Investment Analysis Project

Transcription

1 Investment Analysis Project Aston Business School May, 4 th, 2011 Dr Cesario MATEUS 1

2 Aim Conduct an in-depth investment analysis case study on a single company drawn from FTSE 100 and been listed at least for the last three years. The case study exercise aims to provide students with the opportunity to demonstrate, in the development of a detailed analyst's company report, the skills and knowledge acquired in the area of investment analysis In the project the students should address besides others the following questions/issues: Introductory Material: Company Description, Ticker Symbol, Industry (Type of the industry), officers/directors Holdings, Partners, etc. 2

3 Corporate Governance Analysis: Is this a company where there is a separation between management and ownership? Economy Analysis: Discuss the general economy, Economic life cycle, Economic indicators, Macro-economic forecast and the future expectations from an economy Industry Analysis: Discuss the industry of the company, Industry life cycle, Macro and micro level of industry forecast and future expectations from an industry. Company Information: Copy of any relevant articles that appear in the written media, summarize the listed articles and discuss the effects of the articles to the company s financial structure. Follow the company news and information presented to the Stock Exchange, discuss the effects of the news to the company s stock price. 3

4 Stockholder Analysis: Who is the average investor in this stock? (Individual or pension fund, small or large, domestic or foreign) Risk and Return: Is the risk of the coming from market, firm, industry or currency? What return would you have earned investing in this company's stock? Would you have under or outperformed the market? How risky is this company's equity? Why? What is its cost of equity? How risky is this company's debt? What is its cost of debt? What is this company's current cost of capital Capital Structure Choices: What types of financing that this company has used to raise funds. Advantages or disadvantages for the firm in using debt. Does your firm have too much or too little debt comparing with the industry and the market? 4

5 Dividend Policy: How has this company returned cash to its owners? How would you recommend that they return cash to stockholders? Financial Information: Monthly Stock Prices of the last 3 years. Adjusted and Unadjusted. Monthly Stock Price Graph of the last 3 years, compare it to the FTSE 100 monthly returns. Fundamental Values with fundamental analysis (Last 3 years balance sheet and income statement with the most important accounts and headings, discuss the company s past performance in-terms of financial statements). Valuation: What type of cash flow would you choose to discount for this firm? What is your estimate of value of equity in this firm? How does this compare to the market value? What is the value of the firm? Is the firm over or undervalued? 5

6 Most recent: Market Value, Book Value, Beta, ROE, ROA, ROI, Profit Margin, Current Ratio, Dividends, P/E approach, and other important ratios of your choice from Leverage, Liquidity, Efficiency, Profitability, and Market-Value approaches. Timetable Date Hours May, 4 th Lecture May, 4 th Lecture May, 25 th Lecture May, 25 th Office Hours June, 22 nd Lecture June, 22 nd Office Hours

7 Last year results Nr Students 46 Average Mark 63.8 Median Mark 64 Std deviation 9.84 Maximum 88 Minimum 45 7

8 Risk Analysis and CAPM 8

9 Security Market Line Return Efficient Portfolio Risk Free Return Risk 9

10 Unsystematic and Systematic Risk Adding securities reduces portfolio risk, if they are not perfectly positively correlated. Unsystematic risk (unique risk) Total risk Systematic risk (market risk) No. of securities in portfolio 10

11 Efficient Risky Portfolios Variance of return - a poor measure of risk Investors can only expect compensation for systematic risk Asset pricing models aim to define and quantify systematic risk Begin developing pricing model by asking: Are some portfolios better than others? 11

12 Beta (β) Beta of Asset j Covariance of asset j with market portfolio Variance of the market portfolio Cov Rj, Rm 2 m In the CAPM, a stock s systematic risk is captured by beta The higher the beta, the higher the expected return on the stock 12

13 Beta (β) The basic features of Beta are: β = 1 A 1% change in the market index leads to a 1% change in the return on a specific share. 0< β<1 A 1% change in the market index leads to a less than 1% change in the return on a specific share. β>1 A 1% change in the market index leads to a greater than 1% change in the return on a specific share. 13

14 Beta And Expected Return Beta measures a stock s exposure to market risk The market risk premium is the reward for bearing market risk: R m - R f E(R i ) = R f + ß [E(R m ) R f ] Return for bearing no market risk Stock s exposure to market risk Reward for bearing market risk 14

15 Security Market Line Return Security Market Line (SML) Risk Free Return BETA 15

16 Security Market Line Return SML Rf f 1.0 BETA SML Equation = r f + B ( r m - r f ) 16

17 The Security Market Line Plots the relationship between expected return and betas In equilibrium, all assets lie on this line If stock lies above the line Expected return is too high Investors bid up price until expected return falls If stock lies below the line Expected return is too low Investors sell stock, driving down price until expected return rises 17

18 The Security Market Line E(R P ) A - Undervalued SML R M B A Slope = E(R m ) - R F = Market Risk Premium (MRP) R F B - Overvalued =1.0 i 18

19 Estimating Betas Collect data on a stock s returns and returns on a market index Plot these points on a graph Y axis measures stock s return X-axis measures market s return Plot a line (using regression) through the points Slope of line equals beta R-square value measures the percentage of risk that is systematic 19

20 Measuring Betas Dell Computer Price data Aug 88- Jan 95 R 2 =.11 β = 1.62 Dell return (%) Slope determined from plotting the line of best fit. Market return (%) 20

21 Measuring Betas Dell Computer Price data Feb 95 Jul 01 R 2 =.27 β = 2.02 Dell return (%) Slope determined from plotting the line of best fit. Market return (%) 21

