Awesome Inc. was founded a few years ago by two friends, Bob and Sam. The compan

Question

Awesome Inc. was founded a few years ago by two friends, Bob and Sam. The company is equally owned by Bob and Sam. The original partnership agreement between them gave them each 50,000 shares of stock. The company manufactures and installs commercial heating, ventilation, and cooling units. Sam and Bob are engineering graduates and have developed proprietary technology that increases the energy efficiency. Awesome Inc. has experienced rapid growth because of this proprietary technology. Recently, Bob and Sam have been discussing the possibility of selling their company. Although they don’t need the money immediately, they may sell their holdings if they get a good price. Hence, they have decided that they should value their holdings in the company. Alongside their engineering courses, Bob and Sam also took courses in accounting and finance. Based on the financial statements from last year, Bob and Sam calculated that Awesome Inc. had an EPS (earnings per share) of 5.24 and paid a dividend of $ 1.26 per share. The company also had ROE (return on equity) of 24% and they also believe that 20% is an appropriate required rate of return for their company. In order to get an expert opinion, they hire Joe, who is an expert equity analyst. Joe gathers the following information about Awesome Inc.’s main competitors:

Earnings Per Share

Dividend Per Share

Stock Price

Return on Equity

Required Rate

ABC Inc.

$ 0.70

$ 0.20

$ 14.00

12.00%

11.00%

EFG Ltd.

$ 1.30

$ 0.62

$ 11.87

13.00%

13.00%

XYZ Corp.

$ 1.00

$ 0.38

$ 13.13

14.00%

12.00%

Average

$ 1.00

$ 0.40

$ 13.00

13.00%

12.00%

Joe thinks that Awesome Inc.’s technological advantage will last only for the next four years. After that, the company’s growth will likely slow to the industry growth average. Additionally, Joe believes that Bob and Sam have miscalculated the required rate of return and it should actually be equal to the industry average required rate of return.

Based on the information given above and your knowledge, answer the following questions:

1. Dividend discount model and comparables method are two common techniques used to value stocks. Compare and contrast these techniques.

2. Calculate the value of Awesome Inc.’s stock in the following cases:

a. Assuming that Bob and Sam are correct, and the company continues to grow at its current growth rate forever what is the value per share?

b. Assuming that Joe is correct, what is the value per share?

3. Calculate the value per share using the comparables method.

4. Comment on the difference. Do you think that the technological advantage possessed by Awesome Inc. plays any role in its valuation? Do you think such an advantage can last forever?

5. Calculate Awesome Inc.’s PE ratio as per abovementioned assumptions. Do you see any difference between the industry average and Awesome Inc.’s PE ratio? If yes, explain the reasons for this difference.

6. Great Inc. is thinking about acquiring Awesome Inc. Great Inc. is willing to offer $60 per share to Bob and Sam to give up their entire holdings. Based on your analysis so far, would you recommend Bob and Sam to take this offer? Explain.

7. Bob and Sam want to increase the value of their company’s stock but they don’t want to dilute their equity or issue more debt. How can they increase the value of the stock? Are there any conditions under which this strategy would not increase the value of the stock?

Earnings Per Share

Dividend Per Share

Stock Price

Return on Equity

Required Rate

ABC Inc.

$ 0.70

$ 0.20

$ 14.00

12.00%

11.00%

EFG Ltd.

$ 1.30

$ 0.62

$ 11.87

13.00%

13.00%

XYZ Corp.

$ 1.00

$ 0.38

$ 13.13

14.00%

12.00%

Average

$ 1.00

$ 0.40

$ 13.00

13.00%

12.00%

Explanation / Answer

1) The dividend discount model calculates the price of a stock as the PV of expected future dividends. The discount rate used is the required rate of return for the stock considering its risk characteristics.

The formula is P0 = D1/(Ke-g), where D1 is the next expected dividend, Ke is the required rate of return for the stock and g is the growth rate.

The method hinges on how well the dividend is predicted and its growth rate. Determining the requred rate is also a task. If the firms stock is public traded one can measure Beta of the stock and use CAPM for the appropriate discount rate. Otherwise one may have to use the pure play method.

The comparables method doesn't try to find the intrinsic value, but it just compares the stock's P/E multiple to a benchmark to find if the stock is comparatively undervalued or overvalued. This method is based on the Law of One Price, which holds that similar assets should have similar prices.

The reason for using P/E ratio is that it focuses on the earnings of the company, which is one of the primary drivers of an investments value.

This method can be used if the company is publicly traded which will help in getting the details of the variables like price and EPS.

2-a) The growth rate is ROE*retention ratio = 0.24(5.24-1.26/5.24) = 0.24*0.76 = 0.1823 = 18.23%

The price of the share = D1/(Ke-g) = (1.26*1.1823)/(0.20-18.23) = 1.49/0.0177 = $84.18.

2-b) Here growth rate of the industry should be used from the 5th year, as also the required rate of return.

The industry growth rate = 0.6*0.13 = 0.078 = 7.8%, Required rate = 12%

The price of the stock would be = (1.26*1.1823)/1.12 + (1.26*1.1823^2)/1.12^2+(1.26*1.1823^3)/1.12^3+

                                                 (1.26*1.1823^4)/1.12^4 + {(1.26*1.078)/(0.12-0.078))/1.12^4

                                              = 1.33+1.40+1.48+1.56+(2.65/0.042)/1.12^4= $45.87

3) P/E ratio of the industry is 13/1 = 13.

Using this multiple the price of the stock = 13*5.24 = $68.12.

4) The prices calculated under 2-b and 3 above, use industry average. The values so obtained are far less than the values obtained by Bob and Sam.

Yes, technological advantage can boost the growth rate and hence the value of the stock. However, it may not last long as competitors can catch up and go ahead.

5) Awesome's PE ratios are

for price of 84.18 - 16.06

                45.87 -    8.75

68.12 - 13.00

The last PE is the same as it uses the industry PE.

In the first case (PE of 16.06), the reason for the higher ratio is the higher growth rate of 18.23% being used perpetually, as also the higher required rate of return.

6) Yes, I would recommed the acceptance of the offer.

Though the price of Awesome, using industry P/E, is $68.12, it is based on its current higher earnings, which is not likely to last longer than 4 years. Besides the offered price is much higher than the price used the dividend growth model using the estimates of Joe.

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