Question

Mr Sultan who is a CFO of your company asks you to compute intrinsic value of ABC Ltd. The pertinent financial information about ABC Ltd. are presented below:

      

	2009	2010	2011	2012	2013
Net income (loss)	($3,600)	($1,040)	$10,736	$8,928	$10,978
Beginning book value of equity (1.1.2009)	60,000
Ending Book value	?	?	?	?	?

Additional information:

1- Expected dividend payment is $6,000 per year for all the future years

2- Cost of equity is 10%

3- The current stock price is $10.50 per share with 10,000 shares outstanding.

Required

1-Calculate ABC Ltd.’s abnormal earnings for each of the years from Year 2009 to Year 2013. Use the abnormal earnings model to estimate the intrinsic value of the company.

20The current stock price is $10.50 per share with 10,000 shares outstanding. Critically evaluate whether the firm’s stock is undervalued/overvalued.

Answer 1

Compute Abnormal Earning of each year from year 2009 to 2013

Abnormal Earning= Net Earning-( rate of return* book value)

Net Earning in 2009=($3600)

rate of return =10%

Book value of a company= 60,000

($3600)-( 0.1*60,000)

($3600)-$6000

($2400) Abnormal earning of 2009

2) Abnormal earning of 2010

($1040)-($6000)

($4960)

3) Abnormal earning of 2011

$10,736-$6000

$4,736

4) Abnormal earninng of 2012

$8928-$6000

$2,928

5) Abnormal earning of 2013

$10,978-$6000

$4978

Intrinsic Value of a firm= BV(Book Value) +[AE/(1+r)t]

where: BVt = Book value of equity at beginning of year t r = Cost of equity capital AEt = Expected value of abnormal earnings in year t = Projected earnings in yr t - (r * BV of equity at beginning of year t)

Book Value=60,000+(2400)+(4960)+4736+2928+4978/(1+0.1)^5

60,000+5,282/(1.1)^5

60,000+5,282/1.61

60,000+3280.74

$63281

IN order to know whether the stock price undervalued or overvalued we need to determine first the P/E ratio ie

Price/ Earning ratio

Price= current price per share

Earning= Net income from 2009 to 2013

Net Income=(3600)+(1040)+10,736+8928+10,978=26,002

outstanding shares =10,000

EPS= Net Income/ outstanding shares

=26,002/10,000

=2.60 EPS

Currrent Price=10.5

EPS=2.60

PRICE/EARNING=10.5/2.60

4.03 Times

Stock is overvalued because the earning relatively less than stock price. Price is 4.03 times higher than its earning.