22 Classifying shares by their beta Aggressive shares (i.e. such shares rise faster in a bull market and fall more in a bear market): β>1 Defensive shares (i.e. such shares enjoy less of a rise than the market in a bull market and fall less in a bear market): β<1 Neutral shares (i.e. share price fluctuates in line with the market): β = 1 22

23 Basic Valuation Models Core Concepts 1. Apply dividend discount models (DDM) to equity valuation. 2. Apply relative valuation models to equity valuation ( P/E, P/BV & P/CF) 3. Explain the components of an investor s required rate of return and the process for determining the inputs in the DDM including the required rate of return and expected dividend growth rate. 23

24 Estimating the Intrinsic Value Most investment valuation involves: Estimating the amount and timing of the cash flows Interest, dividends, and capital gains Estimating the growth rate of returns common stock / Real estate (Can grow over time) Preferred Stock / Bonds (fixed) Applying an appropriate discount rate to the cash flows to estimate the investment s intrinsic value The required return for the risk assumed Amount & timing of cash flow Comparing the intrinsic value to the market price If estimated intrinsic value > market price, then BUY! 24

25 Discounted Cash Flow Models Preferred Stock P pdf DIV r P Fixed/Perpetual Income-never matures Market Rate Common Stock P cs DIV DIV DIVn P... 2 (1 R ) (1 R ) (1 RCE) 1 2 CE Projected (not fixed) CE CS n n = DIV n 1 r g Constant (Gordon) Growth DDM g g economy P CS R CE DIV1 g DIV DIV0 (1 g) EPS1 Payout Rate ROE Retention Rate 25

26 Robert Tolson is valuing a preferred stock issued by XYZ Corporation. The preferred stock has a rating of AA and pays an annual 8% dividend on a $25 par value. Robert estimates that the required return on a share of XYZ s common stock is 14%. The 1- year Treasury bill is currently yielding 3%. Also, Robert has the following market information on otherwise equivalent preferred stock issuances: Company Rating Yield Pacific and Northern Inc. AA 7.0% Great Widgets Inc. AA+ 6.2% Spacely Rockets Corp. AA 6.5% Amalgamated Combined Inc. AAA 6.7% Based on this information, Robert s best estimate of the value of one share of the XYZ preferred stock to be: a. $14.29 b. $30.77 c. $66.67 d. $

27 Choice b is correct. Absent any other information such as information that call options or convertibility options are embedded in the preferred stock), this preferred stock can be valued as a perpetuity. A perpetuity is an instrument that pays a constant, regularly scheduled payment that continues forever. In this case, the regular payment is the annual dividend payment. The applicable formula for the value of a perpetuity is: Where: Div 1 is the annual dividend payment, and rp is the required return on the preferred stock. The annual dividend payment is equal to the dividend rate multiplied by the par value, or: DIV 1 =.08 $25 = $2.0 In this problem, the correct required return to use is the market yield on the most similar preferred stock, which in this case is the AA Spacely Rockets Corp. preferred stock with a yield in the market of 6.5% Plugging in the values, the price is calculated as: DIV1 $2 P $30.77 r 0.65 P 27

28 Marie Aparecida is valuing the stock of a mature company, XYZ corp. Maria has the following estimates and market information about XYZ corp: Estimated Earnings per share at t=1 $1.65 Estimated Dividend per share at t=1 $0.95 Current Market Price per share $13.40 Required Return 12% Estimated Dividend Growth rate 3.0% Current risk free rate 3.5% Using the Gordon constant growth dividend discount model, what value does Marie place on a share of XYZ stock. a. $7.92 b. $13.40 c. $18.33 d. $

29 Choice d is the correct. The constant growth model uses the simplifying assumption that dividends grow at a constant rate forever. The formula for the constant growth model is a compact way of calculating the present value today of all these future dividend payments that extend out of infinity. The formula is: P CS R CS DIV1 G DIV Where DIV 1 is the dividend the company is expected to pay in one year (t=1) R CE is the required return on common equity g DIV is the estimated sustainable dividend growth rate P CS DIV1 $0.95 $10.55 R G CS DIV Choice a is incorrect. This result ignores the dividend growth rate and simply divides the expected dividend by the required return. 29

30 Choice b is incorrect. This is the market price of the stock. Note that Marie is using the constant growth model to make her own estimation of the value of the stock. Using the constant growth model, Marie has estimated the stock to be worth $10.55 per share ; however, it is selling in the market at $ in this case, XYZ stock is overvalued in the market and Marie would not buy the security. Choice c is incorrect. This is the result if the expected earnings per share are used in the numerator. The expected dividend per share should be used because the dividends reflect the actual cash flows made to the shareholder. 30

31 Jane Wakeman is using the constant Growth Dividend Discount Model to value a share common stock issued by National Amalgamated Corp. She has made the following estimates regarding the stock and market rates; Estimated Dividend Growth Rate: 3% Expected Return on the Market 9% Risk-free Rate 4% Expected Dividend at t=1 $1.75 Beta 1.2 If Jane changes the risk-free rate in her valuation calculations from 4% to 5% and the market risk premium expected to remain constant, then Jane s estimate of the value of National Amalgamated Corp. will most likely: a. Decrease by $3.13 b. Increase by $0.74 c. Decrease by $0.75 d. Stay the same 31

32 Choice a is correct. The first step is to find the value of the stock when the riskfree rate is 4%. Give the information provided, use the Security Market Line (SML) of the Capital Asset Pricing Model (CAPM) to determine the stock s required of return. The basic equation for finding a stock s required return, E(R i ), using the SML is: Where R F is the risk-free rate β i is the stock s beta R M is the expected return on the market r R ( R R ) CE F M F Plugging in the numbers to the SML equation, one gets: r R ( R R ) CE F M F (.09.04) 10% Next, use the estimated required return of 10% (along with the other inputs) in the Gordon Growth Model to arrive to the value $1.75 PCS $

