Suburban Electronics Company A Case in equity valuation in a public stock offering

PGP 2009-11 2nd Term - Session 17

Shubhangi Shree 54
Case summary: Suburban Electronics is an electronics company founded in 1979 by John Marris who is an electrical engineer with hands on experience on designing of electronic equipments. To fulfil his dream he started Suburban Electronics thereby manufacturing electronic warning devices and burglar alarms. He then partnered with H.J. Mack who was a mechanical engineer.

Suburban electronics sales and earnings have been increasing and the owners desire to expand the size and scale of business. They are thinking to take the company public and in this regard they had approached Sandra Tracy, a principal in small investment banking firm, for stock valuation. Sandra Tracy is exploring different methods of company valuation but is relying heavily on the method of comparison with similar firms. She also wishes to make Marris and Mark understand the whole process so that they are clear about it. She finds out following statistics regarding similar firms: Particulars Price earnings multiple Market value to book value ratio per share Payout percentage Total return offered to equity shareholders Numbers 12-14 3-5 15-25% 20-22%

Marris owning 270000 shares and Mack owning 30000 have an emotional attachment with the company and wish to retain ownership and control after public offering.

1) Final amount = Initial amount (1+r/100) ^n Where, n= number of years And, r= growth rate Sales: Sales in 1982 = 1,292,000$ Sales in 1992 = 8,000,000$ n=10 years This gives compounded growth rate for sales, r = 20% Net-income after tax: Net income after tax in 1982 = 155,400$ Net income after tax in 1992 = 811,448$ n= 10 years This gives compounded growth rate for net income after tax, r = 18% Earnings per share: EPS in 1982 = 0.52$ EPS in 1992 = 2.70$ N=10 years This gives compounded growth rate for EPS, r = 17.9% 2). From the given conditions, three basic assumptions can be made for calculating the range of values of Suburban Electronics Common Stock i) Using Industry Market Value/ Book value Assume Return on equity (25%) is the same as that of industry values Common stock shares =300,000 Market Value / Book value lies between 3-5(industry values)

This gives us Common stock per share values as

Net income after Tax =

811448

Book Value of Common stock (Return on equity is 25%) = 3245792 Using Market Values / Book value from 3-5 We get, Common stock per share = (32.5 54.1) $

ii)

Using Industry P/E ratio

P/E for the company is between 12-14 (industry values)

EPS 1992 = 2.7 Using P/E ratios between 12-14 Common stock per share = (32.4 37.8) $

iii)

Using Industry debt ratio

Assume Debt ratio (25%) is the same as that of industry values Market Value / Book value lies between 3-5 (industry values)

Total Assets = 2900000 Book Value of Common Stock = 2175000 Common Stock per share = (21.75 -36.25) $

3). It is given in the case that the Market Value of Common Shares is between $15 to $25 Thus, the Range of Common stock per share calculated using the Industry Debt Ratio of 25% Which gives common stock per share in the range 21.75 to 36.25 the most reasonable. 4) Use of similar firms in the Suburban Electronics for the valuation of Suburban electronics has a trade off. There are certain advantages and disadvantages in using such an approach:

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5) Additional information required for valuation: NPV of the car alarm project it is going to undertake Projected sales and net earnings growth Planned retention ratios Number of shares to be issued to public Percentage of stake to be issued to public Name and reputation of clients of Suburban Electronics Electronics industry specifics variables Valuation of any publicly listed electronics firm similar in size to Suburban Electronics

6)

Table 2 contains data related only to yearly incomes and earnings per share which is very insufficient for assigning a value to a firms stock. This is so because of the following reasons: It says nothing about the financial health of the company Ratio analysis is not possible by only using Table 2 Many important parameters like Return-on- equity and Return-on-assets can neither be calculated Suburbans liabilities cannot be estimated using only Table 2 Working capital requirements of Suburban cannot be calculated, which is considered to be very important for valuation -Moreover, total number of shares cannot be known Lastly the capital structure is invisible in Table 2

7) Morris and Mack had invested in the firm at the cost of their home and inherited farm. So it is natural for Marris and Mack to desire ownership and control of the firm. But at the same time public offering of the stock was needed for future growth and prosperity. It is a situation essentially faced by many entrepreneurs once the business reaches a certain size and aims for expansion to next scale. One possible solution in this regard is to maintain a 51-55% stake in the company and issue IPO for only 45-49% of ownership. In this way Suburban will be able to gain capital that can be invested in future projects and Marris & Mack will retain the control. Currently: Marris number of shares: 2, 70,000 Mack number of shares: 30,000 Total equity: 300000$ Therefore, value of one share = 1$ Suburban can issue shares at a face value of 1$ to raise any amount less than 300000. Even if they receive more than 3000000, they would be able to maintain more than 50% of ownership. Afterwards as their profits increase from future projects they can go for debt financing of the capital requirements.

8) Without having prior knowledge of the organizational structure of Suburban Electronics it is difficult to comment on the future roles of Marris and Mock. They could expect more of strategic responsibilities rather than being involved in day to day operations of the firm. These roles may include collaborating with new clients, deciding upon business

diversification, expanding the presence in major cities, establishing long term partnerships, etc 9) The owners should not consider an outright sale of the company because of the following reasons: -The company is performing good sales and earnings are increasing in addition to a good reputation in the market -Because of good performance and huge retained earnings then can go for debt financing whenever required -Growth rate and earnings per share has been increasing for a decade -Currently there is no immediate requirement of huge cash by the owners for the personal usage -They have invested a lot of their time, energy and money in bringing the company to this level -IPO can serve the capital requirements for future projects

10) Every company, be it private or public survives under constant influence from larger economy. Suburban Electronics Company is also no exception to this. Being in the electronics manufacturing industry it experiences influence from larger economy in the following manner: Products like car burglar alarms and electronic warning devices are not of immediate need of people so when economy is in recession with people becoming unemployed, the demand for such devices will fall down If average income rises with more inclusive growth then crime rate will be low which in turn would decrease demand for Suburbans company products. 11) Remaining inside the purview of information and data provided the performance of Suburban Electronics seems promising for the next 5-10 year period. It has been growing consistently with increasing EPS which is a positive sign of good efficiency. Also it has a good brand reputation which will be helpful in crisis situations, if any. The company is also bagging huge projects which speaks about its ability to bag opportunities and deliver on time.