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Rebel Cole Sports Dividend Payments and PVGO Present Value of Growth Opportunities

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Ten years ago, in 1998, Rebel Cole founded a small mail-order company selling high-quality sports equipment. Since those early days, Cole Sports has grown steadily and has been consistently profitable. The company has issued 2 million shares, all of which are owned by Rebel Cole and his five children.

For some months Rebel has been wondering whether the time has come to take the company public. This would allow him to cash in on part of his investment and would make it easier for the firm to raise capital, should it wish to expand in the future.

But how much are the shares worth? Rebel’s first instinct is to look at the firm’s balance sheet, which shows that the book value of the equity is $26.34 million, or $13.17 per share. A share price of $13.17 would put the stock on a Price/Earning ratio of 6.6, which is much lower than the 13.1 P/E ratio of Rebel’s larger rival, Molly Sports.

Rebel suspects that book value is not necessarily a good guide to a share’s market value. He thinks of his daughter Jenny, who works in an investment bank. She would undoubtedly know what the shares are worth. He decides to phone her after she finishes her work that day at 9pm or before she starts the next day at 6am.

Before phoning, Rebel writes down some basic data on the company’s profitability. After recovering from its early losses, the company has earned a return that is higher than its estimated 10% cost of capital. Rebel is fairly confident that the company could continue to grow steadily for the next 6 to 8 years. In fact he feels that the company’s growth has been somewhat held back in the last few years by the demands from two of the children for the company to make large dividend payments. Perhaps, if the company went public, it could hold back on dividends and plow more money back into the business.

There are some clouds on the horizon. Competition is increasing and only that morning Molly Sports announced plans to form a mail-order division. Rebel is worried that beyond the next six or so years it might become difficult to find worthwhile investment opportunities.

Rebel realizes that Jenny will need to know much more about the prospects for the business before she can put a final figure on the value of Cole Sports, but he hopes that the information is sufficient for her to give a preliminary indication of the value of the shares.

   1999   2000   2001   2002   2003   2004   2005   2006   2007   2008(E)
EPS($)   -2.1   -0.70   0.23   0.81   1.10   1.30   1.52   1.64   2.00   2.03
Div ($)   0.00   0.00   0.00   0.20   0.20   0.30   0.30   0.60   0.60   0.80
BV ($)   9.80   7.70   7.00   7.61   8.51   9.51   10.73   11.77   13.17   14.40
ROE(%)   -27.0   -7.1   3.0   11.6   14.5   15.3   16.0   15.3   17.0   15.4
Note: EPS = earnings per share, Div = dividends per share, BV= book value per share
ROE = return on equity. The figures of 2008 are based on estimates.

Questions:

a) Help Jenny forecast dividend payments for Cole Sports and to estimate the value of the stock. You do not need to provide a single figure. For example, you may wish to calculate two figures, one on the assumption that the opportunity for further profitable investment is reduced in year 6 and another on the assumption that it is reduced in year 8.

b) How much of your estimate of the value of Cole’s stock comes from the present value of growth opportunities?
(Hint: you can make your assumptions and change the estimated inputs, but make sure that your assumptions are consistent with the information provided and with the theories you have learned from this course)

Solution

Case 1: Assuming that the business can expand for the next 6 years and the growth in earnings to be 50% every year, the earnings per share is calculated. The plowback rate is currently 70%. If this is increased to 80% for the next 6 years, the dividend payments can be computed. Case 2: When there are opportunities for 8 years, then the dividend payments can be calculated using the same assumptions as case 1. PVGO (Present Value of Growth Opportunities) is computed from the growth rate, which in turn is computed using the return on equity and the plowback ratio.

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Rebel Cole Sports Dividend Payments and PVGO Present Value of Growth Opportunities

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