Financial Analysis and Valuation of a Company


Project Two

A Financial Analysis and Valuation of a Company

Companies Selected

If you chose a company by the deadline in March then this has been noted below. It is now assumed you will be undertaking project 2 and will not be undertaking project 3. If your name is not noted below then it is assumed you will be undertaking project 3 – a topic of your choice (with prior approval).

Introduction and Project Requirements

The second project requires that you undertake a financial analysis of a company from the standpoint of a potential investor and provide an evaluation of the investment potential of the company’s shares.

An assessment should be undertaken of the company’s financial position and performance on the basis of both its financial statements and stock market performance. The discussion should also bring out clearly the financial policies of the company and how these impact on the company’s performance. This will require an evaluation of its capital expenditure programme, the form of financing adopted by the company, including an evaluation of its capital structure and its sources of equity and debt funding. You should differentiate between the use of internal sources of funding, in the form of retentions, and the new issues of equity, and also discuss the company’s dividend policy to the extent that this is not covered by the discussion of its retention policy.

In some companies it may be difficult to identify a consistent policy perspective on some of these issues – this can be documented and its implications assessed. The project should also provide an assessment of the company’s recent stock market performance to put the current share price into context. The returns achieved on the company’s shares should be evaluated using an appropriate benchmark as well as the standard market ratios – the earnings yield, dividend yield, etc.

The final objective of the project is an assessment of the value of the company and the investment value of its shares. Even the most experienced and capable security analysts find this a very difficult task, even though they may be monitoring a company’s performance and prospects on a continuing basis. You are simply expected to build on the financial information and analysis you have undertaken to produce some tentative assessments of value. As the focus is on the use of financial information, you are expected, firstly, to undertake a “fundamental analysis” of the company. Secondly, you are expected to use the various valuation models to provide insight into the determination of the company’s market value and make tentatively estimates of the company’s investment value.

The authors of one of the leading textbooks on security analysis and portfolio theory, Bodie, Kane and Marcus, have defined fundamental analysis in the following way:

Fundamental analysts usually start with a study of past earnings and an examination of company balance sheets. They supplement this analysis with further detailed economic analysis, ordinarily including an evaluation of the firm’s management, the firm’s standing within its industry, and the prospects for the industry as a whole. The hope is to attain insight into future performance of the firm that is not yet recognised by the rest of the market.

Bodie, Kane and Marcus, “Investments”, McGraw Hill, 9th ed., p.378

This implies that fundamental analysis is trying to identify stocks or shares which are “mispriced” in relation to their “true or intrinsic value” and some financial theorists might even argue that this is an impossible task. Those who accept the reasoning of efficient market theory will contend that market prices provide the only reliable estimate of intrinsic value. This view can possibly be questioned on the basis of the significant body of anomalous evidence in relation to the efficient market hypotheses that has been accumulated over the last thirty years, though there is little evidence to suggest that the market fails to take specific items of accounting information into account in valuing shares. Another response to the efficient market position is to point to the absence of a well-developed theory to explain how costly information is gathered and analysed in the absence of incentives provided by mispriced securities. It is certainly legitimate to identify the extent to which valuations derived on the basis of fundamental analysis and other approaches considered differ from market prices. Having recognised the efficient market perspective the focus of this project is on the use of analysis and models to derive estimates of intrinsic value. The issues related to valuation will need to be discussed in depth and it is expected that when the analysis has been completed, a range of values will have been developed.

In general terms, this project is intended to give you an opportunity to look in depth at a company and to enable you to explore the practical relevance of some of the analysis developed in the taught component of the course. The project will result in a report that should be a minimum of 8,000 words in length, but a good project would be expected to be around 10,000 words.

Overall Plan of the Project

It is not intended that the content of the project should be narrowly prescribed and there is considerable scope for you to work on your own initiative, but there are a number of constrains imposed on you! The first of these were the limitations you had to deal with in selecting your companies. For instance, you were asked to select a UK company in order to avoid the problems that arise from the different accounting requirements and regulations in other countries. It was also required that the selected company should not be a financial institution and should have made a profit in the last three years so that it is feasible to conduct a financial analysis given the techniques and models you are going to employ.

Possible Structure for the Project

Chapter 1 – Introduction (guideline: 10% of total word count)

This section should provide a brief examination of the economic and financial environment in which the company operates. The UK economy will be the starting point and you should also discuss the markets in which the company operates. At this stage, it is appropriate to identify three to five other companies from the same industry. These companies will provide a basis for drawing conclusions about the industry as a whole and the basis of benchmarks with which to compare the company under consideration. Therefore, it is important to provide a good justification of the peer group selection and outline clearly the associated selection criteria. Any other general factors that are particularly significant to the performance and prospects of the company should also be discussed.

