Question

104

Part One

Value

bre44380_ch04_076-104.indd

104

09/30/15 12:46 PM

MINI-CASE

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Reeby Sports

Ten years ago, in 2007, George Reeby founded a small mail-order company selling high-quality

sports equipment. Since those early days Reeby Sports has grown steadily and been consistently

profitable. The company has issued 2 million shares, all of which are owned by George Reeby and

his five children.

For some months George has been wondering whether the time has come to take the company

public. This would allow him to cash in on part of his investment and would make it easier for the

firm to raise capital should it wish to expand in the future.

But how much are the shares worth? George’s first instinct is to look at the firm’s balance

sheet, which shows that the book value of the equity is $26.34 million, or $13.17 per share. A share

price of $13.17 would put the stock on a P/E ratio of 6.6. That is quite a bit lower than the 13.1 P/E

ratio of Reeby’s larger rival, Molly Sports.

George suspects that book value is not necessarily a good guide to a share’s market value. He

thinks of his daughter Jenny, who works in an investment bank. She would undoubtedly know

what the shares are worth. He decides to phone her after she finishes work that evening at 9 o’clock

or before she starts the next day at 6.00 a.m.

Before phoning, George jots down some basic data on the company’s profitability. After recov

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ering from its early losses, the company has earned a return that is higher than its estimated 10%

cost of capital. George is fairly confident that the company could continue to grow fairly steadily

for the next six to eight years. In fact he feels that the company’s growth has been somewhat held

back in the last few years by the demands from two of the children for the company to make large

dividend payments. Perhaps, if the company went public, it could hold back on dividends and plow

more money back into the business.

There are some clouds on the horizon. Competition is increasing and only that morning Molly

Sports announced plans to form a mail-order division. George is worried that beyond the next six

or so years it might become difficult to find worthwhile investment opportunities.

George realizes that Jenny will need to know much more about the prospects for the business

before she can put a final figure on the value of Reeby Sports, but he hopes that the information is

sufficient for her to give a preliminary indication of the value of the shares.

QUESTIONS

1.

Help Jenny to forecast dividend payments for Reeby Sports and to estimate the value of the

stock. You do not need to provide a single figure. For example, you may wish to calculate

two figures, one on the assumption that the opportunity for further profitable investment

disappears after six years and another assuming it disappears after eight years.

2.

How much of your estimate of the value of Reeby’s stock comes from the present value of

growth opportunities?

Answer 1

No of shares = 2000000

Book value = $2634000

Book value/ share = $13.17

Expected market price with PE of 6.6 = $13.17

EPS = Market price / PE

= 13.17/6.6

= $2.00

PAT = EPS * no of shares

= 2*2000000

= $4000000

Required rate of return (r) = 10%

Assumption 1. Divident payout ratio is 90%

2. Growth rate for first 6 years is 20% i.e. r = 20%

3. growth rate after 7 years onwards 5% mainly due to price increase

Dividend (D) = EPS * payout ratio

= 2*90%

=$ 1.8/ share

Diving at Y6 = 1.8 * 1.2^6 = $5.37

Value of share Y6 = D*(1+g) / r - g

= (5.37*1.05) /(0.1-.05)

= $ 107.50

Value of share at Y0 = 107.5 / (1.10^6)

= $60.68

Therefor value of company = 60.68 * 2000000

= $ 121.36 million