33 The next step is to find the value of a share of National Amalgamated Corp. if the risk free rate shifts to 5%. However, the fact pattern in the problem indicates that the market risk premium remains constant. Therefore, the return on the market must increase to 10% to keep R M -R F constant at 5%. Using a risk free rate of 5%, the required rate of return is now: rce RF ( RM RF ) (.10.05) 11% Next, use the revised estimated required return of 11% (along with the other inputs) in the Gordon Growth Model to arrive at a value of: $1.75 PCS $ Comparing the value of the stock when the risk-free rate is 4% ($25.00) to the value when the risk-free rate is 5% ($21.875), it is seen that the value has decreased by $

34 Supernormal Growth Two-Stage dividend Discount Model Compute the dividends based on the growth rate during the supernormal growth period finite period Periods of supernormal growth DIV 1 = DIV 0 (1+g HIGH ) DIV 2 = DIV 1 (1+g HIGH ) Compute the terminal value of the stock - GGM can be applied once constant growth has been reached DIV = DIV 4 3 =(1+g normal ) P3 r g CE LOW = Normal/Sustainable/Infinite 34

35 Discount the cash flows to determine the current stock value P CS DIV DIV DIV +P = + + (1+r ) (1+r ) (1+r CE CE CE) 35

36 Jason Cicatello is analysing the stock XYZ International. Jason estimates that XUZ International will experience a period of supernormal growth of 20% for the next two years. Thereafter, the growth rate will be the long-run growth rate. Jason has the following estimates and market information about XYZ International. Current market price per share $16.75 Dividend per share at t=0 $1.10 Historical 1-year return on equity (ROE) 15% Estimated cost of equity capital 14% Estimated supernormal dividend growth rate 20% Current risk-free rate 4.0% Estimated long-run dividend growth rate 3.5% Using these estimates and the two stage dividend discount model. What is the value of a share of YZ international? a. $14.40 b. $12.92 c. $13.13 d. $

37 Step 1: GGM can be applied after two years Dividend per share at t=0 current dividend = 1.32 DIV = DIV 2 Estimated long-run dividend growth rate 3.5% = 1.64 DIV 3 Step 2: P CS 2 DIV r g 3 CS P $15.62 Terminal Value 14% 3.5% Step 3: $1.32 CF 1 $ $15.62 =$17.20 CF 2 Estimated cost of equity capital 14% NPV = $

38 Relative Valuation Approaches If the multiple is less than the mean for the peer group, stock appears relatively undervalued Earnings Multiplier Approach Based on the principle that dividends are paid out of earnings P E 0 1 Net Income-Preferred Dividends # Common Shares Outstanding Lower side of the peer group the stock is relatively undervalued DIV t = K E t Payout rate 38

39 DIV K E P CS= = r -g r -g CE DIV CE E K P/E = = justifiable / appropriate P/E 1 multiple r -g CE P/E 1 EPS 1 = intrinsic value E Limitations: Accounting Methods / non-recurring items Management Bias / Estimates Earnings tend to be Volatile / Negative 39

40 Other Multiples Price-to-Cash Flow Harder for management to manipulate than earnings P t P/CF i = CF t+1 Projected CF per Common Share Lower side of the peer group the stock is relatively undervalued Price-to-Book Better for companies with liquid assets that reflect current values (e.g. Banks) Less volatile & Can t be negative P t P/BV i = BV t+1 Assets-Liabilities-Preferred Stock # CSO Projected 40

41 Price-to-Sales Sales are more stable than earnings and can be used to value early-stage companies not yet earning profits P t P/S i = Sales1 S = t+1 # CSO 1 Sales: Can t be negative Less management bias general rule (everybody is using accrual basis) 41

42 Tony Fong is estimating the appropriate P/E ratio for Slate Quarry Inc, a mature, open-pit mining company. Tony has made the following estimates about Slate Quarry Inc: Required return 14% Past 1-year return on equity 16% Dividend growth rate 3% Earnings retention rate 30% Current stock price / share $8.00 Based on this data and an applying the constant growth dividend discount model, an appropriate P/E ratio for the Slate Quarry is: a. 2.7 b. 5.4 c. 6.4 d

43 Choice c is the correct. The key to converting the constant growth model (CGM) to a P/E model is to recognize that the dividend at t=1 (DIV 1 ) will equal the dividend payout ratio K times the t=1 earnings. In general: DIV =K +E t t t Thus, assuming the dividend payout ratio is constant over time, K E 1 can be substituted for DIV 1. The CGM is now rewritten as: DIV K E P CS= = r -g r -g 1 1 CE E CE E Next, to turn the formula into a P/E ratio, divide both sides by E 1 P/E 1= r CE -g E Note that this problem provides the retention ratio (1-k) and not the payout ratio. The payout ratio is 70% (1-30%). K 43

44 The formula can now be used for Slate Querry: 70% P/E 1= =6.4% Tony could then multiply this P/E estimate by his year 1 estimated earnings to arrive at a stock price today. This value will be the same number as if Tony simply computed the stock s value using the basic CGM and substituting his estimate of KE 1 for DIV 1. Choice a is incorrect. This answer incorrectly uses the retention rate in the numerator (instead of the dividend payout ratio). Choice b is incorrect. This answer incorrectly uses the past 1-year ROE in the denominator (instead of the required return). The past ROE does not indicate the return investors will require on the stock going forward. Choice d is incorrect. This answer incorrectly uses both the past 1-year ROE in the denominator (instead of the required return) and the retention rate in the numerator (insteda of the dividend payout ratio) 44

