Question

Stock Valuation at Ragan, Inc.

Ragan, Inc., was founded nine years ago by brother and sister, Carrington and Genevieve Ragan. The company manufactures and installs heating, ventilation and cooling (HVAC) units. Ragan, Inc., has experienced rapid growth because of a proprietary technology that increases the energy efficiency of its units. The company is equally owned by Carrington and Genevieve. The original partnership agreement between the siblings gave each 50,000 shares of stock in the company. In the event either wished to sell their stock, the shares first would have to be offered to the other at a discounted price.

            Although neither sibling wants to sell, they have decided that they should determine the value of their ownership in the company. To get started, they have gathered information about their main competitors, provided in the table on the next page.

            One of their competitors, Expert HVAC Corp., had negative Earnings Per Share last year, due the result of a one-time accounting write-off. Had the write-off not occurred, Earnings Per Share for that company would have been $1.10. The Return On Equity for Expert HVAC Corp is based on net income excluding the one-time write-off.

            Last year, Ragan, Inc., had an Earnings Per Share of $3.15 and paid a dividend to Carrington and Genevieve of $45,000 each. The company also had a Return On Equity of 17 percent. The siblings believe that 14 percent is an appropriate required return for the company.

(continued on next page)

Ragan, Inc. - Competitors
Company name	EPS	DPS	Stock Price	ROE	R
Arctic Cooling, Inc.	$1.30	$0.16	$25.34	8.50%	10%
National Heating & Cooling	1.95	0.23	29.85	10.50	13
Expert HVAC Corp.	-0.37	0.14	22.13	9.78	12
Industry average	$0.96	$0.18	$25.77	9.59%	11.67%

2) To verify their calculations, Carrington and Genevieve have hired Josh Schlessman as a consultant. Josh was previously an equity analyst who covered the HVAC industry. Josh has examined the company’s financial statements, as well as examining its competitors’ financials. Although Ragan, Inc. currently has a technological advantage, his research indicates that other companies are investigating methods to improve efficiency. Given this, Josh believes that the company’s competitive advantage will only last for the next five years. After that time period, the company’s growth will likely slow to the industry growth average. Additionally, Josh believes that the required return used by the company is too high. He believes the industry average required return is more appropriate. Under this growth rate assumption, what is your estimate for the stock price of Ragan, Inc.?

Answer 1

According to the given information, the stock price of the company can be calculated as below

Shares owned by Carrington and Genevieve = 50,000 each

Dividend paid last year = $ 45,000 each

No of total Shares = 50000 * 2 = 100,000 shares

Total Dividend paid to Carrington and Genevieve = 45,000 * 2 = $ 90,000

therefore Dividend per share comes out to be

= Total Dividend / Total Shares

= 90,000 / 100,000 = $ 0.90 per share

As industry average required return is considered more appropriate, we will consider this rate for calculating the future expected dividend

Industry average of EPS in the last year = $ 0.96

Industry average of DPS in the last year = $ 0.18

Dividend Payout ratio as per Industry Average = DPS / EPS

= 0.18 / 0.96

= 0.1875

Retention Ratio = 1 - Dividend Payout Ratio

= 1 - 0.1875 = 0.8125

Growth rate as per industry average = Retention ratio * Industry average ROE

= 0.8125 * 0.0959

= 0.0779 or 7.79%

Expected Dividend in future = 0.90 * ( 1 + growth rate as per industry average)

= 0.90 * ( 1 + 7.79% ) = 0.90 * 1.0779

= $ 0.97

Also the formulation of stock price using Industry average is as follows

= Expected dividend in future / ( Industry average required return - growth rate as per industry average )

= 0.97 / ( 11.67 - 7.79 )

= 0.97 / 3.88 %

= $ 25

So the Price of the share taking the industry average into account comes out to be $ 25.

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