As of February 2016, you are researching HouseDepot, Inc, a hypothetical company
ID: 2466066 • Letter: A
Question
As of February 2016, you are researching HouseDepot, Inc, a hypothetical company subject to cyclical demand for its services. HouseDepot shares closed at $76.85 on February 2016. You believe the 2011-2015 period reasonably captures average profitability A. Use a normalized EPS for HouseDepot based on the method of historical average EPS to calculate the P/E based on normalized EPS Use a normalized EPS for HouseDepot based on the method of average ROE to calculate the P/E based on normalized EPS Why we need to use normalized EPS?Explanation / Answer
A. Normalized EPS is the EPS which is based on normalized and ongoing net incomes. EPS can be normailized using several methods, historical average EPS being one of them. Under this method, an average is taken of the past EPS figures.
Thus normalized EPS = average of EPS of 2011 to 2015
= (1.57+2.01+2.47+3+3.76)/5 = $2.562
Now, P/E = price per share/normalized EPS = 76.85/2.562 = $29.996 ($30 rounded off)
B. Next we will use the average method ROE to calculate the normalized EPS. In this method we will calculate the average ROE. Average ROE = (14.32+17.44+21.11+25.42+35.55)/5 = 22.768
Normalized EPS = average ROE*current BVPS (i.e of 2015)
= 22.768%*8.73 = $1.988
P/E = price per share/normalized EPS = 76.85/1.988 = $38.66
C. We need to use normalized EPS so as to remove the effect of cyclical demand on the company's financials. A company's topline as well as bottomline will reflect the effect of cyclical demand and this effect has to be removed in order to ensure that there is no misleading interpretation of the company's performance.
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