Chapter 2 – Financial Performance and Position of the Company (guideline: 30% of total word count)

In the analysis of the financial performance and position of the company it is anticipated that various ratios should be calculated to enable the profitability, liquidity, asset management and capital structure of the company to be described and analysed. By carefully reading the various statements and analysis that are included in the Annual Report of British companies, it should be possible to produce a view of the company, its performance, strategy, and trends over the past three years. The ratios that are calculated for the company should be compared to those of the other companies, in the same industry that were chosen to act as benchmarks for the company’s position and performance. Using the share price of the company, it is possible to calculate the various investment ratios. The changes in earnings per share and the P/E ratio will enable the outcomes for investors to be discussed and a comparison made with the benchmark companies.

For a more complete and accurate evaluation of the company’s past financial performance, its stock price performance should also be taken into account as the latter will provide a good indication of the wealth created for company’s shareholders over the period under examination. For a long-run stock price performance evaluation, the Abnormal Buy-and-Hold Return (ABHR) can be used but you are welcome to come up with an alternative method/model if you want. The ABHR for company i can be calculated as follows:

where N is the holding period. Typically, the ABHR is calculated for a 24-36 month-period. Therefore, the examination of the past 3-year stock price performance is recommended should there be sufficient stock price data. The benchmark against which the company’s performance will be measured can be the weighted average of the industry peers used in the ratio analysis, the market index (e.g. FTSE 100 if your company is listed in this index) or both. The analysis should be accompanied by a discussion that will present and explain the results and possible deviations from the industry and/or the UK market.

Chapter 3 – Financial Management policies (guideline: 20% of total word count)

Calculating and tracking over a number of periods the dividend per share; the payout ratio; and dividend yield will allow the dividend policy of the company to be assessed and evaluated. At this stage the theory relating to dividend policy should be employed to interpret the policy for the company.

A similar analysis should be undertaken for the other financial policies considered, eg. capital structure. It is possible that you will find that the policies adopted by some companies are relatively consistent over time and easy to interpret, but for others a coherent policy may be difficult to identify. It would be appropriate to also consider factors such as the manner in which the company deals with risk of various kinds.

It is important to demonstrate a good knowledge and understanding of the main theories and be able to critically identify whether the company’s financial management policies can be explained by any of the relative theories or there are other determinants that have played an important role in the formation of these policies.

Chapter 4 – Valuation of the company (guideline: 30% of total word count)

There are a number of different approaches that can be employed to estimate the value of a company. Some are relatively easy to implement but lack a strong theoretical basis, whereas others, such as those based on the discounted cash flow approach, have a strong theoretical basis but are more difficult to implement. The different approaches will almost certainly produce different values that may be difficult to reconcile, but may also provide different insights into the factors determining the value of the company. A number of approaches should be employed and the different values produced should be discussed before expressing judgement on a range of possible values.

1.The theoretically correct methods of valuation are based on the discounted cash flow principle. There are three primary models to consider – the dividend model, the earnings and investment model, and the free cash flow model. All these models are based on some exacting assumptions and require forecasting the future outcomes for the company. You should discuss the assumptions and consider the extent to which it is necessary to relax the assumptions in applying the models to the circumstances of the company being evaluated. In all three models it is necessary to identify a period of a number of years for detailed analysis and at the end of this period the employment termination value.
For the dividend model estimate the expected dividends for the next n years and the expected value of the company at that point in time. This produces the following valuation equation Where it is necessary to determine the time period for detailed analysis. The terminal value is given by The discount rate needs to be determined, possibly based on the CAPM, and this requires estimating Beta, the risk free rate of interest and the market risk premium.
The analysis also requires an estimate of the long run growth rate for the company’s dividends.
For earnings and investment model the relevant specification is This requires asking questions about the sustainability of earnings from existing assets and the contribution of the company’s future investment programme to the value of the company. How much is the company investing and what rate of return does it appear to be generating on this investment? Is the investment programme contributing to value?


2.An alternative approach focuses on the net cash flows that a company is expected to generate. The free cash flow approach to valuation can focus on either the free cash flow to the company, or the firm, FCFF, or the free cash flow to the equity (FCFE). The former (FCFF) specifies the cash flows that are available to all the parties providing the company’s funding, the shareholders and those lending to the company. The latter (FCFE) predicts the cash flows left to the shareholder after all commitments, including payments to all the suppliers of funding, have been covered. The FCFF should be evaluated at the company’s weighted average cost of capital whereas the FCFE should be valued using the company’s equity cost of capital.
In principle the free cash flow models should produce the same valuation as the dividend model, given the same assumptions. However, the free cash flow models take a very much more detailed approach to the development of the net cash flow estimates and in practice are likely to end up with different values to those derived from the dividend model. In providing a more detailed approach the fee cash flow models are not so constrained by its assumptions as is the dividend model.
This very clearly requires a more detailed evaluation of a company’s possibilities than the dividend model. In forcing analysts to develop the more detailed analysis it might also imply the development of a fuller understanding of the company. The analysis is based on the financial statements of the company and most analysts are comfortable with this as a starting point. Despite the generally acknowledged limitations of accounting statements as a basis for valuing companies this implies an objective point for the analyst.
The rationale for adding back depreciation and subtracting capital expenditure is relatively straightforward. But it should be noted that the timing of the terminal value should take into account the period required for capital expenditure and depreciation to fall into a regular pattern.
To derive the free cash flow to the firm requires:
an estimation of the cash flow from the company’s operations – its expected revenues less its operating costs and tax payments. an estimation of the company’s capital expenditure and investment in net working capital, probably representing a cash outflow. The cash flows derived on this basis for future time periods are then discounted back to the present at the company’s weighted average cost of capital.
This can be specified in the following way

