. You have a required return of 11 percent for this company: With so much growth built
into the price, you see it as risky.
a. How much of the $157 price is value the market places on growth?
b. What is the expected growth rate for residual earnings that is implicit in the market price? Do you consider
this growth rate normal?
E7.13. Sellers Wants to Buy (Medium)

Mark Sellers, a hedge fund manager with Sellers Capital in Chicago, wrote a piece in the Financial Times on
September 9, 2006, arguing that Home Depot, the warehouse retailer, was worth $50 per share. Home Depot
traded at $34 per share at the time. Analysts were forecasting a consensus $2.98 earnings per share for fiscal year
2007 and $3.26 for 2008. A forward dividend of $0.60 per share was indicated for 2007 and $0.70 for 2008, with
the dividend payout ratio maintained at the 2008 level in subsequent years. Home Depot reported a book value of
$26,909 million for fiscal year ending January 2006, with 2,124 shares outstanding.
Use a required return of 10 percent per year in answering the following questions:
a. Given the analysts’ forecasts, what is the growth rate for residual earnings after 2008 that is implied by Mr.
Sellers’s $50 valuation?
b. What are the earnings-per-share growth rates for 2009 and 2010 that are implied by Mr. Sellers’s $50
valuation?

Real World Connection

See Exercises E15.11and E15.12 on Home Depot.

E7.14. Reverse Engineering Growth Forecasts for the S&P 500 Index (Medium)
With the S&P price index at 1270 in early 2006, the S&P 500 stocks traded at 2.5 times book value. On most
recent (2005) annual earnings, the stocks in the index earned a weighted average return on their common equity
of 18 percent. Use a required equity return of 10 percent for this “market portfolio.”
a. Calculate the residual earnings growth rate that the market is forecasting for these stocks.
b. Suppose you forecast that a return on common equity of 18 percent will be sustained in the future. What is
the growth in the net assets that you would then forecast at the current level of the index?
228
E7.15. The Expected Return for the S&P 500 (Medium)
On January 1, 2008, the S&P 500 index stood at 1468 with a price-to-book ratio of 2.6. Expected earnings for the
index for calendar year 2008 were 72.56. These earnings estimates, compiled from analysts’ consensus earnings
forecasts for the 500 stocks in the index, are in the same dollar units as the index.
a. What is the forecast of return on common equity (ROCE) for the index for 2008?
b. If you expect residual earnings growth for the corporate sector to equal the GDP growth rate of 4 percent for
the economy as a whole, what is the implied expected return to buying the S&P 500 at 1468?
c. The risk-free rate at the time was 4 percent. If you require a risk premium of 5 percent to buy equities, would
you have bought an index fund that tracks the S&P 500 index?
d. In 1999, the price-to-book ratio for the S&P 500 was much higher, at 5.4. Trailing ROCE was 23 percent.
With the same GDP growth rate for growth in residual earnings, calculate the implied expected return to
buying the S&P 500 at that point in time. Would you have purchased a market index fund that tracks the
S&P 500 index?
E7.16. Inferring Implied EPS Growth Rates: Kimberly-Clark Corporation (Medium)
In March 2005, analysts were forecasting consensus earnings per share for Kimberly-Clark (KMB) of $3.81 for
fiscal year ending December 31, 2005, and $4.14 for 2006, up from $3.64 for 2004. KMB traded at $64.81 per
share at the time. The firm paid a dividend of $1.60 in 2004 and a dividend of $1.80 was indicated for 2005, with
dividends growing at 9 pecent a year for the five years thereafter. Use a required return of 8.9 percent for the
following calculations.
a. Calculate the trailing and forward P/E ratio at which KMB traded in March 2005. Also calculate the normal
trailing and forward P/E ratios for KMB.
b. Calculate the market’s implied growth rate for abnormal earnings growth (AEG) after 2006.
c. What are the earnings-per-share growth rates that the market was forecasting for the years 2007–2010?
d. Analysts were forecasting an EPS growth rate of 8.0 percent per year over these years. What do you conclude
from the comparison of these growth rates with those you calculated in part (c) of the exercise?
e. Analyst average buy/hold/sell recommendation, on a scale of 1 to 5 (with 5 being a strong buy), was 2.6. Is
this rating supported by their forecasts?

Penman, Stephen. Financial Statement Analysis and Security Valuation, McGraw-Hill Higher Education, 2012. ProQuest Ebook Central, [Link]
Created from bham on 2025-10-27 16:24:06.
Copyright © 2012. McGraw-Hill Higher Education. All rights reserved. Ebook pages 286-309 | Printed page 17 of 19

Real World Connection

The continuing case at the end of each chapter follows Kimberly-Clark. See also Exercises E4.9, E8.10, E11.10,
E12.6 and Minicases M2.1 and M5.3.

