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    Value per share; P/E; analyzed the approach

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    In 2000, the firm 3Com spun out its personal digital assistant division as Palm Inc. On February 23, 2001, the financial services firm Telerate reported the following information about Palm.

    The closing price for a share of Palm was $21.69.
    Palm had 565,946,000 shares outstanding.
    Its book value of equity was $1,110,640,000.
    It held $742,888,000 in cash.
    Its trailing P/E was 181.
    Palm was an all-equity financed firm and had no debt.

    During a presentation to investors, Palm's CFO Judy Bruner was asked two questions. (1) What is Palm's cost of capital? (2) What is Palm's return on equity likely to be over the next several years? Palm's CFO responded by saying that she thought that the firm's cost of equity was 16 percent and that her best estimate for ROE was 26 percent per year for the next six years.

    The length of the horizon during which the expected ROE exceeds the required return on equity is called the CAP (an acronym for competitive advantage period). Assume that Palm's managers plan to maintain its dividend payout ratio at zero for six years, the length of the CAP.

    The CFO of Palm also remarked that in view of recent volatility in the price of Palm stock, her firm was trying to understand how the market values Palm, relative to the right factors to value Palm. Its current price of about $22 was below the offer price of $38 that prevailed when Palm had gone public a year earlier.

    Palm's CFO indicated that she focused on trailing P/E and price-to-sales, noting that these may send conflicting signals. For example, she indicated that the market assigned Palm a high P/E ratio (145 at the time) but, relative to other firms such as Handspring, a low price-to-sales ratio (8 at the time). (In 2001, Handspring was a separate firm, which competed with Palm. Palm acquired Handspring in 2003. Subsequently, the firm split itself into two, becoming PalmOne and PalmSource.)

    Case Analysis Questions

    1. On the basis of the data presented in the case, use the textbook techniques to compute the fundamental value of Palm on February 23, 2001. The file Chapter 2 answer template.xls (available on the book Web site, www.mhhe.com/shefrin) is a spreadsheet that is set up along the lines of the textbook valuation of eBay's stock.

    2. Compare the ratio of the fundamental value per share that you computed in the previous question to Palm's market price per share (for February 23, 2001).

    3. Compare Palm's market P/E on February 23, 2001, with the fundamental P/E you derive.

    4. Analyze the approach that Palm's CFO took in trying to ascertain whether or not Palm was fairly valued in February 2001.

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    Solution Preview

    See the attached file.

    The fundamental valuation for Palm is $2.94. Please note that this valuation is slightly lower than the one calculated using the dividend discount model ($3.22) as here we are considering dividends only for 40 years whereas in case of dividend discount model we take it to infinity.

    The market value per share is very high ($21.69) compared to fundamental value per share ($2.94). The market is valuing the stock at a speculatively higher value. The reason for such a high deviation from the fundamental value is that the company works in a high ...

    Solution Summary

    This post shows how to compare the ratio of the fundamental value per share , Palm's market P/E with the fundamental P/E derive and how to analyze the approach in trying to ascertain was fairly valued