The Case Study of Ragan Thermal Systems
Valeo’s directors are considering the opportunity of horizontal expansion by acquiring Ragan Thermal Systems, the thermal systems company, manufacturing and installing commercial ventilation, heating, and cooling units. It is a privately owned company, and the owners of the company are the couple, owning 50,000 shares per person. An analyst was asked to determine the value per share of the company’s stock. The analyst has collected the following information about the company’s publicly traded competitors:
EPS
Stock Price
Dividend Per Share
ROE
R(discount rate)
Artic Cooling
$0.82
$15.19
$0.50
11%
10%
National Heating & Cooling
1.32
12.49
0.75
14
13
HVAC Corp
2.34
48.60
1.25
14
12
Q1: PE formula is: Market Value per Share/ Earnings per Share
Company
Market value ($)
Earnings per share ($)
PE
Calculation
Artic Cooling
15.19
0.82
18.52
15.19/ 0.82
National Heating & Cooling
12.49
1.32
9.46
12.49/ 1.32
HVAC Corp
48.60
2.34
20.77
48.60/ 2.34
Industry
16.25
(18.52 + 9.46 + 20.77)/ 3
Q2: Ragan’s stock price = Industry average PE x (Total Earnings)/ (Total Number of Shares)
= 16.25 x ($320,000/100,000 shares) = $ 52 per share.
Q3: This statement is questionable since the use of PE ratio to value stocks does not warrant caution and efficiency. Although the first variable used to calculate PE, the price, provides a brief confidence to investors, the use of appropriate earnings number can be a challenge. Earnings are the uncertain variable since they are affected by unusual losses or gains. Moreover, there is a dangerous practice of manipulation due to the efforts of company management team. This practice is applied in order to meet earning expectation by using such accounting tricks as subtracting or adding non-recurring expense or gains which can increase the number of bottom line earnings and decrease the PE ratios and stock price (McClure n.p.). Thus, the uncertainty of earnings used to calculate the PE ratio is the first factor which leads to possible inaccurateness of the latter.
Another factor of uncertainty is related to the types of earnings used for the estimation. Trailing or historical earnings are accessible being located in the in the company's income statement. Although the accessibility of this variable, it is not useful for investors since it does not provide information about future earnings of the company. Future or forward earnings are based on the synopsis of financial analysts, and their assumptions may be over-optimistic (McClure n.p.). Thus, although future earnings are more useful for investors’ decisions, they are related to a high risk of inaccurateness.
A lack of information about the company’s future EPS growth is the most significant limitation of the PE ratio. Thus, acquiring the stock of a quickly growing company may be beneficial for investors even though the PE ratio is high because this ratio can be brought to a lower level due to the growth in EPS. Otherwise, the investors are likely to elect the purchase of stock with a lower PE ratio if …
