Prairie Home case

14. Negative Growth. Prairie Home is in a declining industry. Sales,
earnings, and dividends are all shrinking at a rate of 10 percent per
year.

a. If r = 15 percent and DIV1 = $3, what is the value of a share?

b. What price do you forecast for the stock next year?

c. What is the expected rate of return on the stock?

d. Can you distinguish between “bad stocks” and “bad companies”?
Does the fact that the industry is declining mean that the stock is a
bad buy?

18. P/E Ratios. Prairie Home projects a rate of return of 20 percent on
new projects. Management plans to plow back 30 percent of all earnings
into the firm.

Earnings this year will be $2 per share, and investors expect a 12
percent rate of return on the stock.

a. What is the sustainable growth rate?

b. What is the stock price?

c. What is the present value of growth opportunities?

d. What is the P/E ratio?

e. What would the price and P/E ratio be if the firm paid out all
earnings as dividends?

f. What do you conclude about the relationship

between growth opportunities and P/E ratios?

MINICASE

Terence Breezeway, the CEO of Prairie Home Stores, wondered what
retirement would be like. It was almost 20 years to the day since his
uncle Jacob Breezeway, Prairie Home’s founder, had asked him to take
responsibility for managing the company. Now it was time to spend more

time riding and fishing on the old Lazy Beta Ranch. Under Mr.
Breezeway’s leadership Prairie Home had grown slowly but steadily and
was solidly profitable. (Table 3.7 shows earnings, dividends, and book
asset values for the

last 5 years.) Most of the company’s supermarkets had been modernized
and its brand name was well-known. Mr. Breezeway was proud of this
record, although he wished that Prairie Home could have grown more
rapidly. He had passed up several opportunities to build new stores in
adjacent counties. Prairie Home was still just a family company. Its
common stock was distributed among 15

grandchildren and nephews of Jacob Breezeway, most of whom had come to
depend on generous regular dividends.

The commitment to high dividend payout 1 had reduced the earnings
available for reinvestment and thereby constrained growth. Mr. Breezeway
believed the time had come to take Prairie

Home public. Once its shares were traded in the public market, the
Breezeway descendants who needed (or just wanted) more cash to spend
could sell off part of their holdings. Others with more interest in the
business could hold on to their shares and be rewarded by higher future

earnings and stock prices.

1 The company traditionally paid out cash dividends equal to 10 percent
of

start-of-period book value. See Table 3.7.

Fundamentals of Corporate Finance

640

TABLE 3.7

Financial data for Prairie Home Stores, 2000–2004 (figures

in millions)

2000 2001 2002 2003 2004

Book value, start of year $62.7 66.1 69.0 73.9 76.5

Earnings $9.7 9.5 11.8 11.0 11.2

Dividends $6.3 6.6 6.9 7.4 7.7

Retained earnings $3.4 2.9 4.9 2.6 3.5

Book value, end of year $66.1 69.0 73.9 76.5 80.0

Notes:

1. Prairie Home Stores has 400,000 common shares.

2. The company’s policy is to pay cash dividends equal to 10 percent
of

start-of-year book value.

But if Prairie Home did go public, what should its shares

sell for? Mr. Breezeway worried that shares would be sold,

either by Breezeway family members or by the company

itself, at too low a price. One relative was about to accept a

private offer for $200, the current book value per share, but

Mr. Breezeway had intervened and convinced the would-be

seller to wait.

Prairie Home’s value did not just depend on its current book

value or earnings, but on its future prospects, which were

good. One financial projection (shown in the top panel of Table

3.8) called for growth in earnings of over 100 percent by 2011.

Unfortunately this plan would require reinvestment of all of Prairie
Home’s earnings from 2006 to 2010. After that the

company could resume its normal dividend payout and growth rate. Mr.
Breezeway believed this plan was feasible.

TABLE 3.8

Financial projections for Prairie Home Stores, 2005–2010

(figures in millions)

2005 2006 2007 2008 2009
2010

Rapid-Growth Scenario

Book value, start of year 80 92 105.8 121.7
139.9 146.9

Earnings 12 13.8 15.9
18.3 21.0 22.0

Dividends 0 0 0 0 14 14.7

Retained earnings 12 13.8 15.9 18.3
7.0 7.4

Book value, end of year 2 105.8 121.7 140.0 146.9
54.3

Constant-Growth Scenario

Book value, start of year 80 84 88.2 92.6 97.2 102.1

Earnings 12 12.6 13.2 13.9 14.6 15.3

Dividends 8 8.4 8.8 9.3 9.7 10.2

Retained earnings 4 4.2 4.4 4.6 4.9 5.1

Book value, end of year 84 88.2 92.6 97.2 102.1 107.2

Notes:

1. Both panels assume earnings equal to 15 percent of start-of-year book
value. This profitability rate is constant.

2. The top panel assumes all earnings are reinvested from 2005 to 2009.
In 2010 and later years, two-thirds of earnings are paid out as
dividends and one-third reinvested.

3. The bottom panel assumes two-thirds of earnings are paid out as
dividends in all years.

4. Columns may not add up because of rounding.

He was determined to step aside for the next generation of top
management. But before retiring he had to decide whether to recommend
that Prairie Home Stores “go public”—and before that decision he
had to know what the

company was worth.

The next morning he rode thoughtfully to work. He left his horse at the
south corral and ambled down the dusty street to Mike Gordon’s Saloon,
where Francine Firewater, the company’s CFO, was having her usual
steak-and-beans breakfast. He asked Ms. Firewater to prepare a formal
report to Prairie Home stockholders, valuing the company on the
assumption that its shares were publicly traded.

Ms. Firewater asked two questions immediately. First, what should she
assume about investment and growth? Mr. Breezeway suggested two
valuations, one assuming more rapid expansion (as in the top panel of
Table 3.8) and another just projecting past growth (as in the bottom
panel of Table 3.8). Second, what rate of return should she use? Mr.
Breezeway

said that 15 percent, Prairie Home’s usual return on book equity,
sounded right to him, but he referred her to an article in the Journal
of Finance indicating that investors in rural supermarket chains, with
risks similar to Prairie Home Stores, expected to earn about 11 percent
on average.

FOOTNOTES

1 We use the terms “shares,” “stock,” and “common stock”
interchangeably, as we do “shareholders” and “stockholders.”

2 The table shows not only the company’s name, usually abbreviated,
but also the symbol, or ticker, which is used to identify the company on
the NYSE price screens. The symbol for PepsiCo is “PEP”; other
companies’ symbols are not at first glance so obvious.

3 Actually, it’s the last quarterly dividend multiplied by 4.

4 “Equity” is still another word for stock. Thus stockholders are
often referred to as “equity investors.”

5 This is partly due to inflation. Book values for United States
corporations are not inflation-adjusted. Also, when the accountants set
up the original depreciation schedule, nobody anticipated how long these
aircraft would be able to remain in service.

6 We assume it does not raise money by issuing new shares.

7 Notice that the first dividend is assumed to come at the end of the
first period and is discounted for a full period. If the stock has just
paid its dividend, then next year’s dividend will be (1 + g) times the
dividend just paid. So another way to write the valuation formula is

P0 = DIV1 = DIV0 Ч (1 + g)

r – g r – g