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TOY INDUSTRY CHARACTERISTICS

Industry Life Cycle
1. U.S. toy sales grew by 5 percent compounded annually over the past 10 years. However, toy sales
in the United States were down 4 percent last year. Growth of toy sales is expected to be 1.5“3.0
percent annually for the next five years.
2. Non-U.S. toy sales grew by 7 percent compounded annually over the past 10 years. Sales growth
is expected to be 7“8 percent for the next five years.
3. The toy industry is in a period of rapid consolidation. Companies faced with slower internal
growth are considering acquisitions to enhance growth.
Demographics
4. The birth rate in the United States is expected to decline by 3 percent annually for the next three
years.
5. The birth rate in Europe and Asia is expected to increase by 2 percent annually for the next three
years.
6. Age demographics are important drivers of demand both in the United States and in target non-
U.S. markets (only 3 percent of the world™s children live in the United States). Per capita con-
sumption of toys in non-U.S. markets is lower than in the United States.
Consumer Preference
7. Brand names are one of the keys to success in both U.S. and non-U.S. markets. Consumers show
a preference for products manufactured by well-regarded companies.
8. Marketing studies indicate that even technologically superior products will be hard to sell when
manufactured by a company without a brand name or without a substantial advertising budget to
support the product.
9. The top companies dedicate a large amount of money to focus groups and marketing studies in
order to accurately gauge consumer preference.
Market Share
10. The world™s two largest toy manufacturers (MasterToy and FunToyz) control more than 75 per-
cent of the U.S. market. No other manufacturer represents more than 5 percent in market share.
Economies of scale are important for production, advertisement, and promotion.
11. The larger companies in the industry have the ability to develop lucrative and cost-effective ad-
vertising in all media sectors. They have better bargaining power versus the competition and are
more able to negotiate prime-time advertisements.
12. Marketing studies show that sales of products associated with hit movies and television shows
are much higher than for competing products without the entertainment tie-in.
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Retail Environment/Distribution
13. A major discount toy retailer™s inventory-reduction program has negatively affected earnings for
the group. This distribution channel has been critical to success in the past, accounting for a large
percentage of sales. The company has adopted a new inventory control system in order to oper-
ate more efficiently.
14. To reduce dependence on traditional retail channels, companies are diversifying into direct mail
and Internet commerce.
15. Global distribution of product is an essential component of long-term growth for industry leaders.
Diversification
16. Diversification is a key to success. A niche product can quickly lose its appeal. Typically, compa-
nies that rely on one or two key products fail when popularity fades.
17. The top two toy manufacturers have a highly diversified product mix.


CHAPTER 14

1. CFA Examination Level I (adapted)
CFA
®
Mulroney recalled from her CFA studies that the constant-growth dividend discount model (DDM)
was one way to arrive at a valuation for a company™s common stock. She collected current dividend
and stock price data for Eastover and Southampton, shown in Table 14.1.
a. Using 11 percent as the required rate of return (i.e., discount rate) and a projected growth rate of 8
percent, compute a constant-growth DDM value for Eastover™s stock and compare the computed
value for Eastover to its stock price indicated in Table 14.1. Show calculations. [10 minutes]
Mulroney™s supervisor commented that a two-stage DDM may be more appropriate for companies
such as Eastover and Southampton. Mulroney believes that Eastover and Southampton could grow
more rapidly over the next three years and then settle in at a lower but sustainable rate of growth be-
yond 2004. Her estimates are indicated in Table 14.2.
b. Using 11 percent as the required rate of return, compute the two-stage DDM value of Eastover™s stock
and compare that value to its stock price indicated in Table 14.1. Show calculations. [15 minutes]



Table 14.1 Current Information


Current Share Current Dividends 2002 EPS Current Book
Price per Share Estimate Value per Share

Eastover (EO) $ 28 $ 1.20 $ 1.60 $ 17.32
Southampton (SHC) 48 1.08 3.00 32.21
S&P Industrials 1100 16.00 48.00 423.08




Table 14.2 Projected Growth Rates


Next 3 Years Growth Beyond
(2002, 2003, 2004) 2004

Eastover (EO) 12% 8%
Southampton (SHC) 13% 7%
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c. Discuss two advantages and three disadvantages of using a constant-growth DDM. Briefly discuss
how the two-stage DDM improves upon the constant-growth DDM. [10 minutes]
2. CFA Examination Level I
CFA
®
In addition to the dividend discount model (DDM) approach, Mulroney decided to look at the
price/earnings ratio and price/book ratio, relative to the S&P Industrials, for both Eastover and
Southampton. Mulroney elected to perform this analysis using 1997“2001 and current data.
a. Using the data in Table 14.3 and Table 14.4, compute both the current and the five-year (1997“2001)
average relative price/earnings ratios and relative price/book ratios for Eastover and Southampton.
Discuss each company™s current relative price/earnings ratio as compared to its five-year average
relative price/earnings ratio and each company™s current relative price/book ratio as compared to
its five-year average relative price/book ratio. [10 minutes]
b. Briefly discuss one disadvantage for each of the relative price/earnings and relative price/book
approach to valuation. [5 minutes]


