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:
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

In order to calculate the estimated price for 2017 and 2018 using PE ratio we will need to first find EPS for those years

Calculation for EPS using the sales and NP margin

Year Sales Amount Growth Rate Net profit @12% EPS

2012 10 NA

2013 12.5 25%

2014 16.2 30%

2015 22 36%

2016 28.5 30%

2017 37.05 30% 4.45 0.8891

2018 48.16 30% 5.78 1.1557

Taking an average growth rate for last 4 years, the average growth rate comes to 30% we have computed the sales figures for 2017 and 2018

Net profit figures is calculated as Sales * Net profit Margin of 12%

EPS is calculated as Net profit/Number of shares

Price for 2017

PE=Price/EPS

We have PE and EPS so we can calculate Price

Price = EPS*PE ratio

=0.8891*35

= $ 31.12

In same way we get price for 2018 which is $ 57.79

Price per share for 2017 and 2018 is $ 31.12 and $ 57.79 respectively

Justified price at Rate of return is 25%

In order to compute the justified price at a rate of return of 25% we will need to discount the estimated price of 2017 and 2018. So using the present value factor at 25% for 1 and 2 year we can calculate the price as of 0th year which is now.

Price 2017/(1+Rate)^year

Present Value

Year Amt in $

2017 24.89511

2018 36.98331

As the stock is trading at $ 32.50 per share, if Lara has an investment term of 2 years then the stock is expected to give the required rate of return because at end of year 2018 it is expected to trade at $ 57.79 and this could give her a return of 25% p.a.