Question

Case Study, Encore International

In the world of trendsetting fashion, instinct and marketing savvy are prerequisites to success. Jordan Ellis had both. During 2012, his international casual-wear company, Encore, rocketed to $300 million in sales after 10 years in business. His fashion line covered the young woman from head to toe with hats, sweaters, dresses, blouses, skirts, pants, sweatshirts, socks, and shoes. In Manhattan, there was an Encore shop every five or six blocks, each featuring a different color. Some shops showed the entire line in mauve, and others featured it in canary yellow.

Encore had made it. The company's historical growth was so spectacular that no one could have predicted it. However, securities analysts speculated that Encore could not keep up the pace. They warned that competition is fierce in the fashion industry and that the firm might encounter little or no growth in the future. They estimated that stockholders also should expect no growth in future dividends.

Contrary to the conservative securities analysts, Jordan Ellis felt that the company could maintain a constant annual growth rate in dividends per share of 6% in the future, or possibly 8% for the next 2 years and 6% thereafter. Ellis based his estimates on an established long-term expansion plan into European and Latin American markets. Venturing into these markets was expected to cause the risk of the firm, as measured by the risk premium on its stock, to increase immediately from 8.8% to 10%. Currently, the risk-free rate is 6%.

In preparing the long-term financial plan, Encore's chief financial officer has assigned a junior financial analyst, Marc Scott, to evaluate the firm's current stock price. He has asked Marc to consider the conservative predictions of the securities analysts and the aggressive predictions of the company founder, Jordan Ellis.

Marc has compiled these 2012 financial data to aid his analysis:

Data item 2012 value

Earnings per share (EPS) $6.25

Price per share of common stock $40.00

Book value of common stock equity $60,000,000

Total common shares outstanding 2,500,000

Common stock dividend per share $4.00

TO DO

I have the calculations completed. I need help with the last three questions:

%u2022 What is the firm%u2019s current book value per share?
%u2022 What is the firm%u2019s current P/E ratio?
%u2022 What is the current required return for Encore stock?
%u2022 What will be the new required return for Encore stock assuming that they expand into European and Latin American markets as planned?
%u2022 If the securities analysts are correct and there is no growth in future dividends, what will be the value per share of the Encore stock? (Note: use the new required return on the company%u2019s stock here.)
%u2022 Which valuation method do you believe most clearly represents the true value of the Encore stock?

%u2022 Identify the critical issues or problems in the case and analyze the key facts related to the issues or problems.
%u2022 Discuss a tentative solution that addresses the issues or problems and how you would implement your solution.

Answer 1

	Encore International
	Particulars	Amt /No
a	Book value of Equity shares	$                60,000,000
b	Total Common shares outstanding	2,500,000
c	Current Book value /Share =a/b=	$                          24.00	Ans 1.
d	Current Market Price/Share =	$                          40.00
e	Current EPS =	$                            6.25
f	Current P/E Ratio=d/e=	6.40	Ans 2.
g	Current Risk free rate =	6%
h	Current Risk premium =	8.80%
i	Current Required Return from Equity=h+i=	14.80%	Ans 3.
j	Risk premium when the company expands to Europe & Latin America=	10%
k	New Required Return when the company expands to Europe & Latin America=g+j	16%	Ans 4.
l	If there is no growth in dividend , then perpetual dividend per share would be	$                            4.00
m	Required New rate of return =	16%
n	So Value of stock $4/16%=	$                          25.00
	So Value per share would be $25		Ans 5.

Ans 6.
The above method of stock value calculation uses Gordon's dividend
discount model to find the intrinsic value of stock. However, a lot
of assumptions regarding future dividend growth and cost of equity
needs to be considered in this method and any change in any of such
parameters will change the intrinsic value.
The Market Price based valuation is the best way to reflect the true value
of Encore stock as it considers all the inputs from the market and adjust
the stcok value accordingly.
Ans 7.
The critical issues in this case are the estimates for future revenue growth
and the effective measurement of risk premium after Encore ventures into
Europe and Latin America.
Both the future earnings and the future cost of capital are subject to
different forecasts based on different perceptions.
Ans 8.
A tentative way will be to do sensitivity analysis of future earnings with various
input levels and find a conservative average growth rate for dividend or earning.
For getting a reliable cost of equity, the beta and cost of equity of similar firm
with similar gearing and operating in same industry in Europe and Latin America
may be considered as a benchmark equity cost for the valuation purpose.