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Chapter (7):

Stocks Valuation
Integrative Case 3
Encore International
In the world of trendsetting fashion, instinct and marketing savvy are prerequisites to
success. Jordan Ellis had both. During 2015, his international casual-wear company, Encore,
rocketed to $300 million in sales after 10 years in business. His fashion line covered the
young woman from head to toe with hats, sweaters, dresses, blouses, skirts, pants,
sweatshirts, socks, and shoes. In Manhattan, there was an Encore shop every five or six
blocks, each featuring a different color. Some shops showed the entire line in mauve, and
others featured it in canary yellow. Encore had made it. The company’s historical growth
was so spectacular that no one could have predicted it. However, securities analysts
speculated that Encore could not keep up the pace. They warned that competition is fierce
in the fashion industry and that the firm might encounter little or no growth in the future.
They estimated that stockholders also should expect no growth in future dividends.
Contrary to the conservative securities analysts, Jordan Ellis believed that the company
could maintain a constant annual growth rate in dividends per share of 6% in the future, or
possibly 8% for the next 2 years and 6% thereafter. Ellis based his estimates on an
established long-term expansion plan into European and Latin American markets. Venturing
into these markets was expected to cause the risk of the firm, as measured by the risk
premium on its stock, to increase immediately from 8.8% to 10%. Currently, the risk-free
rate is 6%. In preparing the long-term financial plan, Encore’s chief financial officer has
assigned a junior financial analyst, Marc Scott, to evaluate the firm’s current stock price. He
has asked Marc to consider the conservative predictions of the securities analysts and the
aggressive predictions of the company founder, Jordan Ellis. Marc has compiled the
following 2015 financial data to aid his analysis.

Data item 2015 value


Earnings per share (EPS) $6.25
Price per share of common stock $40.00
Book value of common stock equity $60,000,000
Total common shares outstanding 2,500,000
Common stock dividend per share $4.00

TO do
a. What is the firm’s current book value per share?
b. What is the firm’s current P/E ratio?
c. (1) What is the current required return for Encore stock?
(2) What will be the new required return for Encore stock assuming that the firm
expands into European and Latin American markets as planned?
d. If the securities analysts are correct and there is no growth in future dividends, what
will be the value per share of the Encore stock? (Note: Use the new required return
on the company’s stock here.)
e. (1) If Jordan Ellis’s predictions are correct, what will be the value per share of Encore
stock if the firm maintains a constant annual 6% growth rate in future dividends?
(Note: Continue to use the new required return here.)
(2) If Jordan Ellis’s predictions are correct, what will be the value per share of Encore
stock if the firm maintains a constant annual 8% growth rate in dividends per share
over the next 2 years and 6% thereafter?
f. Compare the current (2015) price of the stock and the stock values found in parts a,
d, and e. Discuss why these values may differ. Which valuation method do you
believe most clearly represents the true value of the Encore stock?

Answer:
a. What is the firm’s current book value per share?
Book value of common stock equity $60,000,000
The Current book value per share = = = $ 24
Total common shares outstanding 2,500,000

b. What is the firm’s current P/E ratio?


Price per share of common stock $40
The Current P/E ratio = = = 6.4
Earnings per share (EPS) $6.25

c.
(1) What is the current required return for Encore stock?

Givens:
 The Current risk premium is 8.8%
 the risk-free rate is 6%
Then
The Current Required Rate of Return (RRR) = Current Risk-Free rate + Current Risk Premium
= 6% + 8.8
= 14.8%
(2) What will be the new required return for Encore stock assuming that the firm
expands into European and Latin American markets as planned?
Given (With the assumption of expand):
 The Risk Premium is 10%
 The Risk – Free is 6%
Then:
The New Required Rate of Return (RRR) = Risk- Free rate + The New Risk Premium
= 6% + 10%
= 16%
d. If the securities analysts are correct and there is no growth in future dividends,
what will be the value per share of the Encore stock? (Note: Use the new required
return on the company’s stock here.)
Given:
 Form (2C) - The New Required Rate of Return (RRR) = 16%
 Common stock dividend per share $4.00
then
Using Zero Growth Dividends
𝐷 $4
The Present Value Per Share = 𝑃0 = = = $25
𝑟 16%

e.
(1) If Jordan Ellis’s predictions are correct, what will be the value per share of
Encore stock if the firm maintains a constant annual 6% growth rate in future
dividends? (Note: Continue to use the new required return here.)
Given:

 Constant annual growth (g) = 6%


 a constant annual growth rate in dividends per share of 6%
 Form (2C) - The New Required Rate of Return (RRR) = 16%
 Common stock dividend per share $4.00
then
Using Constant Growth
(𝐷0∗ constant annual growth rate in dividends per share)
The Present Value Per Share P0=
(𝑟−𝑔)
($4∗1.06)
= = $ 42.4
(16%−6%)

(2) If Jordan Ellis’s predictions are correct, what will be the value per share of
Encore stock if the firm maintains a constant annual 8% growth rate in dividends
per share over the next 2 years and 6% thereafter?

Given:

 Constant annual growth next 2 Year (g) = 8%


 Constant annual growth thereafter (g) = 6%
 Form (2C) - The New Required Rate of Return (RRR) = 16%
 2015 Common stock dividend per share (D0) $4.00
Then
Using Variable Growth
𝐷1 = 𝐷0(1 + 8%)1 = 4(1.08)1 = 4.32
𝐷2 = 𝐷0(1 + 8%)2 = 4(1.08)2 = 4.67
𝐷3 = 𝐷2(1 + 6%)1 = 4.67(1.06)1 = 4.95
𝐷1 4.32
𝑃𝑉1 = = (1+16%)1 = $3.72
(1+𝑅𝑅𝑅)1

𝐷2 4.67
𝑃𝑉2 = = = $3.47
(1+𝑅𝑅𝑅)2 (1+16%)2

𝐷3 4.95
𝑃𝑉3 (𝑎𝑡 𝐷2) = = = $49.5
𝑅−𝑔 16%−6%

49.5 49.5
𝑃𝑉(𝐴𝑡 𝐷0) = = = $36.77
(1+𝑅𝑅𝑅)2 (1+16%)2

PV = 3.72+3.47+36.77 = $43.96

f. Compare the current (2015) price of the stock and the stock values found in parts
a, d, and e. Discuss why these values may differ. Which valuation method do you
believe most clearly represents the true value of the Encore stock?

Valuation Method Per Share


Price per share of common stock $40
The Current book value $24
Using Zero Growth Dividends $25
Using Constant Growth $42.4
Using Variable Growth $43.96

The Values Different Because: It has differences on dividends growth.


 BV per share: Can’t be used as stock valuation, except comparing it with peers and
using it as P/B multiples.
 Zero Growth: the most conservative method, but lacks of reality sense therefore not
good method.
 Constant and variable Growth: Both methods have similar stock price target, but
variable is more realistic since it measures shift up or down due to the changing
expectations.

valuation method I believe most clearly represents the true value of the Encore stock
Base on the computation, the book value has no relevance to the true value of the firm. Of
the remaining methods, the most conservative estimate of value is given by the zero-growth
model. Wary the analyst should advise paying no more than $25 per share.