In the world of trendsetting fashion, instinct and marketing savvy are prerequisites to success. Jordan Ellis had both. During 2012, 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 felt 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 these 2012 financial data to aid his analysis:
Data item 2012 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
Required
a. What is the firm's current book value per share? $ 6.25
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 they expand 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?
(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 (2012) 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?