45 Estimating the inputs to Valuation Models Memorizing the models is easy, correctly estimating the inputs is more challenging. The discount rate is the nominal risk-free rate plus a risk premium r CE =(1+R F)(1+r ERP)-1 Equity Risk Premium-Compensate for market risk and business risk, financial liquidity, country, currency, etc The growth rate is a function of ROE and earnings retention g =ROE(1-K) Payout rate 0 E DIV EPS Profit Margin + Asset Turnover + Financial Leverage (Dupont Model) 0 45

46 Janet Schoettinger is estimating the required return to use in valuing the stock of Flintrock Industries. Janet has the following estimates about the stock and the interest rates: Flintrock s stock beta 0.8 Real risk-free rate 2% Expected inflation rate 3% Flintrock s equity risk premium 6% Based on this information and using a build-up approach, the exact discount rate Janet should use for Flintrock Industries is: a. 9.18% b % c. 9.86% d. 8.12% 46

47 Choice b is the correct. The stock s required return will be based on the three components: Real risk-free rate Expected inflation rate Equity risk premium In finding the required return for the stock, one can think of building up from the base real risk-free rate. In this building up process, the real risk-free rate and the expected inflation rate are first combined to get the nominal risk-free rate. This is done as follows: r =(1+rr )[1+E(INFL)]-1 F F (1.02)(1.03) % Where r F, is the nominal interest rate, rr F is the real risk-free rate expected inflation rate. E(INFL) is the 47

48 Next, the nominal risk free rate and the equity risk premium (r ERP ) are then combined to arrive at r CE, the required return (or, cost of common equity) for Flintrock stock: r CE =(1+r F)(1+r ERP )-1 =(1.0506)(1.06)-1 =0.1136=11.36% Note that the approximate answer would simply be the sum of the three numbers: r CE F ERP Approximate =rr +E(INFL)+r = =.11=11% 48

49 Market and Industry Analysis Core Concepts A. Explain the process of valuing a stock market using fundamental analysis B. Identify the investment opportunities associated with the business cycle stages. C. Discuss the impact of the industry life cycle, competitive structure and risk considerations on global industry analysis D. Explain the relationship between company analysis and stock selection. Top/Down Approach 49

50 Summarize 1. Analyze macroeconomic data to identify favorable countries 2. Identify favorable markets and industry growth prospects 3. Select individual companies for investment 50

51 Analysing the Stock Market Based on a broad market index like the S&P 500 The goal is to forecast the earnings for the index: Relate sales to a macroeconomic variable like GDP (IV) % Sales Index = + β (% GDP) Regression analysis Sales (1+% Δ Sales) = Sales Estimate profitability by relating margin (EBITDA) to macroeconomic profitability margins Capacity utilization, unit labor costs 51

52 Forecast the index s earnings based on the sales forecast, the margin forecast, and estimation of depreciation and interest expenses: [Sales 1 EBITDA margin]- Depr.-Interest (1-tax rate) Projected net Income Divided by nr shares outstanding to have EPS Finally, estimate a growth rate based on ROE and payouts ratios for the index: g = ROE INDEX (1 - K) Value Index = EPS 1 Payout r g 52

53 Jae Kim, an equity strategist, is estimating the next year s average sales per share for a major stock market index. He has the following estimates including the results of index regression analysis (based on 20 years of annual data). % Δ Sales Index = α + β (% Δ GDP ) 1 1 N α = 3.2 and β = 1.25 Where GDP N is the nominal gross domestic product Average Index ROE (last five years) 13.5% Nominal 1-year GDP growth (estimate) 3% Average GDP growth (last five years) 2% Index current average sales per share $400 Average Index Retention Rate 55% Based on Jae s regression analysis, what is the 1-year estimated average sales per share for the index? a. $422.60, b. $427.80, c. $ or d. $

54 Choice b is correct. Jae s approach first uses regression analysis and the historical data to estimate the relationship between GDP growth and sales growth for the index. Historically, the relationship between the percentage change in average sales brought about by the percentage change in GDP is: % Sales Index = (% GDP ) Note that the regression estimate should be based on data that cover between one and five complete business cycles. Plugging in the estimate for nominal GDP growth (3%), the estimated percentage change in average sales is: % Sales Index = (3) = 6.95% With an expected growth rate in sales of 6.95%, the average sales for next year is estimated to be: Estimated average sales next year = (current average sales) (1+ estimated growth rate) $400 ( ) = $ N 54

55 Choice a is incorrect. This answer is found by using the average GDP growth rate over the last five years (instead of the estimate for next year s GDP growth) Choice c is incorrect. The provided answer is found by using the estimated growth earnings: g = retention rate ROE. This growth rate is not applicable to sales. Choice d is incorrect. This answer omits the intercept in the regression equation. 55

56 Keith Miller, an equity market strategist, is attempting to estimate the expected P/E ratio of the Russel Keith s approach is to use the Gordon Growth model and the Capital Asset Pricing Model to estimate the earnings multiplier. Keith has made the following estimates. Russel 2000: Projected average effective rate 20% Long term treasury bond yield 10% Russel 2000: Projected average ROE 15% Russel 2000: expected Index market risk premium 5% Russel 2000: Projected pretax earnings per share $100 Based on this information, the expected P/E ratio for Russel 2000 is closest to, a. 4.4 b. 4.0 c d

