Cogito

Reverse Engineering on RIMM

Posted in CFA, finance by qmarks on June 16, 2011

Yesterday I attended to Canadian Coalition of  Good Governance Annual Meeting, there Roger Martin, Dean of Rotman School of Management, said that stock price was nothing but the sum of our expectations on company’s future earnings. It is true that the objective of a company is profit making and the Price that we pay for a stock is the sum of its expected future earnings.  But does the expected future earnings justify the current price? In this post I will do a reverse engineering on RIM, (RIMM:US, RIM:CN)

The concept of Reverse Engineering is first introduced by Ramy Elitzur, Finance Professor at Rotman. The rationale is simple; what if we reverse the valuation process, meaning we assume that the price holds, what is the EPS that price implies? Now little bit Einstein part; in theory, The Earnings Based Valuation says Value of a Company today is its current Book Value and the sum of excess earnings over required return; in other words Vo = BVo + Sum of PV (Income – Cost of Equity * BVo) . Furthermore, if we do this per share basis and re-arrange it , the formula becomes

[Price – Book Value Per Share today]*[Cost of Equity – LT Growth] = EPS next fiscal year less [Cost of EQuity * Book value per share today)

Now let’s apply this to Research in Motion, which  is currently trading around CAD 34.75. That is  the 52 week lowest as of June 15th, 2011. Tomorrow they will announce the Q1 -11 results and Jim Balsillie will tell the investor’s how the BlackBerry maker is super excited about the company’s future prospectus. But the question is does that 34 bucks make sense?

Here is the result of Residual Income Valuation model:

in this model I assumed 12.92% Cost of Equity. Based on Analyst’s Estimated Consensus EPS which is row 1 on the Residual Income Valuation Table, and 3% long term growth rate, the stock should worth CAD 36,77 which is roughly correct.  Now let’s work backwards. Does the 34.75 satisfies the Analyst’s estimated EPS? When we apply the Reverse Engineering model, this share price implies roughly CAD 4 which is lower than the analyst consensus EPS, with the assumption of 13% cost of equity and 3% long term growth rate. In summary that means either Analyst’s are quite optimistic about the future prospectus of RIM, or the share is undervalued at 34.75.

If both Market is right about 35 bucks and analyst are correct about their estimation, then one thing balances those two numbers, Long Term Growth Rate. If those two variables hold, that implies -10% (yes, minus 10 percent) as the LT Growth rate.

The key take-away is that there is a divergence between Research Analysts of RIM and the Market. But they get together on one number: Minus Ten Percent (-10%) Growth Rate.

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