RaySearch Laboratories: a financial analysis

Executive summary

RaySearch has the fundamental goal to establish itself as the leading provider of treatment

planning systems for radiation therapy. Registered on the mid cap segment of the Nasdaq

OMX Stockholm, RaySearch represents a growing contributor to the global sector.

Recent results have stimulated further investment in the company, which has experienced

an almost doubling of its share price over the past year. An evaluation of profitability,

liquidity and solvency confirms that the fundamentals underlying performance are strong.

Relative to its peers, RaySearch continues to outperform the market, generating high

relative returns while maintaining low financial risk.

Overcoming a 2013 lawsuit, the company appears to be on target to reap further gains from

its investment into RayStation, its flagship product. As sales continue to increase, investors

are anticipating accelerated future cash flows to justify their purchase. With a strong

financial and strategic foundation, RaySearch represents an opportunity for investors to

partner with an increasingly successful business model.

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Table of contents

1. Introduction...............................................................................................................................5

2. Profitability evaluation...............................................................................................................5

2.1 EBIT margin..................................................................................................................................5

2.2 Generally accepted accounting principles (GAAP).......................................................................6

2.3 Profit margin................................................................................................................................6

2.4 Relative profitability....................................................................................................................7

Table 1: Relative profitability.........................................................................................................7

2.5 Return on total assets..................................................................................................................8

Figure 1: Du Pont analysis on ROA.................................................................................................8

3. Liquidity evaluation....................................................................................................................9

4. Solvency evaluation....................................................................................................................9

5. Trends analysis.........................................................................................................................10

Figure 2: Multi-year overview ........................................................................................................10

Table 2: Trends analysis...................................................................................................................11

Figure 3: Profitability trends............................................................................................................12

Figure 4: TTM vs 5 Year average margins........................................................................................13

6. Stock valuation................................................................................................................................13

Figure 5: Share price trend diagram................................................................................................13

Figure 6: Relative share performance..............................................................................................14

Table 3: Relative P/E ratios..............................................................................................................14

6.1 Book value.................................................................................................................................15

6.2 Valuation models.......................................................................................................................15

7. Conclusion................................................................................................................................16

8. Recommendation.....................................................................................................................16

References...........................................................................................................................................17

Pecuniary interest declaration.............................................................................................................18

Appendices..........................................................................................................................................19

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1. Introduction

RaySearch Laboratories is a medical technology company that creates advanced software

solutions for improved radiation therapy treatment of cancer. RaySearch was founded in

2000 and is a Swedish registered limited liability company headquartered in Stockholm

(‘Annual report’ 2014).

The parent company’s shares are now listed on the mid cap segment of Nasdaq OMX

Stockholm, with a subsidiary group consisting of five foreign based sales companies –

RaySearch Americas, RaySearch Belgium, RaySearch France, RaySearch UK and RaySearch

Germany (‘Advancing cancer treatment’ 2015).

Annual reports are prepared in accordance with the Swedish Annual Accounts Act

(1995:1554) and the Swedish financial reporting board’s recommendation RFR 2 Accounting

for Legal Entities (‘Annual report’ 2014). All financial statements are presented in Swedish

Krona (SEK).

2. Profitability evaluation

RaySearch’s fundamental goal is to establish itself as the leading provider of treatment

planning systems for radiation therapy (‘Advancing cancer treatment’ 2015). Its long-term

financial target is to have high sales growth and earnings before interest and taxes (EBIT)

margin exceeding 30 percent (‘Annual report’ 2014, p. 10). These targets focus on

profitability and trends, and can serve as the focus of analysis.

2.1 EBIT margin

Higher EBIT margins indicate higher profitability. By dividing operating earnings over net

sales (appendix 1) RaySearch’s 2014 EBIT ratio can be calculated at 27.8 percent - close to

the specified target. Often used interchangeably with operating margin (‘What is the

difference between EBIT and operating income?’ 2016), these ratios allow investors to

understand the true business costs of running the company.

