The Edelman Gem Company, a small jewelry manufacturer, has been successful and h

Question

The Edelman Gem Company, a small jewelry manufacturer, has been successful and
has enjoyed a good growth trend. Now Edelemen is planning to go public with an issue
of common stock, and it faces the problem of setting an appropriate price on the
stock. The company and its investment banks believe that the proper procedure is to
select several similar firms with publicity traded common stock and to make relevant
comparisons.

Several jewelry manufactures are reasonably similar to Edelman with respect to
product mix, asset composition, and debt/equity proportions. Of these companies
Kennedy Jewelers and Strasburg Fashions are most similar. When analyzing the
following data, assume that 2002 and 2007 were reasonably “normal” years for all
three companies—that is, these years were neither especially good nor especially
bad in terms of sales, earnings, and dividends. At the time of the analysis, rRF was
8% and RPm was 4%. Kennedy is listed on the AMEX and Strasburg on the
NYSE, while Edelman will be traded in the Nasdaq market.


Kennedy Strasburg Edelman (total)

Earning per Share*
2010 $4.50 $7.50 $1,200,000.00
2005 $3.00 $5.50 $816,000.00
Price per Share*
2010 $36.00 $65.00 -------------------
Dividends per Share*
2010 $2.25 $3.75 $600,000.00
2005 $1.50 $2.75 $420,000.00
Book Value per Share, 2010* $30.00 $55.00 $9. million
Market/book ratio, 2010 120% 118% ------------------
Total assets, 2010 $28. million $82. million $20. million
Total debt, 2010 $12. million $30. million $11. million
Sales, 2010 $41. million $140. million $37. million

* The data are on a per share basis for Kennedy and Strasburg, but are totals for Edelman

a. Assume that /Edelman has 100 shares of stock outstanding. Use this information to b.
calculate earnings per share (EPS), dividends per share (DPS), and book value per
share for Edleman. (hint: Edleman's 2010 EPS = $12,000).

2010
Earnings per Share (EPS) $12,000
Dividends per Share (DPS) $4,200
Book Value per Share $90,000

b. Calculate earnings and dividends growth rates for the three companies.
(Hint: Edelman's EPS growth rate is 8%).

Kennedy Strasburg Edelman
gEPS 8.40% 6.40% 8.00%
gDPS 8.40% 6.40% 7.40%


Using the following two equations, the growth rate for EPS and DPS can be determined:

(1 + gDPS)5 EPS01 = EPS06
(1 + gDPS)5 DPS01 = DPS06

c. On the basis of your answer to part a, do you think Edelman’s stock would sell at a price
in the same “ballpark” as that of Kennedy and Strasburg—that is, in the range of $25 to $100
per share?

Based on the information in part a I do not believe Edelman's stock would sell for the range
of the other companies' stock price range. Due to the small amount of shares and the inflated
EPS and DPS Edelman's would have a difficult time attracting investors.


d. Assuming Edelman’s management can split the stock so that the 100 shares could be
changed to 1,000 shares, 100,000 shares, or any other number, would such an action
make sense in this case? Why or why not?

Splitting the stock would be an astute move on the part of Edelmen's management. It would
enable the EPS, DPS, and book value to be more in line with the other companies. It would
also put the price of the stock to be in a more reasonable range for investors.

e. Now assume that Edelman did split its stock and has 400,000 shares. Calculate new
values for EPS, DPS, and book value per share.
(Hint: Edelman’s new 2010 EPS is $3.00.)

2005 2010
Earnings per Share $2.04 $3.00
Dividends per Share 1.05 1.50
Book Value per Share 22.50

f. Return on equity (ROE) can be measured either as EPS divided by book value per share
or as total earnings divided by total equity. Calculate ROEs for the three companies for
2010. (Hint: Edelman’s 2010 ROE is 13.3%.)

ROE
Kennedy 15.00%
Strasburg 13.64%
Edelman 13.33%

g. Calculate dividend payout ratios for the three companies for both years.
(Hint: Edelman’s 2010 payout ratio is 50%.)

Payout Ratio
2005 2010
Kennedy 50% 50%
Strasburg 50% 50%
Edelman 51% 50%

h. Calculate debt/total assets ratios for the three companies for 2010.
(Hint: Edelman’s 2010 debt ratio is 55%.)

