Question

QUESTION 1: EQUITY VALUATION
Silverline Electricals Limited was founded ten years ago by Jim and Wendy Birt. The company manufactures and installs both traditional and contemporary models of lights for residential and commercial purposes. Silverline Electricals Ltd has experienced rapid growth because of the new technology that increases the energy efficiency of its systems and the introduction of new models of LED integrated lights. The company is equally owned by Jim and Wendy holding 100,000 shares each.
In August 2018, Jim and Wendy have decided to value their holdings in the company for financial planning purposes. To accomplish this, they have gathered the following information about their main competitors in the industry.
EPS ($)
DPS ($)
Share Price ($)
ROE (%)
Required rate (%)
Colonial Lighting
0.42
0.08
7.65
10.5
9.5
Reliable Lighting Plus
0.46
0.26
6.25
11.5
10.5
FullBright Electricals
-0.24
0.27
24.3
12.5
11.5
Industry Average
0.36
0.27
8.24
11.0
10.5
Last year, Silverline Electricals Ltd had an EPS of $0.52 and paid dividends to Jim and Wendy of $31,200 each. The company also had a return on equity of 15%. Jim and Wendy believe a required rate of return of 12% for the company is appropriate.
Required:
1. Assuming the company continues its current growth rate (growth rate should be inferred from the data given) into the infinite period, what is the share price of the company?
(7marks)
2. To verify their calculations, Jim and Wendy have hired Richard Wang, a consultant. Richard was previously an equity analyst, and he has a good understanding of the electrical Industry. Richard has examined the company’s financial statements as well as those of its competitors. Although Silverline Electricals Ltd currently has a technological advantage, Richard’s research indicates that Silverline Electricals Ltd’s competitors are investigating other methods to improve efficiency. Given this, Richard believes that Silverline Electricals technological advantage will last for only the next five years. After that period, the company’s growth is likely to slow down to the industry average. Additionally, Richard believes that the company’s required return currently is too high and so after year 5, the industry average required return is a more appropriate rate for valuation. Taking Richard’s assumptions into consideration, calculate the estimated share price of Silverline Electricals Ltd.

3. What is the industry average price-earnings ratio? What is Silverline Electricals Ltd’s price-earnings ratio based on Richard’s estimation in part (2) above? Comment on any differences and explain why these differences may exist?

4. After a discussion with Richard, Jim and Wendy agree that they wanted to increase the value of the company’s equity. Like many small business owners, they want to retain control of the company and do not want to sell shares to outside investors. They also feel that the company’s debt is at a manageable level and do not want to borrow more money. What steps can they take to increase the share price? - justify each of your suggestions.

Answer 1

Solution 1

Calculating growth rate

Growth rate = ROE * (1-P)

Where P= DPS/ EPS

G= 15%*(1- 0.31/0.52)

G= 15* 0.2/0.52

G = 6.05%

Growth rate =6.05%

Calculating share price

Price of stock = Dividend / (required rate of return – growth rate)

Share price = price of stock / no of total shares

Where

Dividend = 31200*2 = 64200

required rate of return = 12% given

growth rate = 6.05% (calculated above)

no of total shares = 100000*2 = 200000

price of stock = (62400/ 12-6.05) / 200000

= 1112188.24/200000

Share price = 5.56

Solution 2

Calculating industry growth rate

Growth rate = ROE * (1-P)

Where P= DPS/ EPS

G= 11%*(1- 0.27/0.36)

G= 11* 0.25

G = 2.75%

Growth rate = 2.75%

Calculating share price

Price of stock = Dividend / (required rate of return – growth rate)

Share price = price of stock / no of total shares

Where

Dividend = 31200*2 = 64200

required rate of return for industry = 10.5% given

growth rate = 2.75% (calculated above)

no of total shares = 100000*2 = 200000

price of stock = (62400/ 10.5-2.75) / 200000

= 827303.23/200000

Share price = 4.13

Solution 3

Calculation of PE ratio

PE ratio = share price / EPS

PE ratio for industry

PE ratio = 8.24 / 0.36

= 22.88

PE ratio for Silverline electricals ltd. (II)

PE ratio = 4.13 / 0.36

= 11.47

There is difference in PE ratio due to difference in share prices.

The reason for this is:

Earning and dividend per share is higher in Silverline electrical ltd than the industry average.

Solution 4

To increase the share price:

Stock buyback: It will result in increase in demand of the shares, hence will increase the share price.

Raising Debt: it will result in timely return for the company with fixed returns. Hence, it will result in increase in share price.

Others: there are various other methods to increase the share price such as; diversifying portfolio, mergers or acquisitions, organisational restructuring etc.

I hope it helps, in case of any query feel free to ask.