Maverick (2015) describes the operating margin as a ‘key determinant in evaluating growth

potential’ and ‘essential in the assessment of management efficacy’. The margin

incorporates the effectiveness of capital management and the reliance of the business on

capital resources. As a specific EBIT target was mentioned annual report (‘Annual report’

3

2014, p. 10), the subtle differences between an EBIT ratio and operating margin should be

examined:

2.2 Generally accepted accounting principles (GAAP)

Corporate accounting is required to adhere to the standard conventions known as the

generally accepted accounting principles (GAAP). The terms gross profit margin, operating

profit margin and net profit margin generally refer to one of three key GAAP-approved

measures of profitability. GAAP profit margin calculations are standardised, enabling reliable

competitive analysis.

Non-GAAP profitability metrics such as EBIT and EBITDA (earnings before interest, taxes,

depreciation and amortization) may bear close resemblance to GAAP counterparts but may

hide crucial differences. Boyte-White (n.d.) explains:

…gross profit reflects revenue minus only those costs directly associated with

production of goods for sale. Operating profit is equal to gross profit minus any other

overhead, operational or sales expenses necessary to run the business, including

depreciation and amortization of assets. EBITDA essentially splits the difference

between these two metrics by accounting for all expenses generated by production

and day-to-day operations, but adding back in the cost of depreciation and

amortization.

Prudent profitability evaluation includes analysis of GAAP profitability margins along with

EBIT and EBITDA metrics.

2.3 Profit margin

Using the net profit margin ratio, the expense of gearing can be included (AIB, Topic 2,

appendix 2, Parameters of assessing business performance: summary of financial ratios

2015). Often referred to simply as the profit margin, the net profit margin is considered one

of the most crucial indicators of a company's financial health (Boyte-White n.d.).

RaySearch’s net profit margin of 27.6 percent (appendix 2) represents an exceptional return

in absolute terms (AIB, Topic 2, appendix 2, Parameters of assessing business performance:

summary of financial ratios 2015), as does a gross profit margin of 95.9 percent (appendix

3).

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2.4 Relative profitability

Determining the company’s performance relative to the industry is fundamental to

adequate performance evaluation. Bloomberg groups RaySearch into the Health Care

Equipment & Services industry within the health care sector, where it’s metrics sit amongst

other comparable European companies (‘Health care equipment & services industry’ 2016).

Comparisons with the European subset are limited, with the sample size presenting an

obstacle to reliable appraisal. Comparisons with the US market present an alternative where

the industry averages are drawn from a larger pool companies, some of which have been

identified as direct competitors (‘Annual report’ 2014, p. 29). The 27.6 percent net profit

margin posted by RaySearch in 2014 is considerably above the US industry average of 10.6

percent and the sector average of 16.7 percent (‘Industry information’ 2015).

RaySearch’s profitability becomes even more impressive when global comparisons are

produced. Gurufocus calculates the industry net profit median at 3.2 percent, listing

RaySearch as a high performer among 1750 companies within the global software –

application industry (‘RaySearch Laboratories AB’ 2016). The global operating margin

industry average of 4.7 percent is also radically outperformed by RaySearch.

As a global company with multiple foreign based subsidiaries, RaySearch identifies its major

competitors as Varian, Elekta and Phillips (‘Annual report’ 2014, p.29). Accuray is another US

competitor. Comparisons between these publically listed companies are presented in table

1:

Table 1: Relative profitability

2014 Net profit margin (%)

Operating margin (%)

Relative net profit performance (%)

Global Industry Average 3.2 4.7 0RAYSEARCH 27.6 27.8 +24.4VARIAN 13.3 17.7 +10.1ELEKTA 4.8 8.4 +1.6PHILLIPS 3.5 4.2 +0.3ACCURAY -8.2 -2.9 -11.4

(‘RaySearch Laboratories AB’ 2016)

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Caution should be used in industry average comparisons, as determining relative

profitability is greatly affected by the included subset of companies. Published averages are

approximate, reporting practices vary, and operational seasonality can led to deceptive data

and misleading comparisons (Petty et al. 2012, pp. 161-162). However the results posted by

RaySearch far outreach this uncertainty: it is clear that its recent profitability has far

exceeded that of its peers.