57 Choice d is correct. For this problem, the constant growth dividend discount model is: DIV R2000 V R2000 = r CE -g The dividend at any period will be equal to: R2000 DIV t = K t E t Given this, and assuming that the dividend payout ratio is constant over time K E R2000 can be substituted for DIVR2000 and then the CGM model is rewritten as: DIV R2000 R2000 V R2000= r CE -g r CE -g R2000 K E R2000 To turn the formula into a P/E ratio, divide both sides by E R2000 : K V R2000 /E R2000 =P/E R2000= r CE -g R

58 Next, to use the formula, the various inputs need to be calculated: The average dividend payout ratio is 1 minus the average retention rate: = 0.6 The required return on the Russel 2000 is computed using CAPM and recognizing that the beta estimate of the Russel 2000 is 1:Thus: r CE =r R2000 f +Beta R2000 (Market Premium R2000 )=.10+1(.05)=15% The estimated dividend growth rate will equal: g R2000 =ROE R2000 Retention Ratio R2000 =.15.4=6% Plugging in these numbers the estimated P/E ratio is: K.6 P/E R2000= = = 6.7 r -g CE R

59 Industry Life Cycle Stage 1: Low Volume / No profits (Pioneering Development) Price to sales Stage 2: High Profits ( Rapid Accelerating Growth) Stage 3: More Competition (Mature Growth) Profit Margin goes down Stage 4: Small Margins (Stabilization an Market Maturity) - Longest Gordon Growth Model Applies growth GDP Stage 5: Consolidation (Deceleration of Growth and Decline) Economies of Scale Large firms survive Small Firms Liquidation Value Small firms will worth more dead than alive (Price to book value) Stages 2, 3 and 4 3 stage DDM 59

60 Competitive Structure As number of competitors goes up, rivalry intensify goes up and profit margins goes down N-Firm Concentration ratio The sum of the n largest firms percentage market shares As ratio rivalry EBITDA margins Herfindhal Index (H) The sum of the squares of the market shares of the firms that constitute the industry n H = (M ) i 1 i 2 H = more concentrated the industry, rivalry PM 60

61 Reciprocal of the index gives the equivalent number of firms within the industry if each had an equal share 1 = Equivalente # of firms H Rivalry PM 61

62 Risk Considerations - Porter s 5 Forces Threat of new entrants - Barriers to entry Pure competition none Monopoly Competition low Oligopoly / Monopoly - high High profits attract new competitors Rivalry among firms within the industry Price wars low concentration Availability of substitutes D Price elasticity % Δ P Bargaining power to customers Pushes down prices Thus, profit margins goes down Bargaining power of suppliers % Δ Q =e e 1 elastic Pushes up costs - Thus, profit margins goes down Affect Firm s Competitive structure 62

63 SWOT Analysis SWOT analysis is a strategic planning method used to evaluate the Strengths, Weaknesses, Opportunities, and Threats involved in a project or in a business venture. It involves specifying the objective of the business venture or project and identifying the internal and external factors that are favorable and unfavorable to achieve that objective Strengths: characteristics of the business or team that give it an advantage over others in the industry. Weaknesses: are characteristics that place the firm at a disadvantage relative to others. Opportunities: external chances to make greater sales or profits in the environment. Threats: external elements in the environment that could cause trouble for the business. 63

64 PESTEL Analysis of the macro-environment There are many factors in the macro-environment that will effect the decisions of the managers of any organization. Tax changes, new laws, trade barriers, demographic change and government policy changes are all examples of macro change. To help analyze these factors managers can categorize them using the PESTEL model. This classification distinguishes between: Political factors Economic factors Social factors Technological Environmental 64

65 Company Analysis and Stock Selection Is it already priced in the stock? Sales Good companies do not necessarily make good stocks Growth companies vs. Growth Stock i.e. undervalued Stock Price Stable Earnings Defensive company vs. Defensive stock Stable Price Low Beta Earnings correlated with Business Cycle Cyclical company vs. cyclical stock Volatile Price High Beta 65

66 What is the stock s intrinsic value? Forecast Sales Sales Sales (1+% Δ Sales) 1 0 % Sales = + β (X) Forecast Profit Margin - Competitive Structure Forecast Earnings (EPS) 1 Sales 1 [EBITDA margin]- Depr.-Interest 1 (1-tax rate) Estimate Multiplier (P/E 1 ) r K g Value the Stock V = EPS 1+P/E1 If V P market = BUY Plots above SML - undervalued 66

67 Bob Michaels, an equity analyst, has information on four different industries Industry Average of: Industry 1 Industry 2 Industry 3 Industry 4 R&D Expenses as a percentage of sales 1% 4% 1.5% 2% Percentage of Industry market share held 8% 70% 65% 38% Fixed expenses/variable Expenses 5:1 4:1 2:1 1:1 Average Sales Growth over last four years 3% 12% 11% 8% Based on this information and Porter s Five Forces, which industry should have lowest average EBITDA margin? a. One b. Two c. Three d. Four 67

68 Choice a is correct Step 1: Thus - most competition / intense rivalry R&D Expenses as a percentage of sales Industry 1 R&D barriers to enter Competition lower margins % competition lower margins Fixed costs barriers to exit rivalry competition lower margins Growth rate rivalry competition lower margins 68

69 Regina Flemming, a portfolio manager, is analyzing the stock of a large consumer durables manufacturer, XYZ Inc. Regina has summarized XYZ s business as follows: XYZ manufacturers a limited range of luxury consumer-durable goods. The company enjoys an excellent reputation for innovation and customer service. Historically, sales have been strongly correlated with fluctuations in the economy, as sales decline in economic downturns and increase in economic upturns. The firm s operations and finances continue to be among the strongest in the industry with minimal debt, high liquidity, low operating leverage, and a stock beta of The long-run prospects for this company is very strong. Based on this information, which of the following is true about XYZ company and XYZ stock? a. Cyclical; Cyclical b. Non-Cyclical; Cyclical c. Cyclical, Non-Cyclical d. Non-Cyclical; Non-Cyclical 69