229

Minicases M7.1

Challenging the Market Price: Cisco Systems, Inc.

Cisco Systems, Inc. (CSCO), manufactures and sells networking and communications equipment for transporting data,
voice, and video and provides services related to that equipment. Its products include routing and switching devices;
home and office networking equipment; and Internet protocol, telephony, security, network management, and software
services. The firm has grown organically but also through acquisition of other networking and software firms. Cisco’s
Web site is [Link].
Cisco was a darling of the Internet boom, one of the few firms with concrete products. Indeed its products were
important to the development of the infrastructure for the Internet age and the expansion in telecommunications. At one
point, in early 2000, the firm traded with a total market capitalization of over half a trillion dollars, exceeding that of
Microsoft, and its shares traded at a P/E of over 130. With the bursting of the Internet bubble and the overcapacity in
telecommunications resulting from overinvestment by telecommunications firms, Cisco’s growth slowed. Faced with a
sales slump, CEO John Chambers overhauled the management to streamline the company. By 2004 its revenue had
recovered to the $22.0 billion level.
Subsequently, Cisco’s sales continued to grow, reaching $39.5 billion by 2008. The company acquired the home
networking company Linksys and cable set-top box maker Scientific Atlanta, along with WebEx web-conferencing
software and Flip video cameras. However, sales then remained flat, standing at $36.2 billion in 2009. Profit margins
declined and EPS in 2009 was $1.05, down from $1.35 in 2008. Rivals Motorola and Juniper Networks were gaining
ground. Cisco’s diversification, via acquisitions, into cable set-top boxes and videoconferencing equipment had not
proved successful, with cable companies cutting back on orders for the cable boxes and customers using Skype or
Google Talk to conference for no cost. Mr. Chambers began another shake-up of the company.
At the beginning of 2010, Cisco was trading at $24 per share, or 3.6 times book value of $6.68 at the end of its July
2009 fiscal year. Analysts were forecasting a consensus estimate of $1.42 EPS for fiscal year 2010 and 1.61 for 2011.
The forward P/E of 16.9 implies some growth expectations, and indeed the growth rate forecasted for 2011 EPS over
2010 is 13.4 percent. Cisco paid no dividends at the time.

A. Bring all the tools in this chapter to an evaluation of whether Cisco’s price is appropriate. You will not be able to
resolve the issue without some detailed forecasting of Cisco’s future earnings (which you should not attempt at
this stage). Rather, using the analysts’ forecasts for 2010 and 2011, quantify the earnings forecasts for subsequent
years implicit in Cisco’s $24 price. Identify the speculative components of Cisco’s price using the building block
approach. Figures 7.4 and 7.5 should be helpful to you.

B. If, through diligent analysis, you concluded that Cisco’s long-run residual earnings growth rate can be no more than
4 percent per year, what is the expected rate of return from buying Cisco at $24?
C. What is the no-growth value for Cisco? What is the expected return from buying Cisco if no growth is expected?
Calculate the expected return for different growth rates, including negative growth rates. Does this exercise give
you a feeling for the range of possible payoffs from buying Cisco?
230
D. By August 2011, the stock price had fallen to $15, back to 1997 levels. What lessons do you learn from Cisco’s
decline in fortunes?

You might repeat the exercise for Cisco at a later date—August 2011, for example. You might also set up a spreadsheet
program that can continue the investigation as prices, book value, and forecasts for Cisco change over time. This would
also be a ready tool to apply to other firms.

Real World Connection

Minicase M15.2 also covers Cisco, as do Exercises E2.11 and E19.6.

M7.2

Penman, Stephen. Financial Statement Analysis and Security Valuation, McGraw-Hill Higher Education, 2012. ProQuest Ebook Central, [Link]
Created from bham on 2025-10-27 16:24:06.
Copyright © 2012. McGraw-Hill Higher Education. All rights reserved. Ebook pages 286-309 | Printed page 18 of 19

