Estimation of the Equity Value of the Company - Essay Example

? PART A Answer to Question Equity valuation can be defined as the process of identifying the current market value of the company which is also regarded as the current market capitalization of the company. There are several step of equity valuation process and it requires an adequate understanding of financial management techniques and acumen. The first and foremost step of the equity valuation process is obtaining a decent understanding of the entity and industry to which that particular entity belongs. It is imperative to analyze the financial reports of the corporation because based on these figures and facts the forecast of the future is prepared which eventually assists in determining the value of the equity. During this particular process, the analyst should consider the competitive environment as well which will be of great source in identifying which aspects of the company’s business presents the greatest challenges and opportunities. The analyst must have an understanding of the industry structure as well and basic economic factors such as demand and supply and what are its deriving factors. After obtaining an adequate understanding of the entity and its industry, the next step is to forecast the financial performance of the company in the foreseeable future. This can be define as forecasting sales, dividends, variable and fixed production costs, marketing cost and other related administrative costs. The main purpose of this step is to identify how much profit is the company going to make in near future, because in general terms, today a company can be valued by its investors based on how much money it is going to make in the coming years. There are two approaches through which this analysis can be made. The first approach is regarded as the top down forecasting approach which is based on the average industry performance to which that particular corporation belongs. For example, if in the construction industry, the average profit before tax is expected to increase by 12% in the foreseeable future, then the same of a company in the construction is expected to increase in the same pattern. Alternatively, there’s another approach which is termed as the bottom up approach. By applying this approach, the analyst examines the current financial outlook of the industry based on the financial statements and other relevant sources of financial information which is company specific. Based on these company specific figures, the earnings and profit of the company is forecasted. The most important step in equity valuation process is the selection of an appropriate valuation model. The following table presents certain valuation methods for this purpose Equity valuation Firm valuation (equity plus debt) Cash flow based valuation approaches 1. Dividend valuation model (DVM) 2. Free cash flow valuation model (FCFVM) Profit based valuation approaches 3. Abnormal earnings valuation model (AEVM) 4. Abnormal operating profit valuation model (AOPVM) Based on the above valuation models, an analyst predicts the equity value of the company by selecting any one of the above mentioned models which appears to be apt in the circumstances. Finally the investor must make an investment decision based on the calculated value of equity in the above step. This decision involves investment recommendation to the investor whether it is financially feasible to invest in the stock of the company being valued or not. If the analyst concludes that the equity value of the company is as such which is significantly greater than the current book value of the company, then it represents that the company will reap benefits in the future for the investors, thus the investment decision would be financially viable. Answer to Question 2 Ratio analysis is a very accurate and reliable tool when it comes to analyzing the financial outlook of an entity. The primary reason to conduct a ratio analysis is to quantify the results of the operations of a company and compare them with that of the prior year(s) in order to assess different aspects of the financial feasibility. [1] The ratios can be divided into various categories such as profitability, gearing and liquidity, each focusing on a different area of the financial outlook of the organization and highlighting the company’s performance. These analysis form an integral part of the financial statement analysis, especially from the investors point of view, who always strive to invest in countries having strengthen and stabilizing financial ratios and representing an upward trend. It is of great significance that the ratios must be benchmarked against a standard in order for them to possess a meaning.