Executive summary
Regan Inc. has been involved in the installation and manufacturing of commercial heating, ventilation and cooling (HVAC) units. This report uses dividend growth model to estimate the price of the stock. The report calculates the price of the stock of Regan Inc. after including the super growth period that the company would observe after advancement in technology. Price to earnings ratio of the company has been used and compared it with the industry to analyze how the investors think about the company’s future as well as the industry future. Return on equity has also been calculated if the growth rate of the company is equal to the industry average and then the report formulates strategy that shareholders can take to increase the price of the stock without increasing the level of debt and without losing the control. The report also presents the conclusion at the end.
Introduction
Regan Inc. is a company that has been formed by Carrington and Genevieve Regan. The company has been equally owned between the siblings with each having 50% shares of the company. The company is involved in manufacturing, installation of commercial heating, ventilation and cooling (HVAC) units. Regan Inc. has been growing over the last few years and with the improvements in technology, the growth is expected to improve.
This report analyzes the value per share of Regan Inc. with the current growth rate. Then the report estimates the stock price of the company with higher growth rate and then the price to earnings ratio is used to identify the value of the company. The price to earnings ratio of the industry is also identified and then compared with the price to earnings ratio of Regan Inc. the results of the price to earnings ratio are then analyzed in detail and interpreted using a different formula. Moreover, the expected return on equity of the company are calculated if the growth rate is slowed down up to the pace of the growth of the industry. This report also discuss the strategy that the shareholders can take in order to increase the price without increasing the ratio of debt in their capital structure and without selling shares to other investors. The report also discusses assumptions that have been used in calculating the worth of the company. The last section of the report presents the conclusion and recommendations.
There are different techniques that are used to calculate the value per share of the company. However this report uses dividend growth model to calculate the worth of the company. The concept of dividend growth model reveals that the dividend paid by the company has a very important part in determining the price of the stock. According to this model, the future dividends are discounted and then the price of the stock is determined (Bodie, Kane, and Marcus, 2004).. Dividend growth model has been used frequently by investors to analyze the worth of the shares of the company and it is calculated using the following formula:
P=D*( 1+g)(R-g)
In the above formula, P is the price of the stock
D is the dividend per share of the company
g represents the growth rate of the company
R shows the required rate of return
The values of Regan Inc. have been assumed and these values are:
So, by using the above values in the equation the price or value per share of the Regan Inc would be $17.25
Estimated stock price of the company with high growth rate
It has been expected that the growth rate of the company increases for a period of five years because of technological advancement, therefore the growth rate of the company would increase. The high growth rate of Regan is assumed to be 50% for 5 years and then it will be slowed down and become equal to the company growth rate of 15%.. Non constant growth model is used to determine the price of the stock when the growth rate of the company is high for a particular period and then it is expected to slow down (Besley, & Brigham, 2007). The formula to calculate the price of the stock with non constant growth model is as follows;
Price of the stock=k=0nDt1+k t+Dt (1+g)(k-g)
Thus by discounting the dividends that Regan would earn in the next five years, the price of the share of the company would be $134.35.
Price to earnings ratio
Price to earnings ratio is one of the most used ratios by investors to analyze the worth of the company. Price to earnings ratio is the ratio of the stock price or market value per share of the company and the earnings per share of the company (McLaney, 2009). If the value of the Price to earnings ratio is high, then it shows that investors are expecting the stock to grow at a higher rate and higher earnings in future. However if the value of PE ratio is low, then it shows that the investors are not very confident about the earnings of the company (Beaver, 1966). Although PE is used by many investors as one of the tools to determine the price of the stock, however it is has been recommended to not use this ratio or technique as the only technique to make the decisions (Ross, Westerfield, and Jordan, 2009).
Price to earnings ratio of the industry
Price to earnings ratio of the industry is calculated using the following formula:
Price to Earnings Ratio=Market Value of the shareEarnings per share
So using the above formula, the Price to earnings ratio is found to be 26.84. The PE ratio reveals that investors are willing to pay $26.84 more for $1 of current earnings of the industry.
Price to earnings ratio of the company
The price to earnings ratio of Regan Inc has also been calculated. The price for the company has been determined previously using the dividend growth model and earnings per share of the company have been assumed to be $1.5 per share. Therefore by using these values, the Price to Earnings ratio of the company has been calculated and it is found to be 11.5
Relationship between the two ratios
There is relationship between the Price to earnings ratio of Regan Inc. and Price to earnings ratio of the industry because Regan Inc also belongs to the same industry and as the industry would grow, Regan Inc. is also expected to grow. It has been expected that because of advancement in technology, there would be improvements in the demand of the stock of the companies operating in this industry, thus Regan being part of the industry would also expect to receive an increase in the demand and thus, the company can expect an increase in the price of the stock and therefore it would also increase the Price to earnings ratio not only of the industry but also of the company as well.
