Reference no: EM13967003

Simple and Multiple Regression

The stock market is a forward-looking mechanism that seeks to derive an accurate estimate of the firm's discounted net present value of all future profits. One of the most difficult tasks facing stock-market investors is the accurate projection of EPS growth. Historical EPS growth is only relevant for investors as an indicator of what might be reasonable to expect going forward. This is trickier than it sounds. For example, rapid histori- cal EPS growth is typically associated with firms that offer distinctive products and display shrewd management of corporate assets. While continuing EPS growth is sometimes enjoyed, it is never guaranteed. Past success can even become a hindrance to future EPS growth. For example, the amazing EPS growth displayed by Intel, Inc., during the 1980s and 1990s makes it difficult for the firm to sustain similarly high rates of EPS growth in the future. (Elephants sel- dom run as fast as gazelles.)

The table below shows the relationships between EPS growth estimates obtained from The Value Line InvestmentSurvey and the historical 1-year, 5-year, and 10-year rates of growth in EPS. Value Line estimates are for the 3 to 5 year time horizon ending in 2005-2007; historical rates of EPS growth are taken from the 1992-2001 period. All figures are in percentage terms.

Dependent Variable: Projected EPS Growth Rate

	(1)	(2)	(3)	(4)
Constant	11.871	13.615	12.464	10.552
	(48.08)	(40.06)	(33.86)	(28.73)
EPS Growth 1-Year	0.048			0.041
EPS Growth 5-Year	(14.40)	-0.064		(10.73) -0.086
EPS Growth 10-Year		(-3.84)	-0.038	(-3.67) 0.103
			(-1.58)	(3.84)
SEE	8.162	8.898	8.620	6.969
R2	13.9%	1.3%	0.3%	14.4%
F statistic	207.41	14.73	2.51	42.79
n	1,282	1,091	871	764

Note: t statistics are shown in parentheses.

Data Source: The Value Line Investment Survey for Windows, February 25, 2002 (https://www.valueline.com). Reproduced with the permission of Value Line Publishing, Inc.

A. Consider each of the three simple regressions that relate projected EPS growth and the 1-year, 5-year, or 10-year historical rates of growth in EPS [models (1), (2), and (3)]. Which of these models does the best job of explaining projected EPS growth? Why? How would you inter- pret these findings?

B. Notice that the multiple regression model that relates projected EPS growth to 1-year, 5-year, and 10-year historical EPS growth [model (4)] has the highest R2 and overall explanatory power of any model tested. Is this surprising? Why or why not?