Question

Lara is a security analyst with Texas City brokerage firm. Lara has been following one of the hottest issues on Wall Street, M&I Medical supplies, a company that has turned outstanding performance and showed excellent potential growth. It has 5 million shares outstanding and pays an annual dividend of $0.05 per share. Lara showed her interest in investing in M&I. Assume the company sales for the past five years have been as follows:

Year Sales ($ million)

2012 - 10.0
2013 - 12.5
2014 - 16.2
2015 - 22.0
2016 - 28.5

Lara relates to the prospects of the company, not its past. As a result, she generates the following estimate of future performance:

Expected Net Profit Margin =12%
Estimated annual dividend per share = 5c
Number of share s outstanding = No change
P/E ratio at the end of 2017 = 35
P/E ratio at the end of 2018 = 50

Questions:
1. Determine the annual average growth in sales over the past five years. (Assume sales in 2011 amounted to $7.5 million.)
2. Use the average growth rate to forecast revenue for next year (2017) and the year after (2018).
3. Determine the company’s net earnings and EPS for the year 2017 and 2018.
4. Determine the expected future price of the stock at the od 2017 and 2018.
5. Because of several intrinsic and market factors, Lara feels that 25%is a viable figure to use for a desired rate of return.
a. Using a 25% rate of return and forecasted figures, compute the stock’s justified price.
b. If M&I is currently trading at $32.50 per share, should Lara consider the stock a worthy investment? Explain.

Answer 1

1. Average annual growth in sales from 2011 to 2016

Sales in 2011: $ 7.5 mn

Sales in 2016: $ 28.5 mn

To calculate avarage annual growth we should use the Cummulative Average Growth Rate (CAGR) formula:

CAGR = Growth = (Sales in 2016 / Sales in 2011) ^ (1/5) - 1

Growth = (28.5 / 7.5) ^ 0.2 - 1

Growth = 30.6%

2. Revenue forecast for year 2017 and 2018

Using the growth rate derived in Part 1 (30.6%), we shall determine the exepected sales in 2017 & 2018. Hence,

Sales in 2017 = Sales in 2016 * (1 + Growth)

Sales in 2017 = 28.5 * (1 + 30.6%)

Sales in 2017 = $ 37.22 mn

Sales in 2018 = Sales in 2017 * (1 + Growth)

Sales in 2018 = 37.22 * (1 + 30.6%)

Sales in 2018 = $ 48.61 mn

3. Net Earnings (NE) and Earnings per Share (EPS)

Net Earnings = Net Profit Margin X Sales ...........(Formula)

Earnings per Share = Net Earnings / No. of Shares .......... (Formula)

Here, Net profit margin = 12% .........(Given)

No. of Shares = 5,000,000 .........(Given)

NE & EPS for 2017

Net Earnings 2017 = 12% * Sales in 2017

Net Earnings 2017 = 12% * $ 37.22 mn

Net Earnings 2017 = $ 4.47 mn

EPS = Net Earnings / 5,000,000 = Net Earnings ($ mn) / 5 mn

EPS = $ 4.47 / 5

EPS = $ 0.89

NE & EPS for 2018

Net Earnings 2018 = 12% * Sales in 20187

Net Earnings 2018 = 12% * $ 48.61 mn

Net Earnings 2018 = $ 5.83 mn

EPS = Net Earnings / 5,000,000 = Net Earnings ($ mn) / 5 mn

EPS = $ 5.83 / 5

EPS = $ 1.16

4. Future Stock price at end of 2017 & 2018

Stock price can be calculated from the PE Ratio as given below:

PE Ratio = Market Price per share / Earnings per share ...........(formula1)

Hence, Market Price per Share = PE Ratio X Earnings per Share ...........(formula2)

We have calculated the earnings per share in Part 3 for 2017 and 2018 and, we have been given the PE ratio for end of 2017 & 2018. Using this, we can calculate the stock price at the end of 2017 & 2018.

PE Ratio 2017 = 35 ..........(given)

PE Ratio 2018 = 50 .........(given)

Using formula 2 stated above,

Price at end of 2017 = PE Ratio at end of 2017 X Earnings per Share of 2017

Price at end of 2017 = 35 * $ 0.89

Price at end of 2017 = $ 31.26

Price at end of 2018 = PE Ratio at end of 2018 X Earnings per Share of 2018

Price at end of 2018 = 50 * $ 1.16

Price at end of 2018 = $ 58.33