Reference no: EM133057022

Gilbert Enterprises

Tom Gilbert, founder and chair of the board of Gilbert Enterprises, could not believe his eyes as he read the quote about his firm in The Globe and Mail. The stock had closed at $35.25, down $3.75 for the week. He called his vice-president of finance, Jane Arnold, and they agreed to meet on Saturday morning at 9 a.m. for breakfast.

When Jane arrived, they reviewed the stock's performance for the past few months. Although the stock opened the year (20XX) at $28.50 per share, it had reached a high of $50 in March, but had steadily slid in value to its current level of $35.25 in mid-May. Tom and Jane both thought the stock was undervalued in the marketplace and were seriously considering an announcement that the firm was going to repurchase up to one million of its own shares in the open market beginning on June 1, 20XX. They thought this would send a message to investors that the market had placed the stock at an unrealistically low level.

Before taking any action, they decided to consult with their investment banking representative, Albert Roth, senior vice-president at the investment firm of Baker, Green and Roth. Roth had aided the firm in initially selling its stock to the public ("going public") five years ago, and was quite familiar with its operations. Although he was surprised to receive their call during an early Saturday morning round of golf at the country club, he promised to get back to them in the next few days with his recommendation on a stock repurchase.

Gilbert Enterprises was the third-largest firm in the auto parts replacement industry, specializing in brake parts, power transmissions, batteries, cables, and other products related to used automobiles. Although most of the auto industry advertising relates to flashy new cars, Albert Roth knew that the auto parts replacement industry was becoming increasingly important.

His research indicated that the average age of an automobile life had reached eight years in 20XX, up from a mere 6.8 years from 10 years previously. Why? New vehicle price increases had far surpassed the rise in consumer income. People are forced to keep their old cars longer whether they want to or not. Furthermore, environmental legislation mandated more emission inspections and maintenance programs. Consumers were being forced to spend more money to update older automobiles to meet these standards.

Gilbert Enterprises had the most advanced just-in-time (JIT) inventory management system in the industry. For that reason, Albert Roth believed the firm would enjoy supernormal growth, beyond industry standards, for the next three years. His best estimate was that a 15 percent growth rate during that time period was entirely reasonable. After that time span, a more normal growth rate of 6 percent was expected. Current dividends were 1.20 per share, and he decided to use a discount or required rate of return of 10 percent.

He discussed this approach with his partners, and although they generally agreed, they suggested that he also consider a more traditional approach of comparing the firm's P/E ratio to other firms in the industry. P/E data along with other information are shown in Table 1 for Gilbert Enterprises and three other firms in the industry.

What recommendation would you suggest that Albert Roth make? Do you suggest the firm is under- or overvalued?