Question

Sahara Inc., was founded nine years ago by brother and sister Fatema and Muhanad Al Balushi. The company manufactures and installs commercial heating, ventilation, and cooling units. Sahara Inc. has experience rapid growth because of a proprietary technology that increases the energy efficiency of its units. The company is equally owned by Fatema and Muhanad. The original partnership agreement between the siblings gave each 50,000 shares of stock. In the event either wished to sell stock, the shares first had to be offered to the other at a discounted price.

Although neither sibling wants to sell, they have decided they should value their holdings in the company. To get started, they have gathered the following information about their main competitors:

	EPS Earnings per share	DPS Dividend per share	Stock price	ROE Return on equity	R Required return
Arctic Inc.	$0.82	$0.16	$15.19	11%	10%
Heating & Cooling Inc.	$1.32	$0.52	$12.49	14%	13%
Breese Inc.	$ -0.47	$0.40	$11.47	14%	12%
Industry Average	$0.56	$0.36	$13.05	13%	11.7%

Expert Breese Inc. negative earnings per share were the result of an accounting wright-off last year. Without the wright-off, earnings per share for the company would have been $0.97.

Last year, Sahara Inc., had an EPS of $4.32 and paid dividend to Fatema and Muhanad of $54,000 each. The company also had a return on equity of 25%. The siblings believe that 20% is an appropriate required return for the company:

1. Assuming Sahara Inc., use the Zero Growth model, what is the value of share of stock today (P₀)? Compare with stock prices for other companies and the industry average and give recommendations on changing dividend policy.

2. To verify the calculations, Fatema and Muhanad have hired Josh Smith as a consultant. Josh has examined the company’s financial statements, as well as examining its competitors. Although Sahara Inc., currently has a technological advantage, his research indicates that other companies are investigating methods to improve efficiency. Josh believes that the required return used by the company is too high. He believes the industry average required return is more appropriate. Under this assumption, what is your estimate of Sahara stock price today? Do you agree with Josh’s analysis? Justify your answer.

Answer 1

1. Calculation of retention ratio

Dividend paid = $54000 * 2 = $108000

No. of shares outstanding = 50000 * 2 = 100000 shares

Dividend per share = $108000 / 100000

= $1.08

EPS = $4.32 (given)

Dividend payout ratio = DPS / EPS

Dividend payout ratio = 1.08 / 4.32

= 0.25 or 25%

Retention ratio = 1 - dividend payout ratio

Retention ratio = 1 - 0.25

= 0.75 or 75%

Calculation of growth rate

Growth rate = b * r

Growth rate = 0.75 * 0.2

Growth rate = 0.15 or 15%

Price of share = Dividend for next year / Ke - g

= (1.08 * 1.15) / (0.2 - 0.15)

= 1.242 / 0.05

= 24.84

2. Industry EPS = (0.82 + 1.32 + 0.97) / 3 = 1.04

Industry payout ratio = 0.36 / 1.04 = 0.35

Industry retention ratio = 1 - 0.35 = 0.65

g = 0.13 * 0.65 = 0.0845

The company will grow for five years

Dividend in 6th year = 1.08 * (1.15) ^ 6 = 2.5

Price of share = 2.5 / (0.117 - 0.0845)

= 76.92