Valuation of Shares and Returns: A Case Study of Encore

This case study analyzes the impact of business decisions on the valuation of shares and returns for shareholders using Encore as an example. The analysis includes the computation of book value per share, P/E ratio, required return by equity shareholders, and value per share using the Gordon Dividend model.

CASE STUDY
ENCORE
STUDENT ID:
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Introduction
The key objective in the given case is to highlight how the valuation of shares and the
underlying returns that the shareholders may expect tend to get altered by the key business
decisions that the company makes. These computations have been provided for the casual
wear company Encore on the basis of the information provided in the case study.
Analysis
a) The book value per share needs to be determined for which the following formula may be
deployed (Damodaran, 2015).
Book value per share = Book value of common share equity/Total number of common shares
outstanding
Based on the input data, book value of common share equity = $ 60,000,000
Total number of common shares outstanding = 2,500,000
Hence, book value per share = 60,000,000/2,500,000 = $ 24
b) The P/E ratio can be estimated using the following formula (Parrino & Kidwell, 2014).
P/E ratio = Price per share/Earnings per share
Price per share = $ 40
Earnings per share = $ 6.25
Hence, P/E ratio = 40/6.25 = 6.4
c) In the given case, CAPM approach or Capital Asset Pricing Model would be deployed for
computation of the required return by equity shareholders. The requisite equation of this
model is indicated as follows (Petty et. al., 2015).
Expected return on equity = Risk free rate + Beta * Risk premium

(i) Only the current scenario, the company has not ventured into the European & Latin
American markets and hence the risk premium on the stock would be 8.8%. Further, the risk
free rate is given as 6% while the stock beta has been assumed as 1.
Current Required Return for Encore = 6 + 1*8.8 = 14.8% p.a.
(ii) Now the firm has expanded into the European & Latin American markets as per their plan
and in this case the risk premium on the stock would increase from 8.8% to 10%. Further, the
risk free rate remains as 6% while the stock beta has been assumed as 1.
Required Return for Encore = 6 + 1*10 = 16% p.a.
(d) The Gordon Dividend model would be used to estimate the value per share of the Encore
stock using the following equation (Brealey, Myers & Allen, 2014).
Value per share = Next year dividend /(Required Return on Equity – Perpetual dividend
growth rate)
In the given case, the dividend growth rate is zero. Also, the next year dividend would be the
same as this year dividend ($ 4 per share) owing to no growth in dividends in the future.
Hence, value per share (Encore) = 4/0.16 = $ 25
Considering the above as the fair value, it is apparent that at the current market price of $ 40,
the share is overvalued.
Conclusion
From the above analysis, it can be concluded that the business activities undertaken by the
company tends to impact the required return owing to the effect on underlying risk
associated. This in turn impacts the valuation of the stock as is evident from the above
example of Encore. As a result, it is recommended that the companies while taking decisions
about their operational strategies must be mindful of this impact on valuation of company and
returns for shareholders (Damodaran, 2015).

References
Brealey, R. A., Myers, S. C. & Allen, F. (2014) Principles of corporate finance, 6th ed. New
York: McGraw-Hill Publications
Damodaran, A. (2015). Applied corporate finance: A user’s manual 3rd ed. New York: Wiley,
John & Sons.
Parrino, R. & Kidwell, D. (2014) Fundamentals of Corporate Finance, 3rd ed. London: Wiley
Publications
Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M., & Nguyen, H. (2015).
Financial Management, Principles and Applications, 6th ed.. NSW: Pearson Education,
French Forest Australia