2.5 Return on total assets

Measuring the return on asset investment allows operations management profitability to be

assessed. This formula ignores financing and evaluates how well assets are utilised to create

wealth, regardless of capital structure (AIB, Topic 2, appendix 2, Parameters of assessing

business performance: summary of financial ratios 2015). RaySearch delivers a return on

total assets (ROA) of 20.4 percent (appendix 4), again outperforming an industry which

averages just over 3 percent (‘RaySearch Laboratories AB return on assets’ 2016).

Similar to return on equity (ROE), ROA is affected by profit margins and asset turnover. This

can be seen when broken down by the Du Pont Formula; a method that seeks to

demonstrate the various interrelationships involved in ratio analysis:

Figure 1: Du Pont analysis on ROA

(Fahim n.d.)

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Whilst many analysts argue that a higher ROA is superior, Buffett states that a high ROA may

indicate vulnerability in the durability of the competitive advantage (‘RaySearch

Laboratories AB return on assets’ 2016). Petty et al.’s (2012, p. 13-15) principal 5 also

alludes to the potential vulnerability of exceptionally profitable projects ‘…in competitive

markets, extremely large profits cannot exist for very long’.

RaySearch seeks to maintain its relatively high ROA by driving innovation and differentiating

its main product, RayStation (‘Annual report’ 2014, p. 1). Petty at al. (2012 p. 14) describes

this strategy as creating markets that are not ‘perfectly competitive’, allowing for insulation

from potential rivals.

3. Liquidity evaluation

Nuzum (2016) notes that a decline in liquidity increases the risk of bankruptcy. RaySearch’s

current ratio sits at 3.77, providing an indication that it is well equipped to pay short term

obligations (appendix 5). With a global industry median of 2.1 (‘RaySearch Laboratories AB

current ratio’ 2016), RaySearch attributes it’s highly liquid financial position to a ‘substantial

rise in sales…at the end of the period’ (‘Annual report’ 2014, p. 2). This is congruent with the

trend analysis, which is further examined in section 5. The explanation also allays fears that

the high liquidity may be due to poor working capital management.

4. Solvency evaluation

As insolvency is one of top reasons businesses fail (Nuzum 2016), assessing solvency is

critical to determining the risk associated with a potential investment. In keeping with the

board’s financial risk management policy (‘Annual report’ 2014, p. 5), RaySearch’s debt ratio

has continued to be kept low (appendix 6). This indicates potential to finance new assets

with debt, such as research and development (‘Annual report’ 2014, p. 16).

The debt-equity ratio (appendix 7) is another indicator of low financial risk, a feature

required of companies with higher operational risk (AIB, Topic 2, appendix 2, Parameters of

assessing business performance: summary of financial ratios 2015). These operational risks

are identified as dependence on key personal and partnerships, competition, regulatory

approval and reliance on insurance rebates (‘Annual report’ 2014, pp. 28-29).

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5. Trends analysis

Ratios employed in financial analysis draw on measures from both the balance sheet

(position) and the income statement (performance) (AIB, Topic 2: Financial accounting

concepts and statements: financial analysis 2015). These figures become a greater tool

when compared with historical data:

Figure 2: Multi-year overview

(‘Annual report’ 2014, p. 6)

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By calculating ratios from the published data, trends become apparent. Table 2 shows the

redacted ratios:

Table 2: Trends analysis

RATIO 2014 2013 2012 2011 2010

EBIT (%) 27.8 -12.6 12.4 21.9 33.9

Net profit (%) 27.6 -12.2 12.9 22.8 34.1

Gross profit (%) 95.9 97.0 98.3 99.7 99.9

ROA (%) 20.4 -8.6 7.7 10.6 15.6

Current 3.77 2.88 3.58 5.35 6.86

Particular 2013 profitability ratios become an immediate cause for further investigation. The

EBIT, net profit and ROA margins exhibit a significant negative deviation in trend.

Examination of the annual report (2013, p. 5) showed that the significant decline in profit

was primarily due to a legal settlement:

In May 2011, we were sued by the US company Prowess, which claimed that we had

infringed on a patent that they license…this resulted in a settlement agreement with

Prowess. Under this agreement RaySearch will pay Prowess a fixed amount spread

out over three years and Prowess will drop the lawsuit. Since the outcome of the

settlement pertains to events prior to the close of 2013, a provision covering the

entire settlement amount was posted in the 2013 annual accounts.

