Answers to all 6 questions from case study “Stock Valuation at Ragan Engines”

Mini Case “Stock Valuation at Ragan Engines”

Answers to all 6 questions from case study “Stock Valuation at Ragan Engines” provided.

 

Question 1: Calculate the value per share of the company’s stock at Ragan Engines.

 Solution

Total dividend paid = $640,000

Total earnings = $300,000 x 5.35 = $1,605,000

Payout Ratio = $640,000/$1,605,000 = 0.39

Retention Ratio = 1 – PR = 1 – 0.39 = 0.61

g = ROE x b = 0.21 x 0.61 = 0.13 or 13%

D₀ = $320,000/$150,000 = 2.13

P₀ = D₁/(R – g) = $640,000(1.18)/(0.18 – 0.13) = $13,413,286.96

Concluding, the per share value of company stock will be (13,413,286.96/300,000) = $44.74 dollars approximately. 

Question 2: What is the estimate of stock price?

Solution:

As analyst has done a write-off in order to affect the real answer calculated, so we must also re-calculate it as:

EPS of industry = (1.19 + 1.26 + 2.07)/3 = 1.51

Payout Ratio of industry = 0.44/1.51 = 0.2898

Retention Ratio of industry = 1 – 0.2898 = 0.7102

g = ROE x  b = 0.11 x 0.7102 = 0.0781

Also, it is mentioned that company will be continuing to grow in next five years and the sequence of growth will be as:

D₁ = $640,000(1.1263) = $720,807.48; D₂ = $720,807.48(1.1263) = $811,817.84; D₃ = $811,817.44(1.1263) = $914,319.33; D₄ = $914,319.33(1.1263) = $1,029,762.82; D₅ =

41,029,762.82(1.1263) = $1,159,782.41; and D₆ = $1,159,762.41(1.0781) = $1,250,384

Now the price of stock in the 5th year with required return of industry will be:

Stock value in 5th year = $1,250,384/(0.15 – 0.0781) = $17,395,308.29

Today-Value of Stock = 720,807.48/1.15 + 811,817.84/1.15² + 914,319.33/1.15³ + 1,029,762.82/1.15⁴ + (1,159,782.41 + 17,395,308.29)/1.15⁵

Today-Value of Stock = $11,655,749.48

Question 3: What is the industry average price–earnings ratio? What is Ragan’s price–earnings ratio? Comment on any differences and explain why they may exist.

Solution

Value per share = $11,655,749.48/300,000 = $38.85

After revision, industry PE ratio will be = 18.08/1.51 = 12

Original assumption – Ragan Inc. PE ratio = 44.71/5.35 = 8.36

Revised assumption – Ragan Inc. PE ratio = 38.85/5.35 = 7.26

In my opinion, there is positive correlation existed between the two calculated ratios which means that if the price-earnings ratio of industry will increase, the price-earnings ratio of Ragan Inc. will also increase and vice versa in the case of decrease.

Question 4:  Assume the company’s growth rate declines to the industry average after five years. What percentage of the stock’s value is attributable to growth opportunities?

Solution

The company’s total earnings being paid out as dividends must be considered as cash cow are as follows;

Total earnings = 2(150,000 shares)($5.35) = $1,605,000

Cash cow value of Ragan Inc. = 1,605,000/0.15 = $10,700,000

Total stock value from question 2 is $11,655,749.48

The percentage of income which is not attributable towards the growth margin will be calculated as;

= 10,700,000/11,655,749.48 = 0.9180

Percentage of company income attributable to growth = 1 – 0.9180 = 0.0820 or 8.20%

Question 5: Assume the company’s growth rate slows to the industry average in five years. What future return on equity does this imply?

Solution

Assumption that question 2has all correct answers;

g = ROE × b

0.0781 = ROE(0.6012)

ROE = 0.0781/0.6012 = 0.1299

Question 6: Solution

The stock price can easily be increased in this case by issuance of more dividends to shareholders. The stock price has been calculated as:

D/(R – g)

But in case of lowering growth rate, this strategy will not be helpful for Ragan Inc. in increasing the stock price.