FINC Case Study | essaymoose

Submitted by: James Bunsa

For: FINC 5880

Date: 11 Apr 2014

a. Current Situation

Company I nformationGilbert Enterprises, the third largest publicly traded firm in the auto parts replacement industry, had experienced a decline in its stock price over the past five months. Its founder and chairman, Tom Gilbert, along with the Finance VP, were considering a stock repurchase, thinking the announcement would send a message to investors about the current market undervaluation of the stock.

Industry and Economic InformationResearch had indicated that auto owners were keeping their vehicles longer (8 years on average, up from 6.8 years twenty years earlier), and new vehicle price increases had surpassed the rise in consumer incomes. The trend of investing in older vehicles to keep them on the road longer would bode well for Gilbert. In addition, Gilbert had invested in an industry-leading JIT inventory management system and as a result expected supernormal growth over the next several years.

b. Major Issues

Several significant issues that Gilbert faces include:

· Develop these issues preliminarily, and readdress/refine them after answering the case-specific questionsDoes the growth rate seem reasonable, given the current and expected circumstances (economic and industry)?

· Does the current stock price fairly represent Gilbert’s value in the market?

· What is the “real” value of Gilbert’s stock? And how should it be determined (methods, process)?

· What other data should be considered in the valuation?

· What decision should they make – repurchase stock or do something else?

· What are the possible investor and market reactions to an announcement?

· Other issues ….

c. Approach

Identify the appropriate analytical techniques (dividend valuation model) to evaluate Gilbert’s value in the market; use a price-earnings approach to supplement the dividend model results; and use selected ratio comparative analysis to fairly position Gilbert against its competitors; and specifically answer the case questions.

d. Case-specific Questions

1. Supernormal growth valuation – does the firm seem to be under or overvalued?

Three steps to find intrinsic value, and then compare to market.

· Find present value of supernormal dividends

Discount future supernormal dividends back to present at 10% (required rate of return)

Current dividend

D0 =

(given)

1.20

Future dividends

D1 =

(D0 * 1.15)

1.38

0.9091

1.25

D2 =

(D1 * 1.15)

1.59

0.8264

1.31

D3 =

(D2 * 1.15)

1.83

0.7513

1.37

Total

3.94

Present value of dividends during the supernormal growth period =

3.94

These are calculations to answer the questions

· Find the present value of the future stock price

Find PV of future stock price

P3 = stock price when supernormal growth ends

D4 = dividend at time 4 when constant growth is 6%

Ke = required rate of return (cost of equity = 10 percent

10%

g = 6 percent (constant growth)

P3 =

Ke – g

D4 = D3 (1 + g)

1.935

P3 =

48.363825

Must discount stock price back to current – find PV

at 10%

Est of P0

$36.34

· Find total value (stock price plus value of dividends)

Add price of stock and value of dividends to get total value

Estimate of P0 =

$36.34

If rounding earlier in the problem

Add PV of dividends =

3.94

total is as high as $40.37

Total

$40.27

Conclusion: Because the stock is selling in the market for 35 1/4th, it appears to be undervalued.

2. Gilbert’s P/E ratio is currently is the second lowest of all firms in the industry. However, based on the financial information provided in Figure 1 this does not appear to be appropriate, given that Gilbert currently has the highest growth rate of EPS and growth is expected to accelerate to 15% (supernormal) growth over the next three years.

This is financial ratio a nalysisIt also has the second highest return on stockholder’s equity, and the firm leading this category has a very high debt ratio (resulting in a relatively smaller proportion of equity over which to spread the earnings – it is possible to generate a high return on equity using debt, but still have relatively low profitability, as Reliance has in this case as indicated by its lowest return on total assets ratio in the industry).

In evaluation debt utilization as a separate issue, Gilbert once again looks attractive with a debt to total asset ratio of 33%, with Standard Auto being the only firm with a better (lower) ratio.

Market Values

Market

Book

Replacement

Market

Market to

Value

to Book

Replacement

Gilbert Enterprises

35.25

16.40

43.50

2.15

0.81

Relaince Parts

70.50

50.25

68.75

1.40

1.03

Standard Auto

24.25

19.50

26.00

1.24

0.93

Allied Motors

46.75

50.75

27.50

0.92

1.70

Evaluation of market to book values and market to replacement values will provide additional insight about Gilbert’s financial position in the industry. Although pro forma market value to book value ($40.27/$16.40 = 2.46) is high compared to others (1.40 to .92), this is not an especially meaningful value, because book value is based on historical cost. A more meaningful value is market to replacement, in which Gilbert is much more conservative ($40.27/$43.50 = .93), and is comparable to Standard Auto ($24.25/$26.00 = .93).

Dividends are another area where Gilbert is excelling, second only to Standard in dividend yields.

Finally, how would Gilbert’s pro forma P/E ratio compare with the industry? One must first calculate the EPS, since it is not provided.

P/E = Stock Price/EPS

16.8 = $35.25/EPS

EPS = $35.25/16.8 = $2.098 per share

Now, calculate the pro forma P/E ratio given the estimate of the intrinsic stock price of $40.27 in the earlier analysis.

P/Epf = $40.27/$2.098 = 19.2, still within the appropriate range for the industry (industry average is now 18.9).

In summary, Gilbert appears to be undervalued compared to its competition, considering all of the findings previously reported.

3. Recommendations to Albert Roth:

Based on the answers to Questions 1 and 2, Gilbert Enterprises appears to be undervalued, and Roth should seriously consider recommending the firm repurchase part of its shares in the marketplace. However, there is reason to be cautious:

· Be creative here; you get credit for thinking outside the box (but not too far out)Markets are efficient in their pricing of securities (Efficient Market Hypothesis), and there may be some information that we are not aware of that justifies Gilbert’s lower valuation.

· Secondly, even if the stock is undervalued in the marketplace, management must make certain that this is the best use of its limited investment funds (examine alternative uses).

e. Other options?

Although there are no indications in the case that Gilbert has alternatives to this repurchase plan, it should exhaust the possibilities of purchasing another firm or firms in the industry that might provide positive synergies, add sales in areas that Gilbert is lacking, cover geographic areas currently underserved, or focus on a firm that provides a good “fit” with its state-of-the-art inventory management systems.

As an alternative, it could significantly reduce the number of shares it in considering (up to one million shares), and use the remainder for other investments.

f. Prediction

I believe that Albert Roth will recommend the repurchase, and that it will be successful. After all, Roth in an investment banker and is there to serve his client while earning profits from additional revenue for his firm – Baker, Green and Roth.