The total cost of the settlement was SEK 34.8M and was charged entirely to 2013 (‘annual

report’ 2013, p. 44). The ‘Prowess effect’ can be observed clearly in figure 3:

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Figure 3: Profitability trends

(‘RaySearch Laboratories AB 15-year financials’ 2016)

Prior to 2013 a trend of negative profit growth is observed. This is despite the ongoing

increased sales reported in figure 2. The annual report (2012, pp. 5, 50) proffers the

following explanation:

The fact that profit increased proportionately less than revenue was due primarily to

the build-up of infrastructure for selling and marketing RayStation, which led to

higher costs…the increase in operating expenses derived mainly from higher

marketing and personnel costs.

The investment into the flagship product, RayStation, is realised in the increased research

and development expenditure as well as in other operating expenses (figure 2). The rise

over the period accords with the 2012 release date of RayStation.

A turnaround in this trend occurs in 2014 and has been sustained in the interim reports of

2015 (‘Financial reports’ 2015). Trailing twelve months (TTM) profitability now appears

highly favourable when compared to the five year average:

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Figure 4: TTM vs 5 Year average profitability margins

(‘Raysearch Laboratories AB: financials’ 2016)

6. Stock valuation

RaySearch’s share capital amounts to SEK 17,141,386.50 (‘Annual report’ 2014, p. 44). The

34,282,773 shares are comprised of 11,324,391 Class A shares and 22,958,382 Class B

shares (‘Annual report’ 2014, p. 44). The quotient value per share is SEK 0.50 (appendix 8).

During 2014, the average price of traded shares was SEK 37.9, up from 27.7 (2013). The

traded shares ranged in value from SEK 26.5 to SEK 54.0, with the price rising 93 percent on

year end whilst the Swedish market (OMX) increased 12 percent (‘Annual report’ 2014, p.

44).

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Figure 5: Share price trend diagram

(‘Annual report’ 2014, p. 46)

On the last trading day of 2014 the closing price was SEK 53.0. This equated to a price to

earnings (P/E) ratio of 30.3 (appendix 9). Since then the price has continued to appreciate,

rising to a current SEK 104 (13 Jan 2016), significantly outperforming competitors:

Figure 6: Relative share performance

(‘Bloomberg Business’ 2016)

The TTM P/E ratio has elevated to 45.9, significantly above the global industry average of

24.8:

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Table 3: Relative P/E ratios

Jan 2016 TTM P/E ratio

Global industry average 24.8US industry average 42.1OMX index average 15.7RAYSEARCH 45.9VARIAN 18.1ELEKTA 42.9PHILLIPS n/aACCURAY n/a

(‘RaySearch Laboratories AB’ 2016); (‘Industry information’ 2015); (‘Bloomberg Business’ 2016)

In an efficient market, the high P/E ratio would an indicator of the expected growth in

company earnings. However to ensure that the stock is not subject to a speculative bubble,

other methods of evaluating the intrinsic or fair value should be considered. The intrinsic

value of an ordinary share is equal to the present value of all future cash flows expected to

be received by the investor (Petty et al. 2012, p. 340).

6.1 Book value

The 2014 book value per ordinary share was found to be SEK 7.34 (appendix 10). This has

remained stable (SEK 5.73 – 7.34) over the past five reporting years. The increasing share

price has elevated the price to book (P/B) ratio from 7.2 to a current 12.4 (appendix 11),

well above the global industry median of 2.4 (‘RaySearch Laboratories AB’ 2016). ‘RaySearch

Laboratories AB P/B ratio’ (2016) makes the observation that the P/B ratio works best for

companies that earn most of their profit from underlying assets, such as banks. It has

limited value for software companies with light assets.

6.2 Valuation models

RaySearch has a policy to pay as dividends approximately 20 percent of the Group’s net

profit on condition that a ‘healthy capital structure is retained’ (‘Annual report’ 2014, p. 46).

Despite recent net profits, no dividends have been paid since 2010.

