The computer industry in 1992

• 
  Profitability (ROE) for the Overall Industry Fell Steadily from 23% in 1988 to 11% in 1991 and Sales Had Been Flat for the Last of those Two Years;
  

• 
  In Early 1992, Typical PE Ratios in the Industry Were within the Range 9-12 while Typical PB Ratios Were within the Range 1.0-1.4;
  

Consider the Factors that Determine PE and PB Ratios for the Four Firms in the Case. Based Solely on the Information in the Case, Would You Expect PE and PB Ratios for Each Firm to Be Higher than, Lower than, or within the Ranges Considered Typical for the Industry at this Time?

• 
  Rising Stars:
  

• 
  High growth;
  
• 
  Abnormally high ROEs;
  

• 
  Falling Stars or Harvesters:
  

• 
  High ROEs on existing investments;
  
• 
  Slow growth;
  

• 
  Dogs;
  

• 
  Little prospect for growth;
  
• 
  Little prospect for high ROEs;
  

• 
  Recovering Dogs;
  

• 
  Rebound from temporarily low earnings levels;
  
• 
  Be prevented by competition from returning to abnormally high ROEs;
  

• 
  Expected AEs:
  

• 
  Expected future abnormal ROEs;
  
• 
  Expected future growth rates in the book value of equity;
  

• 
  The cost of equity capital;
  

where:

• 
  ROE_t+i Is the Return on Equity Obtaining in year t+i;
  
• 
  g_j Is the Growth in the Book Value of Equity SE from Year t+j-1 to Yeat t+j
  

• 
  Expected future growth rates in AEs;
  

• 
  The cost of equity capital;
  

DETERMINANTS OF PE RATIOS (1)

with:

• 
  VE_t* denoting the theoretical Value of Equity ex-dividend (the market value of equity in efficient markets) obtaining at date t;
  
• 
  ND_t denoting Net Dividends paid at date t;
  
• 
  AE_t+1 denoting the change in Abnormal Earnings from date t to date t+1, that is:
  
• 
  AE_t+1 - AE_t;
  
• 
  _E denoting the Cost of Equity Capital;
  

Perfectly Competitive Industry

If the cost of equity capital is 12%, the (Trailing) “Normal PE Ratio” is thus 9.3%;

Long-Run Competitive Returns for

“Old Investments”
Let us assume that beyond year t+n :

• 
  Any growth above rate r_I comes in the form of normally profitable projects that do not enhance current value;
  
• 
  Growth below rate r_I is generated by projects generating some constant expected Abnormal ROE (AROE);
  

• 
  High ROE as recently as 1988 (21.9%);
  

• 
  More recent ROEs are only moderately high (15% -17%);
  

• 
  Decline in profitability driven by a decline in gross margins;
  

• 
  Red flag about the quality of earnings:
  

• 
  Large increase in receivables to sales
  

• 
  Large increase in inventory to sales
  

• 
  Unchanged net income;
  

• 
  Analysts are expecting only moderate ROEs (14%) for the next 2 years with sales growth of 10 to 11%, suggesting flat earnings;
  

• 
  The cost of equity capital _E is 12%;
  

• 
  Future ROEs stay at 14%;
  

• 
  Future sales grow at a rate of 10%, as forecast by financial analysts;
  

• 
  The book value of equity also grows at 10%;
  

• 
  Beyond 3 years, any growth above the long-run inflation rate (assumed at 3.5%) comes in the form of normally profitable projects which do not enhance current value;
  

• 
  PE = 9.0 (about “Normal”);
  

• 
  PB = 1.3 (above “Normal”);
  

ATARI

• 
  Atari generated relatively high earnings in 1991 but would have reported a loss if not for the gain on sale of their main manufacturing facility;
  

• 
  Operating income has been negative since 1990 and continues to be negative in Q1 1992;
  

• 
  Ugly strategic position;
  

• 
  Steadily declining gross margins, SGA Expenses Out of Line with Competitors, Weak Asset Turnover;
  

Implications for PB and PE Ratios

PB

Lower than average;

No reason to expect ROEs to exceed the cost of equity in the near future (negative expected AEs);

PB < 1
PE

Lower than average;

Compared with 1991, future abnormal earnings will almost certainly be lower;

PE << (1+_E) / _E = 9.3
TANDEM COMPUTERS

• 
  Tandem is facing difficulties:
  

• 
  Heated competition from other fault-tolerant computer systems;
  
