Financial Management Therory and Practice - Chapter 20 - New Stock Issue 20-3 Th
ID: 2666526 • Letter: F
Question
Financial Management Therory and Practice - Chapter 20 - New Stock Issue20-3
The Edelman Gem Company, a small jewelry manufacturer, has been successful
and has enjoyed a good growth trend. Now Edelman 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 publicly traded common stock and to
make relevant comparisons.
Several jewelry manufacturers 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 2005 and 2010 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 (Totals)
Earnings per share*
2010 $ 4.50 $ 7.50 $1,200,000
2005 3.00 5.50 816,000
Price per share*
2010 $36.00 $65.00 —
Dividends per share*
2010 $ 2.25 $ 3.75 $ 600,000
2005 1.50 2.75 420,000
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 calculate earnings per share (EPS), dividends per share (DPS), and
book value per share for Edelman. (Hint: Edelman’s 2007 EPS _ $12,000.)
b. Calculate earnings and dividend growth rates for the three companies. (Hint:
Edelman’s EPS growth rate is 8%.)
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?
d. Assuming that 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?
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.)
f. Return on equity (ROE) can be measured as EPS/book value per share or as
total earnings/total equity. Calculate ROEs for the three companies for 2010.
(Hint: Edelman’s 2010 ROE is 13.3%.)
g. Calculate dividend payout ratios for the three companies for both years.
(Hint: Edelman’s 2010 payout ratio is 50%.)
h. Calculate debt/total assets ratios for the three companies for 2010. (Hint:
Edelman’s 2010 debt ratio is 55%.)
i. Calculate the P/E ratios for Kennedy and Strasburg for 2010. Are these P/Es
reasonable in view of relative growth, payout, and ROE data? If not, what
other factors might explain them? (Hint: Kennedy’s P/E _ 8_.)
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.)
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’s
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
a. 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, 20
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
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