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Question: CASE 2 Ryan International In the world of skateboard attire, instinct and marketing savvy are pre...
CASE 2
Ryan International
In the world of skateboard attire, instinct and marketing savvy are prerequisites to success. Moogy Ellis had both. During 2017, his international skateboarding company, Ryan, rocketed to $700 million in sales after 10 years in business. His fashion line covered the skateboarders from head to toe with hats, shirts, pants, shorts, sweatshirts, socks, and shoes. In L.A., there was a Ryan shop every five or six blocks, each featuring a different color. Some shops showed the entire line in mauve, and others featured it in canary yellow.
Ryan had made it. The company’s historical growth was so spectacular that no one could have predicted it. However, securities analysts speculated that Ryan could not keep up the pace. They warned that competition is fierce in the fad fashion industry and that the firm might encounter little or no growth in the future. They estimated that stockholders also should expect no growth in future dividends.
Contrary to the conservative securities analysts, Moogy Ellis feels that the company could maintain a constant annual growth rate in dividends per share of 8% in the future, or possibly 12% for the next 2 years and 8% thereafter. Ellis based his estimates on an established long-term expansion plan into European and Latin American markets. Venturing into these markets was expected to cause the risk of the firm, as measured by the beta on its stock, to increase immediately from 1.15 to 1.25.
In preparing the long-term financial plan, Ryan’s chief financial officer has assigned a junior financial analyst, Brad Harris, to evaluate the firm’s current stock price. He has asked Brad to consider the conservative predictions of the securities analysts and the aggressive predictions of the company founder, Moogy Ellis.
Mark has compiled these 2017 financial data to aid his analysis:
Data item
2017 value
Earnings per share (EPS)
$5.00
Price per share of common stock
$54.25
Book value of common stock equity
$75,000,000
Total common shares outstanding
2,000,000
Common stock dividend per share
$2.35
Data Points
Beta, b
Required Return, K
0
4%
.25
5.75%
.5
7.5%
.75
9.25%
1
11%
1.25
12.75%
1.5
14.5%
To Do
a. What is the firm’s current book value per share?
b. What is the firm’s current P/E ratio?
c. (1) What is the current required return for Ryan stock (use CAPM)?
(2) What will be the new required return for Ryan stock assuming that they expand into European and Latin American markets as planned (use CAPM)?
d. If the securities analysts are correct and there is no growth in future dividends, what will be the value per share of the Ryan stock? (Note: use the new required return on the company’s stock here)
e. (1) If Moogy Ellis’s predictions are correct, what will be the value per share of Ryan’s stock if the firm maintains a constant annual 8% growth rate in future dividends? (Note: Continue to use the new required return here.)
(2) If Moogy Ellis’s predictions are correct, what will be the value per share of Ryan’s stock if the firm maintains a constant annual 12% growth rate in dividends per share over the next 2 years and 8% thereafter? (Note: Use the new required return here.)
f. Compare the current price of the stock and the stock values found in parts a, d, and e. Discuss why these values may differ. Which valuation method do you believe most clearly represents the true value of the Ryan stock?
Data item
2017 value
Earnings per share (EPS)
$5.00
Price per share of common stock
$54.25
Book value of common stock equity
$75,000,000
Total common shares outstanding
2,000,000
Common stock dividend per share
$2.35
Data Points
Beta, b
Required Return, K
0
4%
.25
5.75%
.5
7.5%
.75
9.25%
1
11%
1.25
12.75%
1.5
14.5%
Explanation / Answer
a) Book value per share = Total Book value / No. of share outstanding = $75,000,000 / 2,000,000 = $37.50
b) P/E ratio = market price per share / earning per share = $54.25 / $5 = 10.85 times
c) At 0 beta, the rate is 4%. Now, this rate is the risk free rate as it has no risk (0 beta) at this rate. Expected return as per the CAPM is calculated as -
ER = Rf + Beta x Market risk premium
Where, ER = Expected return, Rf = Risk free rate
At 5.75% expected return, beta is 0.25 and we know that risk free rate is 4%. We can use these values to find out the market risk premium -
5.75% = 4% + 0.25 x Market risk premium
Or, Market Risk Premium = 7%
You can use any given rate to find out the market risk premium as that would be the same in all the cases.
(1) Current Beta is 1.15. So, applying the CAPM formula we have -
ER = 4% + 1.15 x 7% = 12.05%
(2) If Ryan stock expands into European and Latin America markets, the beta would become 1.25. So, applying the CAPM formula we have -
ER = 4% + 1.25 x 7% = 12.75%
d) If the dividends are constant, i.e, with zero growth, the formual to calculate the price of a stock is -
Price (P0) = Expected Dividends / Ke = $2.35 / 0.1275 = $18.43
Where, Ke = new required rate of return
e) (1) In case of constant growth in dividends, the formula to calculate the price of a stock is -
P0 = D0 x (1 + g) / (Ke - g)
Where, P0 = price of stock, D0 = last dividend paid, g = growth rate, Ke = new required rate of return
P0 = $2.35 x (1 + 0.08) / (0.1275 - 0.08) = $53.43
(2) In case two growth periods, one abnormal and then constant growth, the price is calculated as follows -
P0 = Present value of dividends during abnormal growth + Present value of price of stock at the beginning of stable growth
Expected dividends or dividends to be paid next year would be calculated as dividends last paid multiplied by the growth rate.
Dividend at the end of year 1 (D1) = $2.35 x (1 + 0.12) = $2.632
Dividend at the end of year 2 (D2) = $2.632 x (1 + 0.12) = $2.94784
Stock price at the beginning of stable growth would be the price at the end of year 2 or lets say P2. Price would be computed using the constant dividend growth formula used in part e (1) where D2 is the last dividend paid, growth is 8% and 12.75% being the expected return -
P2 = $2.94784 x (1 + 0.08) / (0.1275 - 0.08) = $67.0245726315
Now, we just compute the present values of these amounts and add them up -
P0 = D1 x PVIF (12.75%, 1) + D2 x PVIF (12.75%, 2) + P2 x PVIF (12.75%, 2)
P0 = $2.632 x 0.88691796008 + $2.94784 x 0.78662346792 + $67.0245726315 x 0.78662346792 = $57.38
f) The values may differ because of lot of estimation involved in the calculations with respect to growth rates and the expected future dividends which may or may be as per the expectations. Also, assumptions are involved when applying the dividend discount model such as -
i) All new investments are to be financed through retained earnings - which may or may not be true in reality.
ii) Business risks complexion remaines the same even after new investments are made, i.e., required return is constant
iii) The firm has an infinite life
iv) That cost of capital / required return besides being constant is more than the growth rate, i.e., Ke is greater than g.
Out of all method 3, i.e., one where we calculate the present values of dividends and price seems to be the most accurate as it takes into consideration an uneven growth possibility which the other two methods fail to acknowledge.
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