As these cash flows run indefinitely into the future it is necessary to find a way around the problem of having to derive the present value of an infinite series. The natural solution is the use of a terminal value to represent the cash flows beyond some future point.

As in the dividend model the terminal value can be derived by taking the present value of a constant growth perpetuity. Or by applying some other multiplier to the FCFF

The growth rate must be sustainable and the appropriate multiplier should reflect the anticipated growth rate. The period for which the free cash flow is estimated on a year by year basis will depend on the period over which the company’s free cash flow is thought to be usefully estimated on a detailed basis. This may represent a period of non-sustainable growth or a period of adjustment prior to the company settling down to a more normal pattern of behaviour. Generally this period is unlikely to be long enough rendering the terminal value a critical input into the derivation of the value of the company. This implies that considerable care needs to be taken in specifying the terminal value.
Expressed as simple as possible, the FCFF is given by
FCFFt = EBITt (1 – tc) + Depreciationt – Capital Expendituret – Increase in NWCt = Net Earnings available to equity + Interest (1 – tc) + Depreciationt – Capital Expendituret – Increase in NWCt
The FCFE models specify the net cash flows as
FCFE = FCFF – Interest expense (1 – tc) + Increases in Net Debt
The interest expense after tax is deducted as the interest charges are not recognized as a cash outflow in the specification of the FCFF. The FCFE is then valued, as noted earlier, using the company’s cost of equity capital. For this to remain constant it is necessary to assume that the company’s debt-equity ratio remain constant. This implies that in principle the details of “Increases in net debt” have to be considered in conjunction with the company’s level of gearing in determining the discount rate. (In practice there is a tendency to ignore the changes in gearing unless these are significant.)


3.One of the simplest approaches to estimate value involves the application of a multiplier to the current earnings of the company. But it is not quite as simple as it might appear! First of all it has to be recognised that the multiplier should be based on what is considered to be the appropriate price-earnings ratio for the company. In principle this can be derived from the prevailing price-earnings ratios of companies with similar growth prospects and risk characteristics as those of the company being valued. The determination of the benchmark value for the price-earnings ratio requires judgement, particularly when the companies in the same industry have different growth prospects. It is also necessary to ensure that the companies used to derive the “price-earnings” multiplier employ similar accounting policies to determine earnings. In practice this again implies the exercise of judgement to adjust the price-earnings ratios of companies employing conservative estimates of earnings downwards compared to those with more literal estimates of earnings upwards. For security analysts such judgement comes from their experience in analysing accounting information – in the context of the project recognising the nature of problems is the most important step but you will also have to apply some judgement. A further problem arises from the need to apply the multiplier to the “normalised” earnings of the company if earnings in the current period are unusual for any reason. Recognising the potential problem is important and determining some method for normalising the figure for this project is less critical but should be attempted.

Once the values from the different approached have been calculated, it is expected that the outcomes will be discussed and the significance to existing or potential investors be explored. It would be appropriate to identify the factors that are likely to be responsible for the differences between the values that have been estimated.

Chapter 5 – Conclusion (guideline: 10% of total word count)

This final section of the project should bring together the findings of each of the sections and this should enable a reasoned discussion to be provided which will enable existing and potential investors to decide on increasing or decreasing their holdings of the company’s shares.

Again, what is presented above is a general plan of how the project could possibly be structured and some recommended guidelines on the methods that could be employed. You are welcome to present and develop your own ideas and make your own independent contribution to the project. Creativity and innovation will be highly appreciated and rewarded in relation to all aspects of the project including presentation, methodology, analysis and critical reasoning.

References

Bodie, Zvi, Kane, Alex and Marcus, Allan J., Investments and Portfolio Management, McGraw-Hill, 9th edition, 2011. Chapters 21, 22 and 23 provide relevant background reading.

Hillier, Ross, Westerfield, Jaffe and Jordan, Corporate Finance: First European Edition, McGraw-Hill, 2010, Chapters 9, 15 and 17.

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