70 Choice c is the correct. The key point is that the analyst needs to distinguish between the company and the stock. A cyclical company s sales and earnings will rise and fall with the business cycle. As described, XYZ is clearly a cyclical company. Note that the extent of the cyclicality of the company s earnings will be affected by the extent of the company s fixed costs (operating leverage) and the extent of its debt expenses (financial leverage). As described, XYZ s stock is not cyclical. A cyclical stock is one with changes in returns that are greater than the market s changes in return. For instance, if the market is up 10%, a cyclical stock will be up more than 10%. Or, for example, if the market is down 12%, a cyclical stock will be down more than 12%. Given, that XYZ has a beta of 0.85 (less than one), XYZ is not considered a cyclical stock. In summary, XYZ is a cyclical company but not a cyclical stock. 70

71 What is Financial Leverage? What mix of debt and equity (ordinary shares) should be used to finance a firm s operations? How much financial leverage should a firm have in its capital structure? The main questions we address are Can the firm s value be affected by its capital structure choices? Does the value of the firm s cash flows depend on how it is divided between payments to shareholders and debtholders? Is there an optimal capital structure that maximizes the value of the firm? 71

72 What is Financial Leverage? Two main risks faced by firms Business (or operational) risk The variability of future net cash flows attributed to the nature of the firm s operations It is the risk faced by shareholders if the firm is financed only by equity Financial risk The risk attributed to the use of debt as a source of financing a firm s operations 72

73 Do Managers Care About Leverage? Source: Damodaran Online, pages.stern.nyu.edu/~adamodar. Based on survey of CFOs of large US firms who ranked the factors that they considered important in their financing decisions. A 0 is least important and a 5 is most important. 73

74 What Managers Use Source: Damodaran Online, pages.stern.nyu.edu/~adamodar. Based on survey of CFOs of large US firms who ranked the sources of long term capital used by their firm. 74

75 Effects of Financial Leverage Financial risk exists if the firm s operations are financed using debt, that is, when there is financial leverage How much debt and equity does the firm have in its capital structure? Measured as the debt-to-equity or the debt-to-total-assets ratios Effects of financial leverage? Expected rate of return on equity increases The variability of returns to shareholders also increases Increasing leverage involves a trade-off between risk and return Note that leverage varies both within and between industries 75

76 Effects of Financial Leverage 76

77 Key Concepts Business risk is the variability of future net cash flows attributed to the nature of the firm s operations Financial risk is the risk attributed to the use of debt as a source of financing a firm s operations The level of financial leverage varies across firms in the same industry as well as across firms in different industries Modigliani and Miller s proposition 1 states that the market value of a firm is independent of its capital structure 77

78 Key Relationships/Formula Sheet 78

79 Capital Structure 79

80 Capital Structure Can a firm increase its value by choosing the right mix of debt and equity (i.e., the right capital structure) to finance its operations? Capital structures vary across firms, industries, and countries. Is debt better than equity because it is cheaper? Is equity better than debt because firms that borrow may go bankrupt? 80

81 Evidence on Capital Structure 1) More profitable firms tend to use less leverage. 2) High-growth firms borrow less than mature firms do. 3) Firms product market strategies and asset bases influence capital structure choice. 4) Stock market generally views leverage-increasing events positively. 5) Tax deductibility of interest gives firms an incentive to use debt. 81

82 Theoretical Models of Capital Structure Modigliani and Miller s (M&M) capital structure model The agency cost/tax shield trade-off model The pecking order theory The signaling model 82

83 MM and Market Imperfections Modigliani and Miller s original analysis ignores capital market imperfections including Corporate and personal taxes Transaction costs Costs associated with financial distress Different cost of borrowing for firms and individuals Changing cost of debt due to changing risk Agency costs We focus on the major market imperfections of taxes, financial distress and agency costs 83

84 MM and Corporate Taxes The value of the leveraged firm, V L now is V L = V U + PV (Tax shield) V L = V U + (t c D k D )/k D VL = V U + t c D Implication? With the introduction of corporate taxes in the MM analysis the existence of debt matters! The natural conclusion is that firm should maximize the level of debt in their capital structure as this will maximize the value of the firm Does this make sense (especially in the current market environment)? What s missing from this analysis? 84

85 MM with Corporate and Personal Taxes Corporate taxes is only part of the tax picture The existence of personal taxes on interest income can reduce the tax advantage associated with debt financing Firms save on corporate taxes via the interest tax shield by increasing the debt-to-equity ratio However, investors will pay additional personal taxes and will require higher rates of return to compensate them for this and for the higher risk associated with debt Under a classical tax system, the tax advantage of debt at the firm level may be reduced or even eliminated at the shareholder level! 85

86 MM and Other Market Imperfections There are non-tax factors that can cause a firm s value to depend on its capital structure as well Financial distress and bankruptcy costs Agency costs Financial distress is the state where a firm is in breach of its debt obligations, which may not necessarily result in bankruptcy Note also that the following analysis assumes a classical tax system 86

87 MM and Other Market Imperfections Direct costs of financial distress Fees associated with advisors, lawyers, accountants, etc. Indirect costs of financial distress - Financial distress leads a range of stakeholders to behave in ways that can disrupt a firm s operations and reduce its value Effect of lost sales Reduced operating efficiency Cost of managerial time devoted to averting failure Indirect costs are typically much higher than the direct costs The case of Enron Direct costs estimated as high as $500 million Indirect costs in terms of lost market value exceeded $25 billion! 87

