Question

Chemists-R-Us Ltd., a large pharmaceutical chain, had sales per share of $122 in 2019, on which it reported earnings per share of $2.45 and paid a dividend per share of $1.12. The company is expected to grow 6% in the long term and has a beta of 0.9. The current risk-free rate is 7% and the market return is 12.5%.

Required:

(a) Estimate the appropriate price/sales multiple for Chemists-R-Us Ltd. and calculate the share price based upon this multiple.

(b) You observe the shares are currently trading for $34 per share. Assuming the growth rate is estimated correctly, what would the profit margin need to be to justify this price per share?

(c) Given your answer to part b, do you think the market’s valuation of $34 is reasonable? Explain your answer.

Answer 1

a. Rate of dividend payment = Dividend per share / Earnings per share = $1.12 / $2.45 = 0.4571

Long term expected rate of growth = 6%

Cost of equity = Risk free rate + Beta X (Market return - Risk free rate) = 7% + 0.9 X (12.5% - 7%) = 11.95%

Margin of profit = Earnings per share / Sales per share = $2.45 / $122 = 2%

Therefore, price/sales multiple = P/E X Margin of profit = (0.02 X 0.4571 X 1.06) / (0.1195 - 0.06) = 16.287%

Share price based on price/sales multiple = Price/Sales multiple X Sales per share = 16.287% X $122 = $19.87.

b. The required P/S ratio for a $34 share price = Current trading price per share / Sales per share = $34 / $122 = 0.2787

Therefore, required profit margin for the above P/S ratio = Required P/S ratio X (Cost of equity - Long term growth rate) / Rate of dividend payment X (1+ growth rate) = 0.2787 X (0.1195 - 0.06) / (0.4571 X 1.06) = 3.42%.

c. The market price per share based on price/sales multiple is $19.87 whereas the shares of the organization are currently trading for $34 per share. Hence, it could be concluded that the shares of the organization are overvalued.