Question

You have been following a company in the news, RC Incorporated, which sells kombucha tea online. You are considering investing in the company; but before you risk any of your money, you decide to estimate the valuation of the stock to determine what would be a reasonable price to pay per share. To help in your valuation, you have assembled the following information for the most recent fiscal year (which ended today):

- RC Incorporated has no debt

- Revenue was $2M

- Gross margins were 35%

- Depreciation was $100,000

- Tax rate is 30%

- Total CAPEX was $150,000

- Net Working Capital Increased by $20,000

- The company has 300,000 shares outstanding

- Return on Equity was 12%

- Dividend payout is 50% of earnings

From your research, the appropriate discount rate for the cash-flows is 10%.

(a) RC has been growing rapidly, but competition is intensifying. As a first guess, you assume that the company will be able to hold onto its competitive advantage and grow its FCF by 15% for the next 5 years, after which the competition will catch up and FCF growth rate will drop to 3%, in perpetuity. Using a DCF valuation method, estimate the price of a share of RC under these assumptions.

(b) Provide another estimate of the growth rate of earnings using the information in the financial statements. Assuming that free-cashflows will grow at this constant rate forever, provide an estimate of the price of a share of RC under these new assumptions. 3

(c) Using the growth rate computed in part (b), provide a third estimate for the price of a share using a discounted dividend approach instead. (Note: there is no debt, so Earnings = EBIAT)

Answer 1

The left part of the solution shows the solution of calculation of free cash flow for year 0. Starting from PAT, adding back depreciation and subtracting capex and increase in working capital , we arrive at the free cash flow to equity for year 0.

a. FCF in year 0 = 350,000. The rest of FCF is grown at the rates as shown in question

b. The growth rate is calculated as Reinvestment rate X ROE

Gross Margin	35%
Tax	30%
			a.
Year	0		Year	0	1	2	3	4	5
Revenue	$ 2,000,000		FCFF	$     350,000	$ 402,500	$ 462,875	$        532,306	$ 612,152	$        703,975
Gross Profit	$     700,000								$ 10,358,490
Depreciation	$     100,000		Equity Value	$ 8,435,408
EBIT	$     600,000		No of shares	300,000
EBT	$     600,000		Price of share	$          28.12
[-] Tax	$     180,000
PAT	$     420,000		b.
			Growth Rate		Reinvestment Rate X ROE
FCF Calculation			Growth RAte		6.00%
PAT	$     420,000
[+] Depreciation	$     100,000		Equity Value	$ 9,275,000
[-] Capex	$   (150,000)		No of shares	300,000
[-] Increase in WC	$     (20,000)		Price of share	$          30.92
FCF in Year 0	$     350,000
			c.
			Dividend in year 0	$     210,000
			Equity Value	$ 5,565,000
			No of shares	300,000
			Price of share	$          18.55