Question

Mini-Case Stock Valuation

Ten years ago, in 2001, George Reaby founded a small mail-order company selling high-quality spots equipment. The company has issued 2 million shares, all of which are owned by George Reeby and his five children.

For some months George has been wondering whether the time has come to take the company public. This would allow him to cash in part of his investment and would make it easier for the firm to raise capital should it wish to expand in the future.

But how much are the shares worth? Now the company has a book value equity of $26.34 million, or $13.17 per share, if the company sell new shares at this price, this would put the stock on a P/E ratio of 6.6, which is much lower than the 13.1 PE ratio of Reeby’s largest rival, Molly Sports.

George is not sure whether book value is a good price, so he asks his financial consultant Jenney to help him. Jenney quickly collected some financial information stated below. After several rounds of discussion, they both agree that the company can grow steadily at 20% in the next three years. In fact, George feels that the company’s growth rate has been somewhat held back by the demands from two of the children for high dividends. Perhaps, if the company went public, it could cut dividend and plow more money back into the business. Jenney also estimates that the company’s cost of equity is 10%

There are some clouds on the horizon. Competition is increasing, George is worried that beyond the next three or so years it might become difficult to find worthwhile investment opportunities. In the long run, the company’s growth rate will reduce to sustainable growth rate. The company’s ROE is 14.5% and current dividend payout ratio is 50%.

1. Should George use book value per share as stock price? Why or why not?
2. What PE ratio is appropriate?
3. Apply two-stage DDM model to value the stock.
4. What happens to stock price if the company pays less dividend?
5. How much of your estimate of the value of stock comes from the growth opportunities?

Answer 1

P/E 6.6 13.17 Price EPS 2.00 Dividend payout 50% DPS 0.998 14.50% RoE Retention ratio 50% SGR 7,2500% Year 0.0 1.0 2.0 3.0 4.0 Growth rate 20% 20% 20% 7.25% DPS 0.998 1.197 1.437 1.724 1.849 67.239 TV Total 68.963 1.197 1.437 PV @10% 1.088 1.187 51.813 Total PV 54.089 Using book value for share price is not wise as it would underestimate the share price because it do not take into account future growth prospects P/E should be comparable to the competition which is 13.1 P/E using DCF 27.11 Value as per DDM 54.09 If company pays less dividend, then stock price would increase 51.813/54.089 = 95.79% value comes from future opportunities About