Question

Tom and Tina are the co-founders of Genesis2 Electronics Ltd, a company that manufactures and installs contemporary models of electronic products for residential and commercial purposes. Genesis2 Electronics Ltd has experienced rapid growth recently because of the new technology that enhances the energy efficiency of its systems. The company is owned equally by Tom and Tina, each holding 100,000 shares. If either wishes to sell the shares, the shares have to be offered first to the other shareholder at an agreed price. Recently Tom and Tina 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 (Cents)	DPS (Cents)	Share Price ($)	ROE (%)	Required rate (%)
Colonial Electronics Ltd	0.42	0.10	8.25	10.5	10.5
Reliable Solutions Ltd	0.66	0.26	6.25	11.5	11.5
Silver Lining Electronics Ltd	-0.24	0.27	22.40	12.5	12.5
Industry Average	0.28	0.21	12.30	11.5	11.5

Last year, Genesis2 Electronics Ltd had an EPS of $2.725 and paid a dividend to Tom and Tina of $102,500 each. The company also had a return on equity of 14.5%. Tom and Tina believe a required rate of return of 12.5% for the company is appropriate.

Q1. William, an equity analyst, has a good understanding of the electronics industry and so Tom and Tina hired William to verify the company calculations. William has examined the company’s financial statements as well as those of its competitors. Although Genesis2 Electronics Ltd currently has a technological advantage, William’s research indicates that Genesis2’s competitors are implementing other methods to improve their efficiency. Given this, William believes that Genesis2’s 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. Also, William believes that currently the company’s required rate of return is too high and so the industry average required rate of return is a more appropriate rate for valuation. Under William’s assumptions, what is the estimated share price?

Q2. What is the industry average price-earnings ratio? What is Genesis2’s price-earnings ratio based on William’s estimation above in part (2)? Comment on any differences and explain why these differences may exist?

Q3. After discussion with William, Tom and Tina agree that they would like to increase the value of the company’s equity. They want to retain control of the company and so 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 your suggestions.                                                                                                          

Answer 1

Q1.

Estimate share price for Genesis2 can be calculated using below formula:

Share Price = (Dividends per share + Expected Price) / (1 + Expected Return)

Here,

Dividend per share = Total dividends paid/number of shares

= $102,500 + $102,500/ 100,000 + 100,000

= $205,000/200,000

= $1.025

Expected price (as per industry average) = 12.30

According to William, the required rate of return as expected by Tom and Tina is too high. According to him, industry average required rate of return is a more appropriate. Thus,

Industry average required rate of return = 11.5

Therefore,

Stock Price = (Dividends per share + Expected Price) / (1 + Expected Return)

= (1.025 + 12.30)/(1 + .115)

= 13.325/1.115

= $11.95

Q2.

Industry average price-earnings ratio = Market price per share for industry/Earnings per share for industry

= $12.30/$0.28

= 43.9

Genesis2’s price-earnings ratio = Market price per share of Genesis2 /Earnings per share of Genesis2

= $11.95/$2.725

= 4.38

Price-earnings ratio reflects how much an investor should pay for a share on the basis of the current earnings. There is a significant difference between industry average price-earnings ratio and Genesis2’s price-earnings ratio. High industry average price-earnings ratio indicates that investors are anticipating high growth in the future, while low price-earnings ratio for Genesis2 means that company’s earnings growth prospects are lower than that of industries. This difference mainly exists because Genesis2’s technological advantage is only limited to 5 years of time. During these 5 years, company will grow but post that company may face decline in the growth.

Q3.

To increase the share price, Genesis2 Electronics can follow below steps:

1. Genesis2 can buyback their shares from the marketplace. That is, they can use its cash to buy its own shares. By doing so, Genesis2 can convince the markets that its shares are reliable and its future performance will improve. This way, Tom and Tina would be able to retain their control of the company.
2. Second, Genesis2 can also go for corporate restructuring. They can segregate their business divisions and business units into sub-units. This way, even if any unit performs below the overall performance of the company, they can sell that unit to another firm and improve the financial performance through higher demand for equity.
3. Third, Genesis2 can diversify its portfolio. They can re-invest a certain amount of net income in the company and distribute rest as dividend which will impact positively on the share price.