Question

You run a small private equity firm that specializes in identifying profitable acquisitions. You have identified the small, poorly managed, but profitable company GreenWatches, which has the following characteristics: ROE=7.5%, k=10%, b=60%, E1=3.

a. Just from these values, how do you know that GreenWatches is poorly managed?

b. What is the price (intrinsic value) of the stock and what is the current PVGO of the company? Why is the PVGO negative? You believe that you can turn around the company and increase its ROE to 11%. You believe that you can do so by streamlining operations and doing some downsizing. According to your plan you project the same earnings next year (equal to 3) and you project that, from that base, earnings will grow based on the new ROE and plowback ratio, which you plan to set to 40%.

c. What is the projected dividend next year and what is the new intrinsic value of the stock?

d. A large watch manufacturer figures out that you are trying to buy GreenWatches and decides to bid on it also. However, they do not have the skill to increase the ROE or make the other changes you are planning. The best they can do is to immediately set b=0. At what price does your competitor value GreenWatches?

Answer 1

(a) Retention ratio for the company is 0.6 and so payout should be 0.4. And so the divdends paid D1= E1*0.4 = 1.2. Now as dividends paid is quite high and ROE is quite low which is NI/Total equity and also the cost of equity justifies the amount of dividends paid i.e the total shareholders equity present. So we can say the reason behind low ROE is the low net income or less profitability of the firm, Which clearly indicates that the firm is poorly managed.

(b) For intrinsic value at t=0 i.e P₀ we follow the DDM. For that we find growth rate of firm g= ROE*b = 4.5% and the find D0 = D1/(1+g) = 1..15. Now P₀ = D₀ /(1+k) + D₁ / (k-g) = 22.86.

PVGO = Stock Price (P₀ ) - Earnings (E1) /Cost of equity (k) = 22.86 - 3/0.1 = -7.14. This is negative because of mismanagement of the firm. It indicates the growth opportunities available for a firm over its current status and so we consider here E1 and not E0. In other way we can say PVGO = ROE - required rate of return and so we can easily interpret that as ROE is quite less today and required rate for future is high so the PV of growth opportunities can't be positive.

(c) Now if ROE is increased to 11% and cost of equity is same, so we can expect PVGO to be positive now. Also b= 40% now. So new g = 4.4%. now the projected dividend is D2 = 3*0.6= 1.8

For the new intrinsic value P₀ = D0/ (1+k) +D1/( 1+k)² + D2 / (k-g) = 2.036 + 32.14 = 34.17

(d) If competitor says b=0. That means company makes no growth and payout is 100%. So E1 = D1=D0 as there is no growth so constant growing stock is valued as D₁/ k and D1=E1. So price = 3/0.1 = 30.