Question

You are doing research on Paranoid Corp (PC).PC is a young, start up company. Currently, PC’s cost of goods sold is 95% of their sales (so they have a 5% gross margin). PC is expected to grow rapidly and they will not need a lot of capital investment to fuel that growth. Given their low margin, most analysts believe that PC is overvalued but there is one analyst who thinks that PC is undervalued and has a much higher target price than other analysts. Given the information given in the question, what is the analyst that has the much higher target price likely assuming and why is that assumption valid? Need two things: What is the assumption and why is it vaild?

Answer 1

Providers of capital will often provide funds to businesses when they believe in the product and business model of the firm, even before it is generating earnings.

The analyst beleiving the share price to be undervalued has considered two important factors of PC. These factors are:

1. No needs of huge capital investments for growth.

2. Rapid growth in future top and bottom line.

The analyst must be assuming that with high generation of cash earnings in future, PC may consider buyback of shares since the business model will not require much arrangement of funds.

The assumption taken by him is valid becuase with extra cash earnings in hand firm should consider buy back option which will increase EPS of PC and all additional future earnings will give better EPS figures that will increase market price of the shares.