• 
  Competition from substitute technologies;
  

• 
  Tandem’s ROEs have never within the last four years exceeded reasonable estimates of the cost of equity capital (3% in 1991):
  

• 
  Both ROS and AT are low;
  
• 
  Higher leverage relative to competition;
  

• 
  Tandem is undergoing a restructuring in 1992:
  

• 
  Analysts believe the restructuring will translate into improved though weak performance ROE for 1993: 8%;
  
• 
  Sales growth expected to remain low:
  

5% in 1992 and 1993;
Should Be Priced as a Recovering Dog!
TANDEM COMPUTERS

Implications for PB and PE Ratios

PB

Future ROEs are forecast at levels that lie below the cost of equity. Regardless of expected growth, the firm is worth less than its book value;

PB < 1
PE

Higher than average;

Depending on abnormal earnings’ growth, which is expected to be high compared to 1991;

20 < PE < 30?

STRATUS COMPUTER

• 
  Strong performance as proxied by ROEs, 24% in 1988 and 17% in 1991;
  

• 
  Both margins and turnovers look strong relative to the market share leader Tandem;
  

• 
  The higher margins are consistent with Stratus being successfully differentiated as a high-quality producer;
  

• 
  Stratus is almost debt-free. If leverage were increased from 1.3 to Tandem’s 1.6, ROE could be pushed above 20%!
  

• 
  Financial analysts are forecasting ROEs to remain at the current level of 17% for 1992 and 1993;
  

STRATUS COMPUTER

Implications for PE and PB Ratios

Both higher than “normal”;

Both Higher PE and PB ratios than average in the industry;
FINANCIAL SUMMARY

Atari

	88	89	90	91
NI	(36.9)	(4.2)	(34.2)	(23.0)
	Performance (Adj, Avg)
		ROE (%)	29.4	(5.0)	(36.5)	(20.3)
		ROS (%)	8.2	(1.0)	(8.3)	(8.9)
		AT	1.1	1.3	1.4	1.0
FL (%)		45.4	47.4	40.3	30.0
RNOA (%)	17.4	3.7	(17.3)	(11.5)
	Growth Rate (%)
		Sales	(8.3)	(6.3)	(2.9)	(37.3)
		NI	3.5	NR	NR	NR
		Assets	(34.7)	(2.3)	(17.5)	(7.0)
SE		(50.4)	3.3	17.7	24.0

FINANCIAL SUMMARY

Cray Research

	88	89	90	91
NI	140.8	109.8	103.4	105.1
	Performance (Adj, Avg)
		ROE (%)	21.9	17.3	16.9	15.1
		ROS (%)	18.6	14.0	12.9	12.2
		AT	0.8	0.8	0.8	0.9
FL (%)		18.9	20.3	20.4	15.5
RNOA (%)	25.3	18.4	17.8	16.1
	Growth Rate (%)
		Sales	10.0	3.8	2.5	7.2
		NI	4.9	(22.0)	(5.8)	1.6
		Assets	9.9	(3.6)	(1.2)	14.3
SE		10.8	(12.2)	5.9	20.6

FINANCIAL SUMMARY

Stratus Computer

	88	89	90	91
NI	28.9	33.3	34.7	45.8
	Performance (Adj, Avg)
		ROE (%)	23.9	20.7	16.8	16.8
		ROS (%)	10.9	9.8	8.6	10.2
		AT	1.5	1.4	1.4	1.3
FL (%)		6.2	10.7	9.4	3.0
RNOA (%)	22.0	18.6	15.8	16.6
	Growth Rate (%)
		Sales	44.1	28.7	18.3	11.1
		NI	52.9	15.5	4.1	31.8
		Assets	37.4	37.2	17.1	19.8
SE		35.8	32.4	25.2	36.4

FINANCIAL SUMMARY

Tandem Computers

	88	89	90	91
NI	89.4	110.0	110.0	23.9
	Performance (Adj, Avg)
		ROE (%)	11.3	11.9	10.0	2.0
		ROS (%)	6.8	6.7	5.9	1.2
		AT	1.2	1.1	1.1	1.0
FL (%)		4.1	8.2	8.6	7.4
RNOA (%)	11.6	11.6	10.4	2.8
	Growth Rate (%)
		Sales	27.0	24.2	14.3	3.0
		NI	(6.9)	22.9	0.0	(78.3)
		Assets	36.3	22.8	16.0	2.9
SE		18.9	15.4	21.7	3.7

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