Case: Riyadh Sports

CASE: RIYADH SPORTS Ten years ago, in 2000, Ahmad founded a small mail-order company selling high-quality sports
equipment. Since those early days Riyadh Sports has grown steadily and been consistently profitable. The company has issued 2 million shares, all of which are owned by Ahmad and his five children. For some months Ahmad 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? Ahmads first instinct is to look at the firms balance sheet, which shows the book value of the equity is SR26.34 million, or SR13.17 per share. A share price of SR13.17 would put the stock on a P/E ratio of 6.6. That is quite a bit lower than the 13.1 P/E ratio of Riyadhs larger rival, Dammam Sports. Ahmad suspects that book value is not necessarily a good guide to a shares market value. He immediately thinks of his son Wael, who works in an investment bank. Wael would undoubtedly know what the shares are worth. He decides to phone Wael after he finishes work that evening at 9 oclock or before he starts the next day at 8:00 A.M. Before phoning, Ahmad jots down some basic data on the companys profitability. After recovering from its early losses, the company has earned a return that is higher than its estimated 10% cost of capital. Ahmad is fairly confident that the company would continue to grow fairly steadily for the next six to eight years. In fact he feels that the companys growth had 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 Dammam Sports announced plans to form a mail-order division. Ahmad is worried that beyond the next six or so years, it might become difficult to find worthwhile investment opportunities. 2001 -2.1 0.00 9.80 -27.1 2002 -0.7 0.00 7.70 -7.1 2003 0.23 0.00 7.00 3.0 2004 0.81 0.20 7.61 11.6 2005 1.10 0.20 8.51 14.5 2006 1.30 0.30 9.51 15.3 2007 1.52 0.30 10.73 16.0 2008 1.64 0.60 11.77 15.3 2009 2.00 0.60 13.17 17.0 2010E 2.03 0.80 14.40 15.4
EPS (SR) Dividend per share (SR) BV per share (SR) ROE (%)
Ahmad realizes that Wael will need to know much more about the prospects for the business before he can put a final figure on the value of Riyadh Sports, but he hopes that the information is sufficient for her to give a preliminary indication of the value of the shares.
Questions: 1. Imagine you are Waels assistant at the investment bank. Help Wael to forecast dividend payments for Riyadh 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 is reduced in Year 8. 2. How much of your estimate of the value of Riyadhs stock comes from the present value of growth opportunities?
February 11, 2008 REEBY SPORTS Minicase solution, Chapter 5 Principles of Corporate Finance, 9th Edition R. A. Brealey, S. C. Myers and F. Allen What is Reeby Sports worth per share? We will value the company using George Reeby's forecasts. The spreadsheet accompanying this solution sets out a forecast in the same general format as the table on p. 114. Historical results from 2002 to 2007 are also shown. Earnings per share (EPS) equals return on equity (ROE) times starting book value per share (BVPS). EPS is divided between dividends and retained earnings, depending on the dividend payout ratio. BVPS grows as retained earnings are reinvested. The keys to Reeby Sports future value and growth are profitability (ROE) and the reinvestment of retained earnings. Retained earnings are determined by dividend payout. The spreadsheet sets ROE at 15% for the five years from 2009 to 2013. If Reeby Sports will lose its competitive edge by 2014, then it cannot continue earning more than its 10% cost of capital. Therefore ROE is reduced to 10% starting in 2011. The payout ratio is set at .30 from 2006 onwards. Notice that the long-term growth rate, which settles in between 2014 and 2015, is ROE ( 1 dividend payout ratio) = .10 (1 - .30) = .07. The spreadsheet allows you can vary ROE and the dividend payout ratio separately for 2009-2013 and for 2014-2015.1 But lets start with the initial input values. To calculate share value, we have to estimate a horizon value at 2013 and add its PV to the PV of dividends from 2008 to 2013. Using the constant-growth DCF formula,
0.71 PVH = = 23.72 .10 - .07

The PV of dividends from 2008 to 2013 is $3.43 in 2007, so share value in 2007 is:
PV = 3.43 +
23.72 = $16.82 (1.1)6
The spreadsheet also calculates the PV of dividends through 2015 and the horizon value at 2015. Notice that the PV in 2007 remains at $16.82. This makes sense, since the value of a firm should not depend on the investment horizon chosen to calculate PV.
You can vary these inputs, but be careful not to enter ROEs and dividend payout ratios that generate long-term growth rates close to or above the cost of capital. As the growth rate approaches the cost of capital, the DCF formula explodes. If the growth rate exceeds the cost of capital, the DCF formula says stock price is negative, which is impossible. The spreadsheet reports Formula not applicable in this case.
We have reduced ROE to the 10% cost of capital after 2013, assuming that Reeby Sports will have exhausted valuable growth opportunities by that date. With PVGO = 0, PV = EPS/r. 2 So we could discard the constant-growth DCF formula and just divide EPS in 2011 by the cost of capital:
2.37 PVH = = $23.72 .10

This PV is identical to the PV from the constant-growth DCF formula. It doesnt matter how fast a company grows after the horizon date H if it only earns its cost of capital. How much of Reeby Sports 2004 value is due to PVGO? You can check by setting ROE = .10 for 2006-2010 as well as 2011-2012. You should get PV = $13.82. Thus PVGO = 16.82 13.82 = $3.00 per share for investments made in 2005 and in later years. George Reeby has also identified a "comparable," Molly Sports. We could use its P/E ratio of 13.1 to calculate horizon value in 2010 and PV in 2004:
PVH 13.1 2.37 $31.05 PV 3.43 31.07 $20.96 (1.10)6
We could also use Mollys P/E ratio to calculate Reeby Sports 2007 value directly from 2008 EPS: PV = 13.1 2.03 = $26.59 Both values based on Mollys P/E are higher than our DCF calculations. Is Molly significantly more profitable than Reeby Sports, or does our spreadsheet understate Reeby Sports prospects? What if Reeby Sports could continue to earn ROE = .15 for two extra years, until 2015? You can check by changing ROE for 2014 and 2015 from .10 to .15.3 You should get NPV of $18.04 in 2007, somewhat higher than our original DCF calculations, but not enough for Reeby Sports to match Mollys P/E. You may wish to experiment to find inputs that generate P/E = 13 for Reeby Sports in 2007. Do you think these inputs are reasonable?
2 3
See Section 5.5. The ROE for 2013 and 2014 is hard-wired at .10.

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CASE: RIYADH SPORTS Ten years ago, in 2000, Ahmad founded a small mail-order company selling high-quality sports

0.71 PVH = = 23.72 .10 - .07

23.72 = $16.82 (1.1)6

2.37 PVH = = $23.72 .10

PVH 13.1 2.37 $31.05 PV 3.43 31.07 $20.96 (1.10)6

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