Question

Mini Case: STOCK VALUATION AT RAGAN ENGINES Larissa has been talking with the company's directors about the future of East Coast Yachts. To this point, the company has used outside suppliers for various key components of the company's yachts, including engines. Larissa has decided that East Coast Yachts should consider the purchase of an engine manufacturer to allow East Coast Yachts to better integrate its supply chain and get more control over engine features. After investigating several possible companies, Larissa feels that the purchase of Ragan Engines, Inc., is a possibility. She has asked Dan Ervin to analyze Ragan's value Ragan Engines, Inc., was founded nine years ago by a brother and sister-Carrington and Genevieve Ragan-and has remained a privately owned company. The company manufactures marine engines for a variety of applications. Ragan has experienced rapid growth because of a proprietary technology that increases the fuel efficiency of its engines with very little sacrifice in performance. The company is equally owned by Carrington and Genevieve. The original agreement between the siblings gave each 150,000 shares of stock. Larissa has asked Dan to determine a value per share of Ragan stock. To accomplish this, Dan has gathered the folowing information about some of Ragan's competitors that are publicly traded: EPS DPS Stock Price ROE Blue Ribband Motors Corp Bon Voyage Marine Inc. Nautilus Marine Engines $1.09 $.16 $15.19 1.00% 1400% 16 52 12.49 1400 19.00 (32) 54 23.05 18.00 N/A Industry average $.64 $4 $16.91 13.00% 17.00% Nautilus Marine Engines's negative earnings per share (EPS) were the result of an accounting write- off last year. Without the write-off, EPS for the company would have been $1.97. Last year, Ragan had an EPS of $5.08 and paid a dividend to Carrington and Genevieve of $320,000 each. The company also had a return on equity of 25 percent. Larissa tells Dan that a required return for Ragan of 20 percent is appropriate. Assuming the company continues its current growth rate, what is the value per share of the company's stock? 1 Dan has examined the company's financial statements, as well as examining those of its competitors. Although Ragan currently has a technological advantage, Dan's research indicates that Ragan's competitors are investigating other methods to improve efficiency. Given this, Dan believes that Ragan's technological advantage will last only for the next five years. After that period, the company's growth will likely slow to the ind ustry average. Additionally, Dan believes that the required return the company uses is too high. He believes the industry average required return is more appropriate. Under Dan's assumptions, what is the estimated stock price? 2. 3 What is the industry average price-earnings ratio? What is Ragan's price-earnings ratio? Comment on any differences and explain why they may exist. 4 Assume the company's growth rate declines to the industry average after five years. What percentage of the stock's value is attributable to growth opportunities? Assume the company's growth rate slows to the industry average in five years. What future return on equity does this imply? 5 Carrington and Genevieve are not sure if they should sell the company. If they do not sell the company outright to East Coast Yachts, they would like to try and increase the value of the company's stock. In this case, they want to retain control of the company and do not want to sell stock to outside investors. They also feel that the company's debt is at a manageable level and do not want to borrow more money. What steps can they take to try and increase the price of the stock? Are there any conditions under which this strategy would not increase the stock price? 6

Answer 1

A C F P G K M IN O 1 Share Price-DPS(1+implied growth)/(Required Return growth) << Dividend Discount Model (DDM) 2 3 Implied Growth Peer Companies Price/Earnings based on DDM Share Price ROE 4 EPS DPS DDM Value 1.09 5 BRMC 0.16 15.19 11% 14% 13.94 12.81% 15.19 14 % 6 BVMI 1 16 0.52 12.49 19% 10.77 14.24% 12.49 NME (adjusted) 7 1.97 0.54 23.05 NA 18% 11.70 15.30% 23.05 12.50 % Industry Average 8 1.41 0.41 16.91 17.00% 12.02 14.12% 16.91 9 Answer - Industry Average PE Ratio 10 11 Ragan 5.08 2.13 25% 20% 12 13 Notes DPS for Ragan 320,000/150,000 2.13 14 15 Ragan Share Price using relative P/E valuation Industry Avg P/E Ragan's EPS 12.02 5.08 61.07 16. 17 same as Dividend Discount rate 18 Implied Growth rate 16% >This is the growth rate at which PE based value 19 Ragan Share Price using Dividend Discount model DPS (1+gowth)/(R-growth) 61.07 Answer 1 20 21 22 Answer 2 23 1 2 4 TV 4,39 Dividend grow 2.13 24 Dividends 2.47 2.86 3.32 3.85 Ragan's rate for 4 years and then at industry average. So does DPS 25 Growth 16% 16% 16% 16% 14.12% 17% Given Industry Average 26 R 17% 17% 17% 17% 27 PV of Dividend Cash Flow 2.11088 2.091927 2.07315 2.05453 81.3553 89.69 28 Estimated Share Value Answer 2 29 30 Answer 3 31 32 Industry PE 12.02 Based on Above table 17.65 89.69/5.08 33 Ragan's PE based on Answer 2

29 30 Answer 3 31 12.02 Based on Above table 32 Industry PE 33 34 35 17.65 89.69/5.08 Ragan's PE based on Answer 2 Difference in Industry PE and Ragan's PE implies, investors are willing pay more for every dollar of ragan's earnings vs market average for its peers. 36 This can be driven by the current technological advantage to Ragan. This also implies, Ragan may be overvalued and will see price correction soon. 37 38 Answer 4 39 From Anser 2, if growth years 1-4 i also at industry average, share value estimate will be: 40 41 42 4 TV 0 1 2 43 Dividends 2 13 2,43 2.77 3.17 3.61 4.12 Dividend grow at Ragan's rate for 4 years and then at industry average. So does DPS Growth 14.12% 14.12% 14.12% 44 14.12% 14.12% 45 17 % 17 % Given Industry Average 46 B 17 % 17% 17% 47 PV of Dividend Cash Flow 2.07753 2.0263608 1.97645 1.92776 76.3354 48 Estimated Share Value 84.34 49 50 So Share price attributale to growth= 89.69-84.34 6% Answer 4 5.34 51 52