Forecasting and Valuation - Assignment Example

Forecasting and Valuation Name Lecturer Course Date Outline I Introduction II Webjet limited business and its strategy for competitive advantage; III Forecast pro-forma financial statements IV Key historical financial ratios V 5 questions to the CEO VI Valuation A). Valuation assumptions and valuation approach B). Discount rate for the equity C). Earnings Per share and Share price D). Value under discounted free cash flow model VII Comparison of Intrinsic Value with the Current Share Price VIII Recommendation to investors Reference List Appendix Introduction The objective of this project is to apply the discounted cash flow to the firm model for the purpose of stock evaluation along more fundamental lines. This is because markets generally in the longer term tend to adhere more to market fundamentals. We would utilize past information via the financial statements of the firm to come up with the cash flows to the firm under the discounted cash flow to the firm model. The company that chosen for the purpose of this evaluation is Webjet limited the listed on Australia stock exchange. Most investors don’t particularly see dividends as a positive factor under the Discounted Cash Flow to the Firm model at the same time a company that has been paying dividends regularly would imply greater fiscal management and financial health over a company that has never paid a single dividend or pays dividends only once in four years. The project would evaluate the share and we would look at its market value and intrinsic value and of particular explain difference between its intrinsic and market values. We would function by a simple rule of thumb then whereby if the intrinsic value is greater than the market value of the firm then via market fundamentals it would be an ideal time to buy the stock as the stock is undervalued and thus ripe for purchase. If the intrinsic and market values of the stock are the same then we might hold the stock for the moment and there would be no clear need to sell, lastly if we calculate the intrinsic value of the stock to be lower than the market value then it would be an ideal time to exit from the stock as the stock is now overpriced and may fall anytime thus and one must sell. Webjet limited business and its strategy for competitive advantage; The company was founded in Australia and offers travel and hotel bookings. The company is one of large online booking company in Australia. The company as integrated all the assistance some as led into effective cost management. The integration of the systems as assisted in organizing work and the communication flow between various booking offices provide great value for money. The company has employed information technology in ensuring communication is successful in organization. The Webjet limited relies on resources such as advanced technology to maintain its competitiveness, although rival companies with sufficient financial capabilities can imitate them (Khalil, Lefebvre, & McSpadden, 2001, p.460). Much as Webjet limited’s strategic strengths enhance the company’s competitiveness, they are not rare, and hence cannot sustain this competitiveness for long (Porter, 1998, p.36). On the other hand, Webjet limited is incurring high operating costs to support its strengths and sustain its competitive position, reducing its profits in the process. The desire to satisfy the ever-changing customer needs and sustain their loyalty to the company may force it to incur even more costs, and this may be unprofitable in the long-term. To overcome these weaknesses, it is advisable for Webjet limited to focus on reducing its operating costs by replacing its system with new. This will eliminate the need for regular upgrades and increase the company’s capability of meeting its customer satisfaction goals. Consequently, an increase in sales and a decline in expenditure would lead to increased profits in the short-term and sustained competitiveness in the long-term. In addition, Webjet limited should reduce the size of its workforce and adopt mechanization in areas where technology can be applied, since this would reduce the amount of money allocated to payrolls and increase the company’s income revenue (Bragg, 2010, p.78). A large workforce translates to more costs while increasing the possibility of human-related inconsistencies, and as such, Webjet limited should take steps to operate with a smaller workforce. Increased mechanization would also assist in reducing delays by eliminating human error and improving the company’s overall effectiveness, which would be profitable in the long run. Webjet limited possesses strategic resources and capabilities that enable it to maintain a competitive advantage in the industry. There is need, however, for the Webjet limited’s decision-makers to formulate strategies aimed at sustaining this competitiveness in the long-term. It is hoped that the analysis of the Webjet limited’s internal environment presented in this document will be beneficial in highlighting critical strengths and weaknesses, enabling the making of informed decisions. Forecast pro-forma financial statements The forecasted financial statements are in the excel file which is appendix. This information has been used to prepare valuation. Key historical financial ratios From the financial statement it can be noted that the company is purely equity financed therefore it does not have long term debt except deferred tax and provisions. Looking at the liquidity ratios we will note that the short term financial stability is decreasing although it remained above the recommended ratio of 2:1. It was 4.8:1 in 2008 it increased shortly 5.3:1 then it went down to 4.3:1 and 3.4:1 in the year 2010 and 2012 respectively. The graph below shows the trend of liquidity ratio. Looking at the profitability ratios that is profit margin return on total assets and return on equity interesting phenomena will be noted. All the ratios have down ward trend except the year 2009- 2010 when it is increased. The following graph and table shows the ratios and the trend. Strength, the value shows that the market value of the shares earns 14.57 times more for 2011 although it is forecasted to fall to 11.41 in 2017. However, this ratio is better than the industry average in year 2011 of 13.7 times. Due to significant decrease in the profitability of the company, the price earnings ratio deteriorated significantly which is expected to result in lowering down of company’s shares prices in the coming years to attain a stable value since the shares are overvalued at the moment when compared to the values reported for the previous years. The following graph shows performance of the ratio; The company is doing well the industry. 