If earnings are expected to grow at a constant rate, the dividend growth valuation or

dividend discount model may a useful tool to estimate the value of an ordinary share (Petty

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et al. 2012, p. 356). By applying a hypothetical 5% dividend growth rate and a required rate

of return of 10%, the 2010 intrinsic value was calculated to be SEK 10 per share (appendix

12a). Different outcomes may be obtained by substituting variables, such as those shown in

appendix 12b and appendix 12c. Appendix 12b also demonstrates the application of the

PVDG model, a tool useful in demonstrating the present values of both the non-growth and

earnings streams (Petty et al. 2012, p. 358).

With a current market value of SEK 104 (13 Jan 2016), it is clear that the market is still

expecting a further acceleration in growth. Irons (2014) addresses this phenomenon with an

enhanced dividend discount model. Designed to deal with a changing growth rate, the

model is particularly applicable for businesses in the growth phase of their lifecycle. Based

on conservative assumptions, the model estimates the current intrinsic value to be SEK 41.5

(appendix 13). The current market value suggests assumptions are less conservative, with

traders placing a higher premium on expected future cash flows.

7. Conclusion

The retention of profits is an indirect route for shareholders to increase their ROE (Petty et

al. 2012, p. 341). As a growth company, investors are relying on future cash flows to justify

their purchase, rather than on current dividends. The intrinsic value is based on this

perception, taking account of the amount, timing and riskiness of future cash flows (Petty et

al. 2012, p. 331). The performance evaluation identified significant underlying strengths in

the company. These fundamentals have been recognised by investors and are reflected in

the share price.

8. Recommendation

When the market is functioning efficiently, the market value and intrinsic value of a stock

will be equal (Petty et al. 2012, p. 332). This assumes values fully reflect all available

information and investors are rational, which, according to behavioural finance theory, is

not always the case (Petty et al. 2012, p. 332).

A close analysis of the company and the dynamics of the industry may give an investor an

advantage when identifying risk and potential future cash flows. Inside industry knowledge

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may further enhance this advantage, particularly when such information is not readily

comprehensible to the market.

With a strong financial and strategic foundation for a future acceleration in growth,

RaySearch represents an opportunity for investors to partner with an increasingly successful

business model.

References

‘Advancing cancer treatment’ 2015, About Raysearch, viewed 5 Jan 2016, http://www.raysearchlabs.com/about/About-RaySearch/

‘Annual report’ 2009, Investor relations, viewed 11 Jan 2016, http://www.raysearchlabs.com/investor/financial-reports/?year=2010

‘Annual report’ 2010, Investor relations, viewed 11 Jan 2016, http://www.raysearchlabs.com/investor/financial-reports/?year=2011

‘Annual report’ 2011, Investor relations, viewed 11 Jan 2016, http://www.raysearchlabs.com/investor/financial-reports/?year=2012

‘Annual report’ 2012, Investor relations, viewed 11 Jan 2016, http://www.raysearchlabs.com/investor/financial-reports/?year=2013

‘Annual report’ 2013, Investor relations, viewed 11 Jan 2016, http://www.raysearchlabs.com/investor/financial-reports/?year=2014

‘Annual report’ 2014, Investor relations, viewed 5 Jan 2016, http://ar.raysearchlabs.com/en/index.html

Australian Institute of Business (AIB), 2015, ‘Topic 2: appendix 2 - Parameters of assessing business performance - summary of financial ratios’ in Financial Management Learning Materials, AIB, Adelaide.

Australian Institute of Business (AIB), 2015, ‘Topic 2: Financial accounting concepts and statements: financial analysis ’ in Financial Management Learning Materials, AIB, Adelaide.

‘Bloomberg business’ 2016, Bloomberg, viewed 17 Jan 2016, http://www.bloomberg.com/quote/RAYB:SS

15

Boyte-White, C n.d., ‘What is the difference between EBITDA margin and profit margin?’, viewed 5 Jan 2016, http://www.investopedia.com/ask/answers/032715/what-difference-between-ebitda-margin-and-profit-margin.asp

Fahim, T n.d., ‘Finance for non-financial managers’, viewed 9 Jan 2016, http://www.slideshare.net/AhmedElAty/lep-finanace-investment

‘Financial reports’ 2015, Investor relations, viewed 11 Jan, 2016, http://www.raysearchlabs.com/investor/financial-reports/?year=2015

‘Health care equipment & services industry’ 2016, Bloomberg Business, viewed 5 Jan 2016, http://www.investing.businessweek.wallst.com/research/sectorandindustry/industries/industrydetail.asp?region=Europe

‘Industry information’ 2015, Hemscott Americas, viewed 5 Jan 2016, http://biz.yahoo.com/p/521conameu.html#var

Irons, R 2014, ‘Enhancing the dividend discount model to account for accelerated share price growth', Journal of Accounting and Finance, vol. 14, no. 4, pp. 153–159.

