Seahorse Stock Valuation
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AnswersIn order to find the value per share of Seahorse (SH) Inc., we need to calculate its current growth rate. From the data given we know that there are a total of 300.000 shares equally distributed to the two shareholders, EPS is equal to $5.08, ROE is 25% and the required rate of return is 20%. The dividend paid to each shareholder for the last year was $320,000. So DPS is equal to $320,000/150,000shares = $2,13EPSDPSStock PriceROERSeahorse Inc.$5.08$2.13-25.00%20.00% In order to find the current growth rate we begin with the assumption that this year’s earnings should be equal with the earnings of the previous year increased by the appropriate rate of return required by the investors. [pic 1][pic 2][pic 3] ROE for Seahorse is given as 25%. The Retention Ratio (RR) is the percentage of the earnings that stays within the company for further investment after subtracting the dividends to the shareholders.[pic 4][pic 5] The stock price is considered a perpetuity and is calculated as [pic 6] where D1 is next year’s dividend, g is the growth rate that we found and ks is the required rate of return of the firm’s stock which is given as 20%.[pic 7]In this case we will calculate the stock price, assuming that the growth rate and the required rate of return will decline to the industry’s average after five years. This is an example of a supernormal dividend growth model. Taking a closer look to the information of the competitors, we see that Nautigas has a negative EPS of $0.32 as a result of an accounting write-off last year. This is also reflected in the industry’s EPS which seems to be very low. The correct industry’s EPS is calculated if we consider the EPS without the write-off. In this case: EPS= (1.09+1.16+1.97)/3= $1.41
[pic 8] After five years, the growth rate will decrease from 14.5% to 9.2%. The first step is to create a timeline and calculate the dividends.[pic 9]In year 5 the price of the stock (P5) is calculated as perpetuity.[pic 10][pic 11]All these values should be properly discounted with a rate equal to ks=17%, in order to calculate the present value of the stock’s price (P0).[pic 12][pic 13]Price-Earnings (P/E) ratio is calculated by dividing the Market Value per share with the Earnings per share (EPS). P/E ratio shows how much investors are willing to pay per dollar of earnings.In this example the industry average has a P/E ratio of $16.91/$1.41=12, assuming again a non-negative EPS for Nautigas. Seahorse Inc. has a P/E equal to $36.75/$5.08=7.23. P/E ratio usually reflects the expectations that investors have for a company and its future profitability but it should be carefully used for decision making because it can be easily manipulated from accounting methods in the short-term. When evaluating a company based on the P/E ratio we should always compare it with the industry’s average.In this case, Seahorse has a lower than average P/E ratio that might have different interpretations. The low value may indicate that the investors are not expecting high profits for the next years. On the other hand, the low value is an indication that the stock price is undervalued and that the next years the price will increase in order to match the industry’s average. Also, we should notice that the EPS of the company is almost 5 times higher than that of the other firms and affects the P/E ratio, as a denominator. Because Seahorse Inc. is a highly innovative company that uses a unique technology in its products, it is expected that the P/E ratio will increase in the next years mainly by the increase in the market price of the stock.