Agraja Magesh

Case-1 , Week 2

Case 1 - Value Investing

(Answers found below)
Three months ago, your friend watched a video from a self-proclaimed financial
guru who had a new software that could identify undervalued firms. He was initially
skeptical but purchased the software out of curiosity. Knowing that you were taking a
class on financial management, your friend asked you if you would evaluate one of the
firms that the software identified as undervalued. You told him that you were soon
going on vacation, but to send you the financial statements, you would use a couple of
common metrics that you have learned to check the firm’s valuation and would let him
know when you got back from vacation.

You downloaded the file that he sent you and checked the current stock price,
then you went on your vacation. The current common stock price was $50.50 when you
left. Unfortunately, the output of the software had jumbled all of the data for the
financial statements and some elements were missing. This already made you question
the validity of this software, but you were determined to not let that bias your analysis.
Further, your vacation was in a remote area with limited internet access. As a good
friend and competent analyst, you put the statements in the proper formats before
evaluating the firm. On the following page is the output you were able to pull from the
file:
Agraja Magesh
Case-1 , Week 2

Software output:
Retained earnings, balance, year beginning 3100000

Inventory 1550000

Depreciation expense 880000

Cost of goods sold 11250000

Preferred stock dividends 107000

Capital paid in excess of par (common stock) 700000

Bonds payable 2000000

Accrued expenses 460000

Tax rate 0.35

Notes payable 600000

Common shares outstanding 80000

Cash 560000

Preferred stock (5,000 shares, $140 par value) 700000

Plant, property, & equipment, original cost 4900000

Accounts receivable 1670000

Cash dividends declared 750000

Selling and administrative expenses 750000

Sales 15000000

Investments 990000

Accounts payable 510000

Interest expense 340000

Accumulated depreciation 1825000

Marketable securities 325000

Common stock (80,000 shares, $5 par value) 400000

Prepaid expenses 600000

Agraja Magesh
Case-1 , Week 2

Questions:

1) Arrange the information from the output above in a proper presentation for an
income statement. See Table 2-1 in the textbook.

From this reference

S.NO
1 Sales 15000000
2 Cost of goods Sold 11250000
3 Gross Profit (S.NO1-2) 3750000
4 Selling & admin expense 750000
5 Depreciation Expense 880000
6 EBIT(S.NO.3-4-5) 2120000
7 Interest expense 340000
8 EBT(S.NO.6-7) 1780000
9 Taxes (TAX RATE * EBT) 623000
10 EAT(S.NO.8-9) 1157000
11 Preferred Stock Dividends 107000
12 Earnings available to common stockholders 1050000
(S.NO. 10-11)
13 Common share outstanding (S.NO.12/13) 80000
14 Earnings per share 13.125

2) What is the EPS?

EPS is earnings per share. Which can be calculated as follows
Earnings per share = (Net Income or EAT)-preference dividend or prefered stock
dividends)/ shares outstanding at the end of the year or common share outstanding
Agraja Magesh
Case-1 , Week 2

3) Arrange the information from the output above in a proper presentation for a
statement of retained earnings. See Table 2-2 in the textbook.

Referring above image from PPT

1 Retained earnings 3100000
2 + Earnings available to common stock 1050000
holders
3 - Cash dividends declared 750000
4 Retained earnings 3400000

4) Arrange the information from the output above in a proper presentation for a
balance sheet. See Table 2-4 in the textbook.
Agraja Magesh
Case-1 , Week 2

Referring above image

(Assets) Cash 560000

Marketable securities 325000
Acc receivable 1670000
- Allowance for bad debts -
Inventory 1550000
Prepaid expenses 600000
Total current assets (sum of above) 4705000
Other assets (investments)- 990000
Fixed asset (+ plant & equipment) -A 4900000
- Accumulated depreciation -B 1825000
Net Plant and equipment (A-B) 3075000
Total assets (Total c.assets+investments 8770000
+Net plant & equipment )
Agraja Magesh
Case-1 , Week 2

Accounts payable 510000

Notes payable 600000
Accrued expenses 460000
Total current liabilities (sum of above 3) 1570000
Long term liabilities (bond payable) 2000000
Total liabilities (Total C.liabilites +bonds 3570000
payable)

Preferred stock (5,000 shares, $140 par 700000

value)
Common stock (80,000 shares, $5 par 400000
value)
Capital paid in excess of par 700000
Retained earnings 3100000
Total stock holder’s equity 4900000
Total liabilities and stock holder’s equity 8470000

5) What is the P/E ratio for this firm? Price per share /Earnings per share
EPS = 13.125, Assuming current common stock price is share price/price per
share.
P/E= 50.50/13.125 =3.8

6) If the average P/E ratio for this industry is 5, is the firm undervalued or
overvalued compared to the other firms considering this metric?
This can mean that the firm is undervalued and is a good place for investment as
P/E is less than benchmark. If it were greater than it could mean the firm was
over valued.

7) One metric of valuation is the price-book (P/B) ratio. The P/B ratio is a ratio of
the market value of the stock price over the book value per share. What is the
common P/B ratio of this firm? (See concept of net worth, p. 32)

=4900000-700000/80000 =52.5
P/B =Stock price / book value per share
=50.50/52.5 =0.96

8) Is the firm considered undervalued or overvalued using the P/B ratio?

Agraja Magesh
Case-1 , Week 2

Undervalued as P/B ratio is less than 1. However since it is close to 1 we can assume it
is slightly undervalued.

9) Do you have evidence that this firm may be undervalued? Both P/B and P/E
ratios suggest the same .

10) What are the limitations of using only these metrics for firm valuation?

It does not take into account growth perspectives, external environment/industry outlook,
quality of management / product, risk-return expectations, company vision/mission/goal,
company’s legacy/approach, inflation/government aspects, voluntary acts by the
company etc. Most values are based on historic cost/ original costs – its value addition
is not accounted for , nor is its replacement rates etc.
This is only a part of the firm’s valuation.