Toy Retailer Inc. pays no dividend and so the portions of the worksheet (Figure 1) pertaining to dividend yield and dividend valuation appear in gray typeface. However, that doesn't mean that the company's dividend policy can't generate some useful insight.
Growth firms generally pay no dividends because they want to use capital for expansion. Toy Retailer Inc. in the spring of Year 6 paid no dividends, but it had recently announced a buy-back of $1 billion worth of shares over the next few years. At a minimum this is a sign that the company is generating more cash than it feels it needs for future expansion. As companies first move to buy back shares and then pay cash dividends, they are indicating that new projects are not offering the same return potential to the company as once was the case. The move could be one sign that Toy Retailer Inc. may be reaching a more mature stage—it may be turning into more of a mature company rather than a growth firm. In such a situation, the price-earnings ratio would contract and a given level of earnings would support a lower price.
In a growth approach, the historical earnings growth rate provides one guide to future growth. But equally important are market expectations concerning future growth rates. Examining the price-earnings ratios is useful to judge market expectations concerning the future growth of the firm.
At 21.2, the current (early-Year 6) price-earnings ratio of Toy Retailer Inc. is edging toward the lower end of its historical range. It is still above the industry average, and close to the market's Year 5 ratio—which is low for a growth stock. Traditionally, the price-earnings ratio of a growth stock trades above that of the market and the Toy Retailer Inc. ratio has traditionally been about 20% above the market's. While a low price-earnings ratio can be a sign of an undervalued stock, it can also be a sign that the market has lowered its expectations for the firm—it may no longer view the company as a true growth stock. It is worthwhile to consider whether the market may be correct in its assessment.
The Year 5 return on equity for Toy Retailer Inc. was below both the long-term average and the industry average. The return on equity measures how well the firm is being run on both an operational and financial basis. To boost return on equity, a company must increase the profit margin on goods being sold, make better use of its assets, or increase the level of financial leverage. While the ratio is close to industry norms, the slide in return on equity for Toy Retailer Inc. is surprising in light of the increase in financial leverage. An examination of the profit margin over this time shows an overall decline; battling the competition does have its costs, as does expansion. However, the profit margin has shown an increase lately.
Valuing the Company
The bottom of Figure 1 provides valuations using the earnings-based model. Applying the model to Toy Retailer Inc. paints an interesting picture.
The first item that needs to be determined is the appropriate per share earnings figure for Year 6. The worksheet uses an estimate based on the five-year earnings growth rate of 10.9% and the most recently reported earnings per share [1.65 × (1 + 0.109)], leading to a high valuation of $51.79 and a low valuation of $33.67. This compares to a current price of $34.62. Sounds enticing, but let's look at some of the assumptions.
Is the growth rate reasonable? Actually the growth rate used here (10.9%) is somewhat below the rates estimated by other analysts. For instance, Value Line estimates a higher growth rate of 17.5%, while the S&P Earnings Guide projects a growth rate of 18%. Using a higher growth rate would, of course, raise the valuations somewhat.
Of greater concern, however, are the high and low price-earnings ratios based on historical averages. These averages are based on a time period when the company was clearly a growth stock. But as we have seen, there are reasons to question whether the company can continue to be considered a growth firm; the market right now may be raising questions about this.
If Toy Retailer Inc. is valued as a mature stock, its price-earnings ratio would on average parallel the market's. Currently (mid-Year 6), the market's price-earnings ratio is 20.6; using that in the model would produce a valuation of $37.70 based on the worksheet's Year 6 earnings per share estimate; using Value Line's higher Year 6 earnings per share estimate would produce a valuation of around $41.
Conclusion
Examining different assumptions is a critical part of the valuation, and will help you isolate some of the major factors that are affecting a stock's price. While the Valuation Worksheet examines quantitative factors, it is clear that many subjective factors go into the equation. To judge these factors, it is necessary to go beyond the statistics. Any final decision should be based on a better understanding of the company, its management, and its competitive environment. This can only be accomplished by a thorough reading of the firm's financial reports, as well as the reports and summaries on the firm and its industry.
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