Debt/Total Assets Ratio
43%
37%
55%

i. Calculate the P/E ratios for Kennedy and Strasburg for 2010. Are these ratios reasonable
in view of relative growth, payout, and ROE data? If not, then what other factors might
explain them? (Hint: Kennedy’s P/E = 8)

P/E
Kennedy 8.00
Strasburg 8.67

In terms of growth, payout, and ROE these ratios do not appear reasonable. It would seem
that Kennedy should have the higher P/E. Because I am not real familiar with these situations
I am wondering if where the companies are listed has anything to do with the variance in the
results. Now, after you have gotten back up on your chair after falling on the floor laughing, I
also wonder if,even though the companies are fairly similar, are they enough different to have
these results due to their sizes?

j. Now determine a range of values for Edelman’s stock price, with 400,000 shares
outstanding, by applying Kennedy’s and Strasburg’s P/E ratios, price/dividends ratios,
and price/book value ratios to your data for Edelman. For example, one possible price for
Edelman’s stock is (P/E Kennedy)(EPS Edelman) = 8($3) = $24 per share. Similar
calculations would produce a range of prices based on both Kennedy’s and Strasburg’s data.
(Hint: Our range was $24 to $27.)

Market Prices
Multiple of Multiple of Multiple of
EPS 2010 DPS 2010 Book Value/Share
Kennedy 8.00 16.00 1.20
Strasburg 8.67 17.33 1.18

Indicated Market Price for Erdman
Stock Based on Data of:
Kennedy Strasburg
Based on Earnings 24.00 26.01
Based on Dividends 24.00 26.00
Based on Book Value per Share 27.00 26.55



k. Using the equation rs = D1/P0 + g, find approximate rs values for Kennedy and Strasburg.
Then use these values in the constant growth stock price model to find a price for Edelman’s
stock. (Hint: We averaged the EPS and DPS g-values for Edelman.)


l. At what price do you think Edelman’s shares should be offered to the public? You will want to
select a price that will be low enough to induce investors to buy the stock but not so low that it
will rise sharply immediately after it is issued. Think about relative growth rates, ROEs,
dividend yields, and total returns (rs = D1/P0 + g).

Explanation / Answer

If 100 shares are outstanding, then we have the following for Edelman: 2001 2006 Earnings per share $8,160 $12,000 Dividends per share 4,200 6,000 Book value per share 90,000 b. Using the following two equations, the growth rate for EPS and DPS can be determined. (1 + gDPS)5 EPS01= EPSO6. (1 + gDPS)5 DPS01 = DPS06. gEPS gDPS Kennedy 8.4% 8.4% Strasburg 6.4 6.4 Edelman 8.0 7.4 c. Based on the figures in Part a, it is obvious that Edelman's stock would not sell in the range of $25 to $100 per share. The small number of shares outstanding has greatly inflated EPS, DPS, and book value per share. Should Edelman attempt to sell its stock based on the EPS and DPS above, it would have difficulty finding investors at the economically justified price. d. Edelman's management would probably be wise to split the stock so that EPS, DPS, and book value were closer to those of Kennedy and Strasburg. This would bring the price of the stock into a more reasonable range. e. A 4,000-for-1 split would result in 400,000 shares outstanding. If Edelman has 400,000 shares outstanding, then we would have the following: 2001 2006 Earnings per share $2.04 $ 3.00 Dividends per share 1.05 1.50 Book value per share 22.50 f. ROE Kennedy 15.00% Strasburg 13.64 Edelman 13.33 g. Pavout Ratio 2001 2006 Kennedy 50% 50% Strasburg 50 50 Edelman 51 50 All three companies seem to be following similar dividend policies, paying out about 50 percent of their earnings. h. D/A is 43 percent for Kennedy, 37 percent for Strasburg, and 55 percent, for Edelman. This suggests that Edelman is more risky, hence should sell at relatively low multiples. i. P/E Kennedy $36/$4.50 = 8.00x Strasburg $65/$7.50 = 8.67 These ratios are not consistent with g and ROE; based on gs and ROEs, Kennedy should have the higher P/E. Probably size, listing status, and debt ratios are offsetting g and ROE. j. The market prices of Kennedy and Strasburg yield the following multiples: Multiple of Multiple of Multiple of Book EPS, 2006 DPS, 2006 Value Per Share, 2006 Kennedy 8.00x 16.00x 1.20x Applying these multiples to the data in Part e, we obtain the following market prices: Indicated Market Price for Edelman Stock Based on Data of: Kennedy Strasburq Based on earnings, 2006 $24.00 $26.01 Based on dividends, 2006 24.00 26.00 Based on book value per share 27.00 26.55 k. Kennedy Strasburg Edelman Based on Kennedy: Based on Strasburg: The potential range, based on these data, is between $21.54 and $33.66 a share. The data suggest that the price would be set toward the low end of the range: (1) Edelman has a high debt ratio, (2) Edelman is relatively small, and (3) Edelman is new and will not be traded on an exchange. The actual price would be based on negotiations between the underwriter and Edelman; we cannot say what the exact price would be, but the price would probably be set below $21.54, with $2,0 being a reasonable guess

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