Reverse Engineering Google: How Do I Understand the

Market’s Expectations?
Valuation models can be dangerous if used naively: An analyst can plug in any growth rate or required return estimate
to get a desired valuation. Indeed, a valuation model can be a vehicle to build speculation into the valuation: Choose a
speculative growth rate—or speculative near-term forecasts—and you will get a speculative valuation. Garbage in,
garbage out.
Remember the fundamentalist dictum: Beware of paying too much for growth. We would like to apply valuation
models in a way that disciplines speculation about growth. Chapters 5 and 6 have shown that residual earnings and
abnormal growth models protect us from paying too much for earnings growth from investment that does not add value.
They also protect us from paying for earnings growth generated by accounting methods. But they cannot protect us from
our own foolish speculation.
Benjamin Graham hit the nail on the head:
The concept of future prospects and particularly of continued growth in the future invites the application of formulas out of
higher mathematics to establish the present value of the favored issue. But the combination of precise formulas with highly
imprecise assumptions can be used to establish, or rather justify, practically any value one wishes, however high, for a really
outstanding issue.1

Reverse engineering gives us a way of handling valuation models differently: Rather than using a model to get a
value, use a model to understand the forecasts implicit in the market price. This fits well with active investing. Investing
is not a game against nature, but rather a game against other investors. For the active investor, there is no “true” intrinsic
value to be discovered. Rather, he or she is playing against others; active investors “win” if they find that others’
expectations (embedded in the market price) are not justified by sound analysis. Thus, the right question is not whether
a valuation model gives you the “right” value but rather whether the model can help you understand what expectations
explain the market price. With this understanding, the investor then compares those expectations to his or her own.
Rather than challenging the price with a “true” intrinsic value, the active investor challenges price by challenging
others’ expectations. Reverse engineering is the vehicle.
At this point, you have not done the analysis to form confident expectations, but you can do the reverse engineering
to understand others’ expectations. This case asks you to do so with Google, Inc., a firm for which the market has had
high expectations.
231
After coming to the market at just under $100 per share in a much heralded IPO in August 2004, Google’s shares
soared to over $700 by the end of 2007. The firm, with revenues tied mostly to advertising on its Web search engine and
Web application products, held out the promise of the technological frontier. It certainly delivered sales and earnings
growth, increasing sales from $3.2 billion in 2004 to $16.6 billion in 2007, with earnings per share increasing over the
same years from $2.07 to $13.53. One might be concerned about buying such a hot stock. This case asks you to
challenge the market price in mid-2008, but to do so by challenging the forecasts implicit in the market price. Tease out
those forecasts using the abnormal earnings growth valuation model.
In mid-2008, Google traded at $520. Analysts at the time were forecasting EPS of $19.61 for 2008 and $24.01 for
2009, yielding a forward P/E of 26.5. Analysts’ consensus five-year EPS growth rate was 28 percent.

A. Apply abnormal earnings growth (AEG) valuation to value Google based on these forecasts. Beta shops report a
typical beta for Google of about 2.0, so use a high required return of 12 percent (against the current risk-free rate
of 4 percent).
B. Analysts’ intermediate-range forecasts (up to five years ahead) are notoriously optimistic, especially for a “hot
stock” like Google. Anchoring on only the 2008 and 2009 forecasts, estimate the growth rate in abnormal
earnings growth (AEG) that the market is forecasting for years after 2009. What does your answer tell you about
analysts’ five-year growth rate?
C. Build a valuation building block diagram, like that in Figure 6.3 in the text, and plot the EPS growth rates for 2010
to 2012 that are forecasted by the market price.
D. How would you now go about challenging the market price of $520? Calculate Google’s PEG ratio. Does this help
you?
E. Suppose you conclude that the highest (AEG) growth rate that Google can maintain (in perpetuity) is 6 percent.
What is the expected return to buying the stock at $520 with this growth rate?

Real World Connection

Minicase 19.1 also deals with the valuation of Google.

Penman, Stephen. Financial Statement Analysis and Security Valuation, McGraw-Hill Higher Education, 2012. ProQuest Ebook Central, [Link]
Created from bham on 2025-10-27 16:24:06.
Copyright © 2012. McGraw-Hill Higher Education. All rights reserved. Ebook pages 286-309 | Printed page 19 of 19

1
The formula works only for forward ROCE greater than the growth rate (which it typically is).
2
The correlation between the growth rates and year-ahead returns in excess of the 10-year U.S. government bond yield is #0.
14. (Excess returns adjust for changing interest rates.)
3
The active investing of this chapter is treated with more detail in S. Penman, Accounting for Value (New York, Columbia
University Press, 2011).
1
B. Graham, The Intelligent Investor, 4th rev. ed. (New York: Harper and Row, 1973), pp. 315–316.

Penman, Stephen. Financial Statement Analysis and Security Valuation, McGraw-Hill Higher Education, 2012. ProQuest Ebook Central, [Link]
Created from bham on 2025-10-27 16:24:06.