[2] Profitability Ratios   2011 2010 2009   Profitability Ratios Gross profit margin 13.56% 12.15% 8.44% Net profit margin 7.79% 5.84% 2.25% ROCE 15.78% 11.57% 4.60% EPS 52.50 28.00 16.90 Gross profit margin is an analyzing tool which assists in identifying how effectively and efficiently the company is utilizing its raw materials, variable cost related to labor and fixed costs such as rent and depreciation of property plant and equipment. The gross profit margin has shown an inclining trend in the past three years which can be due to controlling variable cost and at the same time increasing the revenue at a higher rate. Increase in revenue can be described due to several factors such as increase in per unit sales price, increase in customer base and increase in overall sales volume due to higher demand in the market. Net profit margin, on the other hand analyzes the profitability of the company before deducting the taxation and finance charges from the earnings. The ratio has also followed the trend of the gross profit margin. Return on capital employed (ROCE) is, according to the analyst, is considered to be the most significant ratio in order to evaluate a company’s performance from an investor’s point of view. ROCE measures a company’s ability to earn a return on all of the capital that is being employed by the company. The ratio is calculated as net income upon total capital employed, which is the sum of debt and equity financings. The ROCE has also shown improvement from the previous financial year which is a sign of improvement and sound financial outlook. It can be translated as a fact that the company is effectively and prudently utilizing its capital and offering return to its investors that are adequate and attractive at the same time. Liquidity Ratios 2011 2010 2009 Liquidity Current ratio 1.48 1.42 1.4 Acid test ratio 1.48 1.35 1.33 Debtors turnover period 20.92 15.32 11.03 Inventory turnover 81.53 35.68 0.75 The liquidity ratio measures the company’s ability to pay its short term liabilities. The ratio illustrates that how quickly a company can convert its assets into cash and cash equivalent in order to pay off its short term liabilities. The most commonly used liquidity ratio, the current ratio, which is calculated by comparing the current assets and current liabilities. The acid test, which is also regarded as the quick ratio, is calculated by subtracting the inventory balance from the total current assert balance. . Out of the current assets mentioned, inventories are regarded as the one which takes comparatively more time to be converted into cash or cash equivalent. Both the current and acid test ratio has followed inclining trend which is due to better asset management decisions made by the management of easy jet. The main improvement in the current and acid test ratio of the company is due to increase in the money market deposits and cash and cash equivalent. [3] Receivable turnover represents how quickly the cash is received from the debtors. The ratio is calculated by dividing the revenue generated from the sales by the receivable balance as mentioned in the balance sheet of the company. The formula calculates the number of times the debtors are turned over during a year. The higher the value the more efficient the management is or it could also mean that the debts are more liquid. This ratio has shown incredible increase during the current financial year. Analyzing the movement in this ratio, it can be noticed that the revenue for the company has increased during the current financial year, but the receivable balance has decreased. This can be further interpreted as the fact that the company actively monitored its cash collection procedure and was able to reduce its closing receivable balance. It is better to keep the current assets in the most liquid form which is cash and cash equivalent. Gearing Ratios 2011 2010 2009 Gearing Ratios Equity ratio 0.38 0.37 0.36 Debt ratio 0.62 0.63 0.64 Debt : equity ratio 0.38 : 0.62 0.37 : 0.63 0.36 : 0.64 Borrowing ratio 1.02 1.04 1.09 The gearing ratios and indicate the level of risk taken by a company as a result of its capital structure [4]. The equity ratio of the company has increased which is a good sign which can be interpreted as a fact that the company is now financing more of its operating asset through internally generated funds rather than borrowing from any financial institution. This reduces financial risk. [5] Another ratio to assess the financial leverage of the company is by calculating the borrowing ratio of the company. The ratio is calculated by dividing all the short term and long term borrowing of the company in the form of overdraft, long term loan and finances etc., with the shareholder’s equity. [7] The borrowing ratio presents similar trends as the debt ratio, and also due to the fact that the ratio uses the same dependents. Answer to Question 3 The forecast for the revenue is based on the historical revenue trend of the company for the last five years. In order to forecast the revenue for the coming five years, the break-even point analysis is used. Under this method the variable and fixed cost is calculated using the high low method. The fixed cost has the attribute of remaining the same over the period whereas the variable cost changes with percentage change in the sales revenue. [6] In order to forecast the growth percentage of the revenue, the average growth in sales revenue from the financial year 2009 to financial year 2011 is calculated. This growth rate amounts to 14%. For the projecting the earnings (net income), the operating and other administrative costs are also needed to be projected. They are calculated using the contribution margin analysis (computed through the high low method) Year Sales Total Operating Cost Operating Profit 2009 2,667 2,607 60 2010 2,973 2,800 174 2011 3,452 3,183 269 Particular Sales Revenue Operating Cost High (A) 3,452 3,183 Low (B) 2,667 2,607 Differential C=A-B 785 576 Variable Cost (Differential Cost/Differential Revenue) (D) 0.734 Fixed Cost 649 Thus the above contribution margin analysis shows that variable cost will be 73% of the revenue and fixed cost will remain the same over the period. Forecast of the coming year would be as follows. Financial Year ? in millions 2011 (Actual) 2012 2013 Operative revenue 3,452 3,935 4,486 Operative cost Variable (2,534) (2,888) (3,293) Fixed Cost (649) (649) (649) Net Income before tax 269 398 545 Corporation tax @ 35% 94 139 191 Net income after tax 175 259 354 Estimate of the equity value of the company Free cash flow method The estimated value of the company’s equity is calculated by discounting the free cash flow of the company for the foreseeable future using the weighted average cost of capital of the company (WACC) which is taken to be at 21%. [8] (Since the beta of easy jet is not published on any of the finance portal nor is the dividend payout ratio, the WACC discount rate is assumed) Financial Year ? in millions 2011 (Actual) 2012 2013 2014 (onwards) Projected Net income (Note 175 259 354 Non Cash items (Depreciation/Amortization) 95 106 118 Working capital adjustments (111) (128) (149) Capital Adjustment (221) (245) (272) Free Cash Flow to Firm (FCFF) (61) (9) 51 Discounting Factor (@ 21 %) 1 0.683 0.564 Present Value (Note 1) (61) (6) 29 387 Economic Value 349 Note 1 ? in millions Free cash flow at the end of financial 2013 51 Growth rate 14.00% Discount rate 21.00% PV at 2014 of the foreseeable FCF (calculated using the constant growth model) 830 PV at year 2011 (discounting the cash flows at 21%) 387 Abnormal Operating Profit Valuation Method 2011 2010 2009 Average 2012 2013 2014 onwards ? in millions Noncurrent assets 2,731.00 2,487.60 2,190.80 Non-Current liabilities (1,587.00) (1,437.20) (1,303.50) Net long term operating assets 1,144.00 1,050.40 887.30 Stocks - 73.20 73.20 Debtors 165.00 194.10 241.80 Creditors (916.00) (828.73) (750.70) Net Operating assets 393.00 488.97 451.60 568.43 648.01 738.73 Sales 3,452.00 2,973.10 2,666.80 3,935.28 4,486.22 5,114.29 Asset Turnover 8.78 6.08 5.91 6.92 Net operating profit after tax 225.00 121.30 71.20 Net Operating profit after margin 6.52% 4.08% 2.67% 4.42% 174.04 198.41 226.18 WACC 0.21 0.21 0.21 WACC X NOA 119.37 136.08 155.13 AOP 54.67 62.32 71.05 Discounting factor 0.83 0.68 0.31 Present Value 45.18 42.57 231.09 Economic Value 318.84 The above tables show the value of easy jet plc based on abnormal operating profit value method (APOVM). In the above calculation, the trends, in the past three years, of non-current assets, noncurrent liabilities, net long term operating assets, stocks, debtors and creditors are taken. After calculating the net operating assets, the asset turnover is calculated by dividing the sales with the operating assets. The average increase in the assets turnover is multiplied with the forecasted sales (expected to grow at average 14%) to yield the expected net operating assets. Moving on, the net operating profit margin is calculated and applied on the sales to yield the expected net operating after tax in the foreseeable future. The weighted average cost of capital (WACC) which is 21% is multiplied with the net operating asset figure. AOP is calculated by subtracting the net operating after tax with the WACC x NOA figure. All of these figures are discounted in order to yield the economic value of the easy jet as at financial year 2011. Future forecast The financial statement ratio analysis of easy jet plc presents the fact that the company has a very strong and stable financial outlook. All of the ratios of the company are showing promising patterns. The gross profit and net profit margin, the profitability ratios have increased from the prior years and same trend has been followed by all the liquidity ratios. The gearing ratios of the company portray the fact that the company does not have any major financial risk and most of its assets are financed through equity rather than debt. The equity valuation of the company through free cash flow method and abnormal profit methods presents the economic value of the company which also appears to be stable. It is expected, based on this valuation that the company is going to perform well in the foreseeable future and return on the investment will be higher for investors. PART B Answer to Question 1 Quality of earnings can be defined as the amount of earnings that is attributable to higher sales or lower cost rather than the earnings that is created through artificial or one off transactions. The earnings quality, pure accounting terminology, basically identifies the overall reasonableness of the reported earnings. In this definition, reasonableness can be defined as how repeatable, predictable and achievable the earnings are. This accounting concept point outs the fact that the economic impact of a given transaction may be differing between several corporations across the industry due to the fact that they have different business characteristics. An example of this concept would be the fact that in the times of high inflation, the quality of earnings of any corporation generally suffers because a large proportion of the firm’s expenditures are inflated due to the change in the rate of inflation. The quality of earnings can generally be summarized as the extent to which the earnings are cash and non-cash, recurring or non-recurring and how much accounting judgments and estimate is involved in measuring them. The financial analyst usually uses this concept of quality of earnings in order to indentify how will the financial statements of any corporation would be helpful to the user in order to project the future earnings of the company with certainty. The characteristics affecting the quality of earnings provide a basis for considering the items of income and expenses through which the quality of earnings can be identified. For example, the overall consistency