Table 14.3

EASTOVER COMPANY (EO)
1996 1997 1998 1999 2000 2001

Earnings per share $ 1.27 $ 2.12 $ 2.68 $ 1.56 $ 1.87 $ 0.90
Dividends per share 0.87 0.90 1.15 1.20 1.20 1.20
Book value per share 14.82 16.54 18.14 18.55 19.21 17.21
Stock price
High 28 40 30 33 28 30
Low 20 20 23 25 18 20
Close 25 26 25 28 22 27
Average P/E 18.93 14.23 9.93 18.63 12.33 27.83
Average price/book 1.63 1.83 1.53 1.63 1.23 1.53

SOUTHAMPTON COMPANY (SHC)
1996 1997 1998 1999 2000 2001

Earnings per share $1.66 $3.13 $3.55 $5.08 $2.46 $1.75
Dividends per share 0.77 0.79 0.89 0.98 1.04 1.08
Book value per share 24.84 27.47 29.92 30.95 31.54 32.21
Stock price
High 34 40 38 43 45 46
Low 21 22 26 28 20 26
Close 31 27 28 39 27 44
Average P/E 16.63 9.93 9.03 7.03 13.23 20.63
Average price/book 1.13 1.13 1.13 1.23 1.03 1.13

S&P INDUSTRIALS
5-Year Average
1996 1997 1998 1999 2000 2001 (1997“2001)

Average P/E 15.83 16.03 11.13 13.93 15.63 19.23 15.23
Average price/book 1.83 2.13 1.93 2.23 2.13 2.33 2.13
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Table 14.4 Current Information


Current Current Dividends 2002 EPS Current Book
Share Price per Share Estimate Value per Share

Eastover (EO) $ 28 $ 1.20 $ 1.60 $ 17.32
Southampton (SHC) 48 1.08 3.00 32.21
S&P Industrials 1100 16.00 48.00 423.08



3. CFA Examination Level I
CFA
®
At year-end 1991, the Wall Street consensus was that Philip Morris™ earnings and dividends would
grow at 20 percent for five years after which growth would fall to a market-like 7 percent. Analysts
also projected a required rate of return of 10 percent for the U.S. equity market.
a. Using the data in Table 6 and the multistage dividend discount model, calculate the intrinsic
value of Philip Morris stock at year-end 1991. Assume a similar level of risk for Philip Morris
stock as for the typical U.S. stock. Show all work. [7 minutes]
b. Using the data in Table 14.5, calculate Philip Morris™ price/earnings ratio and the price/earnings
ratio relative to the S&P Industrials Index as of December 31, 1991. [3 minutes]
c. Using the data in Table 14.5, calculate Philip Morris™ price/book ratio and the price/book ratio
relative to the S&P Industrials Index as of December 31, 1991. [3 minutes]
4. CFA Examination Level I
CFA
®
a. State one major advantage and one major disadvantage of each of the three valuation methodolo-
gies you used to value Philip Morris stock in Question 13. [6 minutes]
b. State whether Philip Morris stock is undervalued or overvalued as of December 31, 1991. Sup-
port your conclusion using your answers to previous questions and any data provided. (The past
10-year average S&P Industrials Index relative price/earnings and price/book ratios for Philip
Morris were 0.80 and 1.61, respectively.) [9 minutes]
5. CFA Examination Level II
CFA
®
Your supervisor has asked you to evaluate the relative attractiveness of the stocks of two very simi-
lar chemical companies: Litchfield Chemical Corp. (LCC) and Aminochem Company (AOC). AOC
also has a June 30 fiscal year end. You have compiled the data in Table 14.6 for this purpose. Use a
one-year time horizon and assume the following:
• Real gross domestic product is expected to rise 5 percent;
• S&P Industrials expected total return of 20 percent;
• U.S. Treasury bills yield 5 percent; and
• 30-year U.S. Treasury bonds yield 8 percent.
a. Calculate the value of the common stock of LCC and AOC using the constant-growth dividend
discount model. Show your work. [5 minutes]
b. Calculate the expected return over the next year of the common stock of LCC and AOC using the
capital asset pricing model. Show your work. [5 minutes]
c. Calculate the internal (implied, normalized, or sustainable) growth rate of LCC and AOC. Show
your work. [5 minutes]
d. Recommend LCC or AOC for investment. Justify your choice by using your answers to a, b, and c
and the information in Table 14.6. [10 minutes]
6. CFA Examination Level II
CFA
®
Westfield Capital Management Company™s equity investment strategy is to invest in companies with low
price-to-book ratios, while taking into account differences in solvency and asset utilization. Westfield is
considering investing in the shares of either Jerry™s Department Stores (JDS) or Miller Stores (MLS).
a. Calculate each of the following ratios for both JDS and MLS. Use only the financial data in
Table 14.7. Show your work. [6 minutes]
(1) Price-to-book ratio
(2) Total-debt-to-equity ratio
(3) Fixed-asset utilization (turnover)
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Table 14.5 Philip Morris Corporation: Selected Financial Statement and Other Data“Years
Ending December 31 ($ Millions Except Per-Share Data)


1991 1981

Income Statement
Operating revenue $56,458 $10,886
Cost of sales 25,612 5,253
Excise taxes on products 8,394 2,580

Gross profit $22,452 $ 3,053
Selling, general, and administrative expenses 13,830 1,741
Operating income $ 8,622 $ 1,312
Interest expense 1,651 232

Pretax earnings $ 6,971 $ 1,080
Provision for income taxes 3,044 420

Net earnings $ 3,927 $ 660
Earnings per share $4.24 $0.66
Dividends per share $1.91 $0.25

Balance Sheet

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