Maverick, J 2015, ‘Key financial ratios to analyze the healthcare industry’, viewed 5 Jan 2016, http://www.investopedia.com/articles/active-trading/082015/key-financial-ratios-analyze-healthcare-industry.asp#ixzz3vhhaW65D

Nuzum, T 2016 ‘HD sample assignment extract for you’, Financial Management Discussion Forum, 12 Jan 2016, viewed 18 Jan 2016, https://moodle.aib.edu.au/mod/forum/discuss.php?d=5487

‘RaySearch Laboratories AB’ 2016, Gurufocus, viewed 5 Jan 2016, http://www.gurufocus.com/stock/RSLBF

‘RaySearch Laboratories AB 15-year financials ’ 2016, Gurufocus, viewed 11 Jan 2016, http://www.gurufocus.com/financials/OTCPK:RSLBF#

‘RaySearch Laboratories AB current ratio’ 2016, Gurufocus, viewed 10 Jan 2016, http://www.gurufocus.com/term/current_ratio/OSTO:RAY%20B/Current%2BRatio/RaySearch%2BLaboratories%2BAB

‘Raysearch Laboratories AB: financials’, Investing.com, viewed 11 Jan 2016, http://au.investing.com/equities/raysearch-laboratories-ratios

‘RaySearch Laboratories AB P/B ratio’ 2016, Gurufocus, viewed 17 Jan 2016, http://www.gurufocus.com/term/pb/OTCPK:RSLBF/P%252FB%2BRatio/RaySearch%2BLaboratories%2BAB

‘RaySearch Laboratories AB return on assets’ 2016, Gurufocus, viewed 9 Jan 2016, http://www.gurufocus.com/term/ROA/OSTO:RAY%20B/Return%2Bon%2BAssets/RaySearch%2BLaboratories%2BAB

Petty, J, Titman, S, Keown, A, Martin, J, Martin, P, Burrow, M & Nguyen, H 2012, Financial management: principles and applications, 6th edn, Pearson Australia, NSW.

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Pecuniary interest declaration

As a result of my analysis and recommendation, as of 14 January 2016 I hold 532 RaySearch

B shares.

Appendices

Appendix 1 EBIT margin / operating margin

Net sales (285217) - Operating expenses (205857) = 79360 / Net sales (285217)

= 27.8%

Appendix 2 Net profit margin

Net sales (285217) - Operating expenses (205857) - financial items (659) = 78701 / Net sales

(285217)

= 27.6%

Appendix 3 Gross profit margin

Gross profit (273590) / net sales (285217)

= 95.9%

Appendix 4 Return on total assets (ROA)

EBIT (Net sales (285217) - Operating expenses (205857)) = 79360 / Total assets (389753)

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= 20.4%

Appendix 5 Current ratio

Current assets (212721) / Current liabilities (56385)

= 3.77

Appendix 6 Debt ratio

Total long term liabilities (81820) / total assets (389753)

= 21.0%

Appendix 7 Debt-equity ratio

Total debt (17311 + 41096) = 58407 / total equity (251548)

= 23.2%

c.f. US Industry average = 44.0% (‘Industry information’ 2015).

Appendix 8 Quotient value per share

Total share capital (17141000) / total shares* (34282773)

= 0.5 SEK

* Each Class A share carries ten votes and each Class B share carries one vote at the Annual

General Meeting (AGM). Class A shares are not listed on the stock exchange (‘Annual report’

2014, pp. 44-45)

Appendix 9 P/E ratio

Share price (53.0) / earnings per share (1.75)

= 30.3

Appendix 10 Book value

Equity (251548000) / total shares (34282773)

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= 7.34

Appendix 11 Price to book (P/B) ratio

Share price at 2014 year end (53.0) / book value (7.34)