of accounting policies from one financial year to another financial year is very important. An example of this would be the accounting policy for the Non-Current assets of any organization. The International Accounting Standard 16 “Property, Plant and Equipment’ requires the firms to carry their property, plant and equipment at historical cost or the revaluation mode. In case of revaluation model, the asset will be carried at the current fair market value and thus the difference between the cost and fair market value (for the financial year in which the revaluation took place) would be shown as the increase in the retained earnings. This is a onetime event and the revaluation of asset in the coming financial year is likely not to result in any increase in the earnings. The other factors which the financial analyst usually gives significance to are the overall degree of estimation or subjectivity in determining the earnings. Trend in reserve balances is another way through which the quality of the earnings can be identified. A highly fluctuating reserve balance indicates that certain extraordinary transaction occurs during the financial year which has caused the drastic change in the reported balances of the reserves. For example, if a company sells a major lot of its non-current assets during its current financial year which results in a significant disposal gain, the current year profit of the company will be significantly higher than the corresponding figure of the prior year. Disclosure of related party transaction can also highlight the quality of the reported earnings of the firm. Related party transactions can, in general, be defined as the transactions with the corporations or individuals with whom the company has significant business relations and the company is likely to act, or they are likely to act in accordance with the instructions of one another. More and more related party transaction distorts the quality of earnings for the current financial year. In addition, the ratio of net income to cash from operations and contingencies disclosure are also likely to assist the financial analyst in order to distinguish between the sustainable and transitory earnings. Answer to Question 2 Pension accounting involves a great deal of accounting estimates and judgments, especially the actuarial assumption which forms the integral part of the pension accounting. The pension accounting causes significant confusion among the investors regarding the earnings quality issues. However, it can be generally observed that a company might report expense in its financial statement for a current financial year, whereas for another period it might report income. In order to understand this drastic fluctuation in the income statement of any company, it is of prime importance to grasp an understanding of the items which impacts the income statement of the company once they are recorded. The current service cost and interest cost are recognized in the income statement of the company which pertains to the pension accounting. The interest cost is the interest payable on the present value of the obligation of the company and the current service cost is the benefits that will be allocated to the employees, in the future, for their current service. In addition, the income statement of the company also shows the return on plan assets of the pension fund which is subtracted from the aggregate of the interest cost and the current service cost. Thus, it might happen in any financial year that the return on the plan assets of the pension funds increases the aggregate of the current service cost and the interest cost which causes the company to report income for that financial year rather than expense. Current service cost can be defined as the additional liability created in the pension fund because another year has lapsed. In terms of quality of earnings, the current service cost is of prime importance as the comparison of current service cost with the prior year will reveal where and how much the company has altered its actuarial assumption and judgments. Current service cost is adjusted every year in accordance with the revised actuarial assumptions and corresponding discount rates etc. Based on these facts, the financial analyst should give prime importance to the underlying facts and basis on which the current service cost of pension fund is recognized in the income statement so that the quality of the earnings of the corporation can be objectively evaluated. References [1] Richard Loth “Profitability Indicator Ratios: Profit Margin Analysis.” investopedia.com. Investopedia, n.d. Web. 19 April 2012. [2] Rosemary Peavler “Use profitability ratios in financial ratio analysis”Bizfinance.about.com” About.com – a part of the New York Times company, n.d. Web. 19 April 2012. [3] Jim Mueller “Diving into financial liquidity” investopedia.com. Investopedia, n.d. Web. 19 April 2012. [4] “Gearing ratios” qfinance.com. Bloomsbury information limited, n.d. Web. 19 April 2012. [5] “Equity Financing.” investopedia.com. Investopedia, n.d. Web. 19 April 2012. [6] Pierre Vernimmen “Corporate Finance – theory and practice” John Wiley & Sons Ltd. Volume 10 [7] Rosemary Peavler “Debt and Equity Financing.” Bizfinance.about.com” About.com – a part of the New York Times company, n.d. Web. 19 April 2012. [8] “Free Cash Flow - FCF.” investopedia.com. Investopedia, n.d. Web. 22 April 2012. [9] David Zion and Bill Carcache “The Magic of pension accounting” credit Suisse equity research, n.d. Web. 19 April 2012. Read More