88 Agency Costs of Capital Structure Agency costs arise from the potential for conflicts of interest between the parties forming the contractual relationships of the firm Management may make decisions that transfer wealth from debtholders to shareholders The sources of potential conflict are Dilution of claims Dividend payout Asset substitution Underinvestment 88

89 Agency Costs of Capital Structure Dilution of claims A firm may issue new debt which ranks higher than existing debt The claim of old debtholders on the firm s assets now less secure New debtholders earn what they re promised so there s a wealth transfer from old debtholders to shareholders Dividend payout A firm may significantly increase its dividend payout which decreases the firm s assets and increases the riskiness of its debt Wealth transfer from debtholders to shareholders 89

90 Agency Costs of Capital Structure Asset substitution A firm s incentive to undertake risky (and even negative NPV) investments increases with the use of debt there is limited ilability associated with equity If risky investments are successful most of the benefits go to shareholders If risky investments fail most of the costs are borne by debtholders Undertaking such (negative NPV) investments will result in total firm value falling, but the relative value of equity will rise and the value of the debt will fall Wealth transfer from debtholders to shareholders 90

91 Agency Costs of Capital Structure Underinvestment A firm may potentially reject low risk investments even if they are positive NPV investments With risky debt, it may not be in the interest of shareholders to contribute additional capital to finance these new (positive NPV) investments Although the investments are profitable and will increase firm value, shareholders may still lose because the risk of the debt will fall and its value will increase 91

92 An Optimal Capital Structure Incorporating the benefits and costs of debt, leads to the following expression of the value of a leveraged firm The present value of expected bankruptcy costs depends on the probability of bankruptcy and present value of costs incurred if bankruptcy occurs The trade-off theory of capital structure The possibility of a trade-off between the opposing effects of the benefits of debt finance and the costs of financial distress may imply that an optimal capital structure exists Management should aim to maintain a target debt-equity ratio 92

93 Key Concepts Modigliani and Miller s proposition 2 states that the expected return on equity of a leveraged firm increases in direct proportion to its debtto-equity ratio With corporate taxes, the MM analysis shows that the higher the level of debt the higher the firm s value Under the imputation tax system, introducing personal taxes may result in a tax neutrality between debt and equity or even a bias towards those shareholders whose personal tax rates are higher than the corporate tax rate Introducing bankruptcy costs and agency costs results in a trade-off between the costs and benefits associated with debt and an optimal capital structure 93

94 Key Relationships/Formula Sheet 94

95 Weighted Average Cost of Capital the weighted average cost of capital Estimate the weighted average cost of capital Use the weighted average cost of capital in capital budgeting Examine the limitations of the weighted average cost of capital 95

96 The Weighted Average Cost of Capital The weighted average cost of capital (WACC or k 0 ) is the benchmark required rate of return used by a firm to evaluate its investment opportunities The discount rate used to evaluate projects of similar risk to the firm It takes into account how a firm finances its investments How much debt versus equity does the firm employ? The WACC depends on Qualitative factors The market values of the alternative sources of funds The market costs associated with these sources of funds 96

97 Estimating the WACC The main steps involved in the estimation of the WACC are Identify the financing components Estimate the current (or market) values of the financing components Estimate the cost of each financing component Estimate the WACC We will consider each step for typical financing components 97

98 Identify the Financing Components Debt Identify all externally supplied debt items Do not include creditors and accruals as these costs are already included in net cash flows Ordinary shares Obtain number of issued shares from the balance sheet Do not include reserves and retained earnings Preference shares Obtain number of issued shares from the balance sheet 98

99 Valuing the Financing Components Use market values and not book values Value coupon paying debt using the following pricing relation 99

100 Valuing Long Term Debt Example: BLD Ltd has 10,000 bonds outstanding and each bond has a face value of $1,000 with two years remaining to maturity. The bonds pay coupons (or interest) at a rate of 10% p.a. every six months. If the market interest rate appropriate for the bond is 15% p.a., what is the current price of each bond? What is the total market value of debt in BLD Ltd s capital structure? 100

101 Valuing Long Term Debt Coupon (or interest) payments are made every six months Number of payments, n = 4, semi-annual payments Annual interest payments = 0.10(1000) = $ So, semi-annual interest payments = $50.00 Repayment of principal at the end of year 2 = $ Required return on debt, k d = 15% p.a. So, semi-annual required return on debt, k d = 7.5% 101

102 Valuing Long Term Debt The price of the bond is P 0 = $ So, total value of debt = 10000(916.27) = $9,162,700 Note: As the coupon rate is lower than the market rate, the price is less than the face value, that is, the bond is selling at a discount to face value If the coupon rate is greater than the market rate, the price would be at a premium to face value 102

103 Valuing Ordinary Shares Example: ABC Ltd has 300,000 shares on issue which each have a par value of $1.00. If the shares are currently trading at $3.50 each what is the total market value of ABC s ordinary shares? There are 300,000 shares on issue with a market value of $3.50 per share Market value of equity = = $1,050,000 The par (or book) value of shares is not relevant here 103

104 Valuing Preference Shares Preference shares pay a fixed dividend at regular intervals If the shares are non-redeemable, then the cash flows represent a perpetuity and the market value can be computed as P 0 = D p /k p Where P 0 = The current market price D p = Value of the periodic dividend k p = Required return on preference shares 104

105 Valuing Preference Shares Example: Assume the preference shares of XYZ Ltd pay a dividend of $0.40 p.a. and the cost of preference shares is 10% p.a. What is the price of the preference shares? If XYZ Ltd has 500,000 preference shares outstanding, what is the market value of these shares? The cash flows from the preference shares are D p = $0.40 per share So, P 0 = 0.40/0.10 = $4.00 Market value of shares = = $2,000,