= 7.2

Share price 13 Jan 2016 (104.0) / book value (8.36)

= 12.4

Appendix 12 Dividend discount model

a) 2010: 5% dividend growth rate

Earnings per share (EPS) = 0.84Retained earnings (r) = 0.34 (40.5%) Dividends (D1) = 0.5 (59.5%)Required rate of return (RE)= 0.1 (10%) Growth rate(g) = 0.05 (5%)

Ordinary share price = dividend in year 1 (D1)

Required rate of return (RE) – growth rate (g)

= 0.5 / (0.1 – 0.05)

= 10

So, assuming the company had a 5% dividend growth rate and the required rate of return was 10%, the 2010 stock value would be SEK 10. The market value was SEK 38.

b) 2010: 6.1% dividend growth rate

Earnings per share (EPS) = 0.84Retained earnings (r) = 0.34 (40.5%) Dividends (D1) = 0.5 (59.5%)Required rate of return (RE)= 0.1 (10%) Return on equity (ROE) = 0.151 (15.1%)

Growth rate (g) = 0.405 (r) * ROE (0.151)Growth rate(g) = 0.061

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Ordinary share price = dividend in year 1 (D1)

Required rate of return (RE) – growth rate (g)

= 0.5 / (0.1 – 0.061)

= 12.8

So, applying the company’s 6.1% dividend growth rate with a required rate of return of 10%, would value the 2010 stock at SEK 12.8. The market value was SEK 38.

Or, applying the PVDG model:

1. The present value of the non-earning stream:

VE,NG = EPS1

RE

= 0.84 / 0.1

= SEK 8.4

2. Value of the future growth opportunities coming from retained earnings:

PVDG = NPV1

RE - g

= NPV1

0.1 – 0.061

= 0.039

NPV1 = r * EPS1 * ROE

RE – r * EPS1

So NPV1 = 0.405 * 0.84 * 0.151 0.1 - 0.405*0.84

Therefore NPV1 = 0.513702 – 0.3402

= 0.173502

So PVDG = SEK 4.45

3. The value of the combined streams:

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VE = SEK 8.4 + SEK 4.4

= SEK 12.8

c) 2016 TTM: 12.1% dividend growth rate

Earnings per share (EPS) = 2.26Retained earnings (r) = 0.915 (40.5%) Dividends (D1) = 1.345 (59.5%)Required rate of return (RE)= 0.15 (15%) Return on equity (ROE) = 0.299 (29.9%)

Growth rate (g) = 0.405 (r) * ROE (0.299)Growth rate (g) = 0.121

Ordinary share price = dividend in year 1 (D1)

Required rate of return (RE) – growth rate (g)

= 1.345 / (0.15 – 0.121)

= 46.3

So, applying the company’s 2010 rate of dividends with a 12.1% dividend growth rate (based on current ROE) with a required rate of return of 15%, would value the 2016 stock at SEK 46.3. The market value was SEK 104 (13 January 2016)

NB: Valuing the current stock with a 10% required rate of return is not possible due to the limitation of the models (Petty et al. 2012, p. 343)

Appendix 13 Enhanced dividend discount model

Simplifies to:

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Where:

EPS1 = expected annual earnings per share one year in the future at the firm’s normal growth rate;p = the normal retention rate;(1 – p) = the normal dividend payout rate;pg = the temporary increase in the retention rate (during the growth phase);r = the required rate of return;g = the normal growth rate;gn = the increase in the dividend growth rate, attributable to the increased retention rate (gn = ROE * pg);DR = the reduction in the dividend attributable to the increased retention rate (DR = EPS1 * pg).

Assuming:

Dividends (D1) = 1.345 (from appendix 12c)EPS0 = 3.00ROE = 0.165g = 0.05Accelerated growth rate = 0.20 Accelerated growth period = 3 yearsr = 0.10 pg = 0.2 (Normal retention rate (p) = 0.55; accelerated growth period retention rate = 0.75)

Then:

So, applying the company’s 2010 rate of dividends with a 3 year period of 20% accelerated dividend growth followed by a return to a 5% dividend growth rate with a required rate of return of 10%, would value the 2016 stock at SEK 41.5, assuming a ROE of 16.5%. The market value was SEK 104 (13 January 2016)

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