5 questions to the CEO Is the company accepted to change their pricing policy? Is there prospect of increasing market share and worth rate? Is the company planning to introduce new business activity? Will the company change their dividend policy or increase their share capital? Are there plans of injecting debt capital to company? Valuation The simplest way to measure the value of a publicly held firm is to go into the marketplace and find the price at which the most recent transaction in the firm`s. Market price quotations for many securities are published daily local newspapers. Prices of less actively trade stocks can be obtained from a stockbroker. The value of shares of small closely held companies, for which there is no actual market, cannot be measured in this manner. However, the market value of similar firms that have publicly traded shares may act as a very rough approximation of the firm`s share values. Publicly traded stocks normally sell above their book value, through in some cases the market price may be less than the book value. The average price-earnings ratio in an industry can be used as a guide to a firm`s value if it is assumed that investors value the earnings of a given firm in the same way as they do the earnings of the average firm in the industry. Multiplying the forecast annual earnings per share of a firm by this ratio gives us an estimate of the value of the firm`s shares. This measure of value, like the preceding ones, lacks any deep theoretical roots. It is best looked on as a tool for forecasting a firm`s future share price (Nikolai, Bazley and Jones, 2009). The accuracy of the forecast depends greatly on how average the company is since the use of the industry average price-earnings ratio assumes the firm to be average. However, this measure of a firm`s value is certainly better than the preceding measures since it does implicitly consider expected earnings. Valuation assumptions and valuation approach The assumption is that the rate of growth is steady for the period under forecast and any actual market reaction will not change. This means that one can predict with a degree of certainty for 6 years thus length of free cash flow used for valuation is 6 years. Although the currently the company has not had a beta but sometime back it was 1.13 thus we use. Beta is calculated when looking at the relationship between market returns and the preferred financial asset returns. The market premium has been assumed to be 7% and the risk free rate is assumed to be 3.75%. Discount rate for the equity The biggest concern for every investor is assessing the risk of the company they are investing in. In trying to determine the risk of an organization, there are many things that have to be considered to take into account many internal and external factors that affect the organization, so there a particular metric that would do this. Investors use beta measure to record the risk profiles. The beta of a company is important to consider as it measures the risk of the particular stock with that of the whole market. In such a case Capital Asset Pricing Model (CAPM) is a model that is widely accepted and used as a way of assessing the levels of risks associated with a particular asset that is being considered for investment. Although this model is not perfect however its use has allowed investors to somewhat predict the level of the investment risk that is associated. The main message which CAPM model gives to its users is that how much return premium they can expect from their investment in any security keeping in view the riskiness relative to the market benchmark. This means that the expected return on investment in an asset depends upon the risk assessment of the stock in relation to the volatilities that can be observed in the comparable set of securities or market. This also implies that it allows investors to determine the expected return on their investments in a portfolio which allows them to eliminate the unsystematic risk. Thus, on the basis of this model risk associated with the investment can be ascertained based on the assumptions that this model uses. Thus we use CAPM in calculating discount rate which will be used to calculate present value of predicted cash flows from the divers of valuation. The following is the calculation of the cost of equity; re = rf + β (rm - rf) re is cost of equity, rf is the risk free rate, β is beta and (rm - rf) is the market premium Therefore; re = 0.0375+ 1.13(0.07) re = 0.1166 re = 11.66% The aforementioned calculation shows the relationship between risk and return for the particular stock. So the expected return on this particular stock is considered to be the return of a risk free security plus the consideration of a premium for the additional risk being incurred. Earnings Per share and Share price Stockholders are mainly concerned about the earnings that will eventually pay them back as dividends from the company or on the other hand retains in the company to expand shareholders interest in the company since the firm retains the earnings. Earnings per share (EPS) are expressed on a per share basis. Therefore EPS = Amount available to shareholders / Average Outstanding Shares (Brigham and Houston, 2009). The current stock price of the company is at $3.38 something with an EPS of 0.16 and a P/E of 21.26 only. The stock price is actually representing the company realistically in terms of its