Price to earnings ratio show how investors feel and predict the future of the company (Lev, 1969). As from the calculations it has been found that the Price to earnings ratio of Regan Inc. is 11.5 whereas the average of the industry is as high as 26.84 and there is a huge difference between the two ratios. This difference between the two ratios identify that the investors are expecting goods returns from the overall industry however the performance of Regan Inc. is not up to the mark and the investors are not highly confident whether the stock of the company would yield sufficient returns therefore they are not ready to pay higher amount to attain the shares of the company.
Interpreting the Price to earnings ratio
Price to earnings ratio can also be calculated using the following formula:
P0/E1 = 1-b / R – (ROE * b)
In the above equation, P0 shows the current price
E1 shows the earnings of the company in the next period
b shows the retention ratio of the company
R shows the required rate of return
ROE shows the Return On Equity
In order to calculate the ROE of Regan Inc. the following formula has to be used:
Growth = Retention ratio * ROE
Or, ROE = Growth rate / Retention ratio
So, by using the above values the ROE of Regan is found to be 18.75%.
So with the value of ROE identified, the PE ratio of Regan Inc. using the new formula is found to be 10.
Now the same formula will be applied to calculate the price to earnings ratio of the industry. However to use this formula, the retention ratio of the industry has to be calculated and it is found by the following formula:
Retention Ratio=Dividends per shareEarnings per share*100
So by using the above formula the retention ratio of the industry is found to be 88.46%.
Now the Price to earnings would be calculated using the other formula and it is found to be 4.086
This formula has shown contradictory results i.e. the Price to earnings ratio of industry is much lower than the price to earnings ratio of Regan. Thus using this formula it is identified that Regan has performed better than the industry and investors are more confident about the earnings of Regan in comparison to the industry.
One of the main reasons of using this formula is that it is linked with the dividend growth model and this formula uses the ratio of dividends that the company pays to its shareholders as an important component. The payout ratio of the industry is very low in comparison to the Regan Inc and this has been the main reason for lower PE of industry than the PE of Regan.
Future return on equity if growth rate of the company slows to the industry average in five years
If the growth rate of the company slows down to the industry average then the ROE of the company will be calculated using the same formula:
ROE = Growth rate / Retention ratio
The growth rate is equal to the industry growth rate which is 10% and retention ratio would be 80%. So the ROE of the company would be 12.5%
Strategy to Increase the Stock price
There are few strategies that Carrington and Genevieve can follow in order to increase the price of the stock. However as Carrington and Genevieve do not want to sell the stocks to outside investors as they would lose control over the business and at the same time they do not want to increase the level of debt in their capital structure, therefore one of the strategies that these two can follow is to increase the dividend that has been paid. Dividend paid by the firm is one of the most important elements that help in increasing the price of the stock. The price of the stock is calculated as mentioned in the dividend growth model by the following formula:
P=D*( 1+g)(R-g)
In the above formula, if dividends are increased then it will increase the price of the stock directly. Currently the dividend paid per share is $0.3 per share out of the $1.5 earnings per share. If the dividends are increased to $1 per share then the stock price would jump from $17.25 to $57.5. So by increasing the dividends, the stock price can be increased.
Assumptions in the analysis
There are some assumptions used in this report in order to analyze and compare Regan against its competitors and industry. Assumptions about Regan Inc. that have been used are presented in the table below:
All these values have been assumed in order to find the price and value of the share and compare it with the industry.
Conclusion and recommendations
The report has used dividend growth model to calculate the price of the Regan Inc. The report has also used the high growth rate of the company as the industry expects to use advance technology and thus it would lead to an increase in the earnings and the earnings are expected to remain high for five years. The report has also used the Price to earnings ratio of the company and then compared it with the industry Price to earnings ratio. Moreover, the detailed formula to calculate the PE ratio has also been used and it has shown that the PE of Regan is higher than the PE of industry and the main reason is that the industry payout ratio is very low in comparison to the payout ratio of Regan and this has been the main factor that has decreased the PE ratio of the industry.
The report has also recommended the strategy that Carrington and Genevieve should use to increase the price of the stock without losing the control of the company and without increase the level of debt and the strategy is to increase the payout ratio. With higher dividends paid by the company because of higher payout ratio, the price of the company would increase. The management of the company i.e. Carrington and Genevieve need to follow this strategy as it would help them to increase their stock price.
References
Beaver, W. H. (1966). Financial ratios as predictors of failure. Journal of accounting research, 71-111.
Besley, S., & Brigham, E. (2007). Essentials of Managerial Finance, 14 edn. USA: Thomson Higher Education.
Bodie, Z., Kane, A., and Marcus, A. (2004). Essentials of Investments, 5th ed. London, McGraw-Hill Irwin.
Lev, B. (1969). Industry averages as targets for financial ratios. Journal of Accounting Research, 290-299.
McLaney, E. (2009). Business Finance: Theory and Practice. Pearson Education: New Jersey.
Ross, S., Westerfield, R., and Jordan, B. (2009). Fundamentals Of Corporate Finance Standard Edition. New York, McGraw-Hill.
