Question

Question 3: the newspaper reported last week that Little Sheep earned $28 million this year. Sales revenue is $350 million. The company current has an asset turnover ratio of 0.5, and a total equity of $186.667 million. Little Sheep declares that it will pay out 30% of their earnings as dividends. The company has 2 million common shares outstanding. The required rate of return is 12%

1. What is the profit margin of the company?
2. What is the equity multiplier (i.e. leverage)?
3. Find the return on equity of the company
4. Based on your answer in c, what is the growth rate? What will next year’s earnings per share be?
5. What is current price per share of this company today P0, based on the dividend discount model?
6. Now suppose one year from now, the company stars face severe competition, and as a result, its profit margin changes to 6%. All other financial ratios and the discount rate remain the same. Find the stock price one year from now P1.
7. Based on part f, what is the holding period return you earn if you purchase the stock today and sell it one year form now? decompose the return into dividend yield and capital gains yield.

Answer 1

Answer of Part a:

Profit Margin = Profit / Sales * 100
Profit Margin = $28 million / $350 million * 100
Profit Margin = 8%

Answer of Part b:

Asset Turnover Ratio = Sales / Total Assets
0.50 = $350 million / Total Assets
Total Assets = $700 million

Equity Multiplier = Total Assets / Total Equity
Equity Multiplier = $700 million / $186.667 million
Equity Multiplier = 3.75

Answer of Part c:

Return on Equity = Profit Margin * Asset Turnover Ratio * Equity Multiplier
Return on Equity = 8.00% * 0.50 * 3.75
Return on Equity = 15.00%

Answer of Part d:

Retention Ratio = 1 - Payout Ratio
Retention Ratio = 1 - 0.30
Retention Ratio = 0.70

Growth Rate = Return on Equity * Retention Ratio
Growth Rate = 15.00% * 0.70
Growth Rate = 10.50%

Next Year Earnings = This Year Earnings * (1 + Growth Rate)
Next Year Earnings = $28 million * 1.1050
Next Year Earnings = $30.94 million

Next Year Earnings per share = Next Year Earnings / Shares Outstaning
Next Year Earnings per share = $30.94 million / 2 million
Next Year Earnings per share = $15.47