actual worth. The return on investment from the company is steady and growing steadily as well with a lot of strong core competencies but not generating income in an explosive manner like well known technology companies do. The PE multiple is also average as well. In short, the company is a solid business but does not belong to the impressive category either as a business or as an investment option. Solid and steady depicts them perfectly. Growth rate of any particular company analysis the assets, earnings and the growing dividends in the particular financial year. Dividend discount model initiates a clear understanding of different growth rates and also the relationship between share price, rate of return and dividend is analyzed. Any particular company may have no growth, constant growth or non constant growth (Brealey, Myers and Marcus, 2007). Value under discounted free cash flow model From the excel output in the appendix it shows that value of the share is $3.99 when free cash flows planning horizon is 6 years. The 6th year is taken as a terminal year which is used to calculate perpetual present value. The following is an extract of the excel output for valuation Growth rate 10.7% Operating profit % 37.6% Tax on operating profits 25.3% Fixed asset investment % of sales growth 22.7% Working capital investment % of sales growth -15.0% Cost of capital 11.7% Year 0 1 2 3 4 5 6 2011 2012 2013 2014 2015 2016 2017 Sales 43,548.00 48,192.83 53,333.08 59,021.58 65,316.82 72,283.51 79,993.27 Op profit 18,112.02 20,043.84 22,181.72 24,547.62 27,165.87 30,063.38 Tax 4588.34 5077.74 5619.33 6218.69 6881.97 7616.00 Fixed assets 10,915.93 12,080.22 13,368.70 14,794.60 16,372.60 18,118.90 Working capital -7252.69 -8026.26 -8882.35 -9829.74 -10878.18 -12038.44 cash flow 26363.60 29175.54 32287.40 35731.18 39542.26 43759.84 Discount factor 1.0000 0.8956 0.8021 0.7183 0.6433 0.5761 0.5160 Planning horizon 23610.60 23400.42 23192.11 22985.65 22781.03 22578.23 Summary Sum of planning horizon PVs 115,969.81 PV of perpetuity, discounted 5 years 193,638.38 Marketable securities (Assets held for sale) 0.00 Corporate value 309,608.19 Long-term debt - Shareholder value $ 309,608.19 No. of shares (000) 77,584 Share price based on calculation $ 3.99 share price in 1 July 2011 $ 2.02 ( finance yahoo) share price in 7th May, 2012 $ 3.38 Comparison of Intrinsic Value with the Current Share Price The intrinsic value of the share is $3.99 while the value of the share is $ 2.02 at 1st July, 2011 or $ 3.38 as on 7th July, 2012(Yahoo Finance, 2012). This means that the share is undervalued by the market. This means the share is less risky investment. It should be noted that the share price of a company is influenced by the type of information that is realized to the market. For example declaration of profit or disclosing future project will influence investors to invest in the company and the share price will increase. In this case the company share are undervalued thus their less risk shares. The management is adding value to the company in terms of the expansion overseas and entering new markets aside from their core business. The stock price of the company is also very close to its actual intrinsic value. The financial valuation of the company indicates that they are indeed strong and growing at a healthy rate. The residual income is growing at a constant rate despite the negative factors still present. The only downside to their operation is their need for massive capital inputs. They literally have bigger assets than the calculated present value from the free cash flow method. They surely won’t be as fast in terms of growth and revenue generation unlike technology companies but they are very resilient when it comes to technological changes and economic downturns by the very nature of their businesses as well. In short, they are big and strong but unfortunately they are also slow in terms of investment growth rate. Recommendation to investors The decision to buy, sell, or hold depends on, among other market and growth factors, the calculated value of stock. Stocks judged to be undervalued are bought while those judged to be overvalued in relation to their theoretical value are sold (Collins, 2003). On the other hand, investors hold on to stocks which are neither overvalued nor undervalued in relation to their theoretical value (Palepu, Healy and Bernard, 2010). For an investor who is holding portfolio of assets such as stocks, notes, real estate property, bonds and treasury bills web jet limited is a good investment because the share value as per the market on 1st July 2011 is $ 2.02 and intrinsic value is 3.99. This means the share return is higher which will improve the value of the portfolio. For an investor who is currently holding the shares of web jet he should not sell them but keep them. This is because web jet limited is a good investment for a potential investor as the returns are high. Reference List Bragg, SM., 2010. Cost Reduction Analysis: Tools and Strategies. Hoboken: John Wiley & Sons, p.78. Brealey, R, Myers, S & Marcus, A., 2007. ‘Fundamentals of corporate finance’, .Sydney: McGraw-hill. Brigham, E. F., & Houston, J. F., 2009. Fundamentals of financial management. Mason: CENGAGE Learning. Collins, J., 2003. From Good to Great. San Francisco: Harper Collins Publishers Khalil, T. M., Lefebvre, L. A., & McSpadden, R., 2001. Management of Technology: The Key to Prosperity in the Third Millennium. Oxford: Emerald Group Publishing. Nikolai, L., Bazley, J. & Jones, J., 2009. Intermediate Accounting. Mason: Cengage Learning. Palepu, K., P. Healy & V. Bernard, V., 2010. "Business Analysis and Valuation using Financial Statements: Text and cases" Peirson, G, Brown, R, Easton, S & Howard, P, Pinder, Sean 2000, ‘Business finance’, 7th edn, The McGraw-Hill Companies, Inc, Sydney. Porter, M. E., 1998. Competitive Advantage: Creating and Sustaining Superior Performance : with a New Introduction. New York: Simon and Schuster. YahooFinance, 2012. " Webjet Limited’’ Available from: .[Accessed 07 May 2012]. Appendix – excel file Read More