Analyzing A Company – Encore International

Encore International

The international casual-wear company, Encore International, earned close to 300 million United States dollars in sales in the year 2012. This is after being in business for more than 8 years. Although Encore had realized a large growth in sales, securities analysts feared that the company might not keep up to the pace due to fierce competition in the fashion industry. On the contrary, Jordan Ellis, Encore’s founder, was confident that the company could realize an annual growth in dividends in the rate of 6 percent per share in the near future or 8 percent in two years and 6 percent sometimes later. According to Ellis, such growth would result the company’s expansion plan into Latin American and European markets. This paper gives a detailed evaluation of the current stock price of Encore International in order to verify the prediction of Jordan Ellis as well as those of the securities analysts.

What is the firm’s current book value per share?

  1. Book value per share is used to compare the amount of stockholder’s equity to shares outstanding. It is one of the measures used to show the value of stock of a company. Book value per share for a firm is calculated by diving book value of common stock equity by total common share outstanding (Fernandes, 2007). Therefore, the current book value per share for Encore International is:

Book value/Shares outstanding=60,000,000/2,500,000= 24 United States Dollars.

What is the firm’s current P/E ratio?

  1. Price-to-Earnings ratio is used to value a company that measures its share price in relation to its earnings per share. This ratio is calculated by dividing price per share of common stock by earnings per share (Shen, 2000). The current Price-to-Earnings ratio for Encore International is

Price per share of common stock/earnings per share=40/6.25= 6.4 United States Dollars.

What is the current required return for Encore stock?

  1. Required rate of return in one of the metrics used in equity valuation. The purpose of the required rate of return is to set the minimum return that investors are expected to accept, given all other required options are available. One of the models used to calculate the required rate of return is the Capital Asset Pricing Model, CAMP model (Greenwood and Shleifer, 2013). Required rate of return of a company’s stock is calculated by:

Risk-free-rate + β stock (Rmarket-Risk-free-rate), where β is equal to 1 and (Rmarket-Risk-free-rate) is equivalent to the risk premium on stock.

(1). Therefore, the current required return for Encore stock is:

6 percent + 1 (8.8 percent) = 14.8 percent.

What will be the new required return for Encore stock assuming that they expand into European and Latin American markets as planned?

(2). The new required return for Encore stock assuming that they expand into European and Latin American markets as planned is:

6 percent + 1 (10 percent) = 16 percent.

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?

  1. Suppose there is no growth in future dividends, the value per share of the Encore’s stock is calculated by dividing common stock dividend per share by the new required return on the company’s stock. Since there is no growth in dividends, the value of stock dividend is equal to one. This is gotten by:

(4 United States Dollars X 1) / (16 percent-0) = 25 United States Dollars.

  1. (1). If Jordan Ellis’ predictions are correct, the value per share of Encore stock if the company maintains a constant annual growth rate of 6 percent in future dividends is:

(4 United States Dollars X 1.06) / (16 percent-6 percent) = 42.4 United States Dollars.

(2). If Jordan Ellis’ predictions are correct, the value per share of Encore stock if the company maintains a constant annual 8 percent growth rate in dividends per share over the next two years and 6 percent thereafter is:

= ($4 x 1.08/1.16) + ($4 x {1.08}² /{1.16}²) + ($4 x {1.08}² x {1 + 6%}/10%/

= 3.72 + 3.47 + (49.5/{1.16}²)

= 7.19 + 36.79

= 43.98 United States Dollars.

  1. Table 1: Stock values for Encore International
Valuation Method                    Values in United Stated Dollars
Book value per share 24
Zero growth 25
Constant growth 42.4
Variable growth 43.98
Stock price 40

The current (2012) price of the stock and the stock values found in parts a, d, and e are different as represented in table 1 above. These values differ because of the variations in the growth of dividends. From table 1 above, book value per share cannot be used as stock valuation for Encore International, but it can only compared with other stock values to understand the impacts of dividend growth on the value of stock. Among the stock values given in the table, zero growth is a conservative method of stock valuation for Encore International, but it cannot be used in this case because it lacks some sense of reality. Constant growth and variable growth have similar targets on stock price, but variable growth is more realistic than constant growth since it can be used to measure shifts in stock prices considering the changing expectations about the company’s future performance in the fashion industry. Based on the calculations above, Encore’s current stock is still undervalued as compared to the value of variable growth. The company should consider its financial plan as well as the risks involved in order to experience growth in future dividends.

 

References

Fernandes, P. (2007). Company valuation methods: The most common errors in valuation. IESE Business School: University of Navarra Press.

Greenwood, R. & Shleifer, A. (2013). Expectations of returns and expected returns. Harvard: Harvard Business School.

Shen, P. (2000). The P/E ratio and stock market performance. Economic Review, Fourth Quarter, 23-36.

 

 

 

 

 

 


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