106 Estimating the Costs of Capital The costs of a firm s financing instruments can be obtained as follows Use observable market rates - may need to be estimated Use effective annual rates For the cost of debt use the market yield Focus here is on the costs of debt, ordinary shares and preference shares Note: We ignore the complications of flotation costs and franking credits associated with dividends (sections and of the text) 106

107 Cost of Debt Example: The bonds of ABD Ltd have a face value of $1,000 with one year remaining to maturity. The bonds pay coupons at the rate of 10 percent p.a. If the current market price of the bonds is $1,018.50, what is the firm s cost of debt? The annual interest (coupon) paid on the debt is = $100 So, = ( )/(1 + kd) k d = (1100/ ) 1 = 8.0% 107

108 Cost of Ordinary Shares It is common to use CAPM to estimate the cost of equity capital, where the cost of equity is Note that the equity beta is the estimate of the firm s relative risk compared to movements in the market portfolio The market risk premium is typically estimated using historical market data The riskfree rate is typically based on the long term government bond rate 108

109 Cost of Ordinary Shares Example: Assume that the risk free rate is 6 percent, the expected market risk premium is 8 percent and the equity beta of XYW Ltd s equity is 1.2. What is the firm s cost of equity capital? Using the CAPM, we have Note: Can also use the dividend discount models covered in Lecture 4 (but not commonly used by managers ) 109

110 Cost of Preference Shares Recall that, P 0 = D p /k p Thus, k p = D p /P 0 Example: The preference shares of DBB Ltd pay a dividend of $0.50 p.a. If the preference shares are currently selling for $4.00 per share, what is the cost of these shares to the firm? The cost of preference shares is given as k p = D p /P 0 So, k p = 0.50/4.00 = 12.5% 110

111 Weighted Average Cost of Capital The weighted average cost of capital (ko) uses the cost of each component of the firm s capital structure and weights these according to their relative market values Assuming that only debt and equity are used, we have 111

112 Weighted Average Cost of Capital Assuming that preference shares are used as well as debt and equity Be careful of rounding errors in initial calculations Be careful to work in consistent terms Calculations in percentages versus decimals Check your answers with some common sense logic 112

113 Taxes and the WACC Under the classical tax system Interest on debt is tax deductible Dividends have no tax effect for the firm The after-tax cost of debt, k' d = (1 t c ) k d where t c corporate tax rate The cost of equity (ke) is unaffected The after-tax WACC is defined as 113

114 Calculating and Using the WACC Example: You are given the following information for BCA Ltd. Note that book values are obtained from the firm s balance sheet while market values are based on market data. The firm s marginal tax rate is 30%. Estimate the firm s before-tax and after-tax weighted average costs of capital 114

115 Calculating and Using the WACC Before-tax weighted average cost of capital WACC weights are based on market values so book values are not relevant Note: Weight in bonds, D/V = 50/150 = 0.333, and so on Before-tax cost of capital = 11.47% 115

116 Calculating and Using the WACC The after-tax cost of capital requires the after tax cost of debt Note: Weight in bonds, D/V = 50/150 = 0.333, and so on After-tax cost of capital = 10.67% 116

117 Calculating and Using the WACC Example: Assume that a firm is financed by 60 percent equity, 10 percent preference shares and the remainder by debt. The corporate tax rate is 30 percent. The costs of capital for debt, preference and equity capital are 10 percent, 12 percent and 15 percent, respectively. What is the firm s after-tax weighted average cost of capital? If the firm is considering three independent projects with IRRs of 10%, 12% and 14% which of these projects should it accept? 117

118 Calculating and Using the WACC The debt ratio is D/V = = 0.30 k 0 = [0.10 (1 0.30) 0.30] + ( ) + ( ) k 0 = 12.3% The firm should accept all projects with an IRR greater than the cost of capital (why?) Accept the project with an IRR of 14% Reject the projects with IRRs of 10% and 12% 118

119 Calculating and Using the WACC Example: ASL Ltd has a debt-to-equity ratio of 25%. The cost of debt is 8 percent and the corporate tax rate is 30 percent. If the after-tax weighted average cost of capital is 20 percent, what is the firm s cost of equity? The cost of equity can be obtained using the weighted average cost of capital relationship Note that we re given a D/E ratio of 0.25 We need the D/V = D/(D + E) ratio 119

120 Calculating and Using the WACC D/E = 0.25 implies D = 0.25(E) So, D/(D + E) = 0.25(E)/[0.25(E) + E] = 0.25(E)/1.25(E) D/(D + E) = 0.20 and E/(D + E) = = 0.80 The weighted average cost of capital is k 0 = 0.20 = 0.08(1 0.30)(0.20) + k e (0.80) So, k e = [ (1 0.30)(0.20)]/(0.80) k e = 23.6% 120

121 Limitations on Using the WACC Recall: The weighted average cost of capital is the discount rate that is used to evaluate projects of similar risk to the firm The WACC cannot be used in the following situations If the project alters the operational (or business) risk of the firm If the project alters the financial risk of the firm by dramatically altering its capital structure Examples of risk altering projects? What should the firm do if the WACC cannot be used? 121

122 Key Concepts The weighted average cost of capital is the discount rate that is used to evaluate projects of similar risk to the firm There are four main steps involved in the estimation of the weighted average cost of capital Identify the financing instruments Estimate the current (or market) values of the financing components Estimate the cost of each financing component Estimate the weighted average cost of capital The WACC cannot be used to evaluate projects that alter the business or financial risks of the firm 122

123 Key Relationships/Formula Sheet 123