Equity Valuation in the Style of Warren Buffet - Essay Example

? Equity Valuation in the Style of Warren Buffet Project Table of Contents Introduction 4 The Four Filters Approach 4 Filter Understanding of a company and its products 4 Filter 2 – Competitive Advantage 5 Filter 3 – Ability and Trustworthiness of Management 5 Filter 4 – Intrinsic Value Analysis 5 Free-Cash Flows 5 Key Assumptions 6 Stock Valuation – Determination of Intrinsic Value 7 Ratio Analysis 8 Profitability Ratios 9 Solvency Ratios 10 Turnover Ratios 11 Liquidity Ratios 12 Conclusion and Recommendations 14 Works Cited 15 Appendices 16 Table 1 – Income Statement of Apple Inc 16 Table 2 – Balance Sheet of Apple Inc 17 Table 3 – Cash Flow Statement of Apple Inc 18 Introduction The investment decision of an investor can be improved and optimized by implementing the four filters invention of W. E. Buffett and C. T. Munger. It is an investment formula which is often underestimated by the academic and business communities. But another school of thought suggests that Four Filters is an intellectual tool in the field of behavioral finance. The strategy is proved to be effective over time and prevents investors from making costly and foolish investment losses. The investment strategy uses both quantitative and qualitative factors which finding a good stock. The company chosen for financial analysis is Apple Inc. (Ticker Symbol AAPL) which is a Fortune 500 company whose shares are publicly traded. Apple Inc. is a leading hardware and software company which has headquarters in Cupertino, California, U.S. The company has over 400 global retail stores spread in over 14 countries and it is listed in NASDAQ as a publicly traded company. The Four Filters Approach Filter 1 – Understanding of a company and its products The company sells its products globally through retail outlets, online stores and direct sales with the help of third party distribution networks. The company is best known for its innovative hardware products and next generation media including iPhone, iPad, iPod, Smart Phones, and so on. The company’s products and services also include MAC, iCloud, App stores, Apple TV, App Stores, MAC App Stores and iBookstores. Their software services include iOS operating system, OS X, iTunes, iWork and iLife production and creativity suites. The company’s customers are small and medium sized businesses, retail customers, enterprises, educational institutions, and government customers. Filter 2 – Competitive Advantage Apple Inc. is the second largest company in information technology sector in the world. In terms of revenues, only Samsung Electronics (leading Korean company and key competitor of Apple) exceeds the consolidated revenue of Apple. In the year 2008, Fortune magazine name the company as the most admired company in United States as well as globally. Filter 3 – Ability and Trustworthiness of Management The company delivers innovative products and services to customers that include software, hardware, peripheral, and applications. Apple is committed to providing best user experience by leveraging its ability of producing unique design. The company continuously invests in marketing, advertising, research and development in order to boost sales and produce innovative products and technologies. The company’s long term strategy includes expansion of distribution network for reaching more customers globally in developing countries and providing them with high quality sales and support experience. Filter 4 – Intrinsic Value Analysis Free-Cash Flows The free cash flows are used to measure the financial performance of the company and it is calculated by subtracting capital expenditures from operating revenues. The free cash-flow represents the company’s ability to generate money required for expanding asset base and hence they are important to identify opportunities that can enhance shareholders’ value. Cash is very important to invest in new products, make M&A, reduce debt and pay dividends. The FCF is calculated using the following formula: In order to determine the intrinsic value of the company, the free-cash flows of the company has to be forecasted for at least the next 5 years and then the company’s potential FCF has to be determined as follows: 1 2 3 4 5 Items/Year 2014 2015 2016 2017 2018 EBIT 48,999 67,552 93,130 128,393 177,008 Depreciation & Amortization 6,757 9,342 12,917 17,859 24,692 Capital Expenditure -8,165 -11,289 -15,608 -21,580 -29,837 Increase in Working Capital 5,824 8,052 11,133 15,393 21,283 Free-Cash Flow (FCF) 43,397 80,131 110,522 152,439 210,255 Key Assumptions The following key assumptions were made in order to forecast the company’s FCF on the basis of past earnings and current financial position of assets and liabilities of the company: ASSUMPTIONS % Change Revenues 1.01% Cost Of Goods Sold 7.20% GROSS PROFIT -2.83% Selling General & Admin Expenses, Total 0.47% Depreciation & Amortization, Total -0.84% Other Operating Expenses -10.53% Accounts Payable 15.58% Accrued Expenses 9.47% Cash And Equivalents 8.59% TOTAL CASH AND SHORT TERM INVESTMENTS 6.70% Accounts Receivable 4.74% Inventory 13.47% Long-Term Debt 5.53% TOTAL CURRENT ASSETS 3.23% NET PROPERTY PLANT AND EQUIPMENT -3.89% Long-Term Investments 12.59% TOTAL CURRENT LIABILITIES -4.67% Stock Valuation – Determination of Intrinsic Value Details: Outstanding Shares (million) 899.70 Current Price ($) 519.55 Beta (B) 0.61 historical market risk premium 7.50% Cost of Equity 7.08% Cost of Debt (Before tax) 2.40% After-Tax Cost of Debt 1.68% Tax 30% Growth Rate 3.25% Market Price of Equity (in Million USD) 467,439 Risk-free Rate (US 10 Year bond) 2.50% Average Market Return 7.50% 1 2 3 4 5 Items/Year 2014 2015 2016 2017 2018 EBIT 48,999 67,552 93,130 128,393 177,008 Depreciation & Amortization 6,757 9,342 12,917 17,859 24,692 Capital Expenditure -8,165 -11,289 -15,608 -21,580 -29,837 Increase in Working Capital 5,824 8,052 11,133 15,393 21,283 Free-Cash Flow (FCF) 43,397 80,131 110,522 152,439 210,255 NPV (FCF) 41,443 73,077 96,254 126,781 166,991 TPV 599,728 Value of Company (in Million AUD) 599,728 WACC 4.72% Target Debt-to-Equity ratio 0.6 Terminal Year CF 2984 Estimated Value per Share of AAPL ($) 666.59 SUMMARY Trailing Leading Market Price/Share $ 519.55 $ 666.59 Earnings/Share $ 41.17 $ 56.75 P/E Ratio $ 12.62 $ 11.75 P/E Ratio (TTM) $ 39.63   Annual Dividend $ 12.20 $ 12.20 Price/Share $ 39.63 $ 39.63 Dividend Yield 2.26% 0.78% Ratio Analysis The financial statement of a company aims to provide information about enterprise’s financial position on a given date. Such information helps investors and other decision makers to strategize correct course of action especially regarding whether to invest in a particular stock or not considering its profitability, solvency, liquidity, etc. In a business enterprise the decision makers may be internal (such as the management, stakeholders, employees, etc.) or external (creditors, investors, government, competitors, etc.). The financial statements such as the company’s income statement and balance sheet in isolation are not enough to give meaningful information unless it is compared with other financial statements. A year-on-year (Y-O-Y) comparison provides a glimpse of how the particular company has been performing over the years. Analysts have to consider many external factors such as macro-economic scenario, competition level, policy constraints, demand-supply scenario, expansion strategy, etc. before finally recommending the stocks to investors. In order to assess the financial position of a company the ratio analysis is often used as popular tool. Ratio analysis has immense application in interpretation of financial statements by helping perform both intra-firm and inter-firm comparison. Intra-firm comparison helps to measure the performance of the company on Y-O-Y basis while inter-firm comparison helps to evaluate company’s performance with its competitors. Profitability Ratios The profitability of a company can be measured in terms of gross turnover or sales or the capital employed, or total assets. It is a key indicator of the company’s performance in its industry of operation and also helps to measure the company’s financial position. These ratios are mainly derived from the income statement of the company. Some example of profitability ratios are Gross profit Margin, Net profit Margin, Operating Margin, Return on capital employed etc (Thukaram, p.99). The overall profitability trend of Apple Inc. has been stable and very marginally improving from 2010 to 2013. However, the operating profit and net margin of the company has increased at an annual rate of 0.6% and 0.3% respectively during the same period under observation. Solvency Ratios The solvency ratios help to analyze the ability of a company to meet its long term obligations. The ratio focuses on the actual after tax income of the company by quantifying profit after taxes and other liabilities. However, the ratio may also consider the depreciation expenses, which is a source of free cash, in contrast to the total debt of the organization. The ratio provides an appraisal of the probability of a company to continue honoring its debt liabilities to external investors. The acceptable or ideal ratio varies from one industry to another, but in general it is accepted by analysts that if the company has solvency ratio higher than 0.2 or 20%, then such companies may be considered as financially sound (Siddiqui, pp.642). From the above it is clear that the company had solvency ratio higher than 0.2 or 20% from 2010 to 2013 implying that it may be considered as a financially sound organization. Turnover Ratios The turnover or activity ratios help to evaluate the activities level of business in terms of sales or turnover. The higher the activity, the higher would be the turnover of the business. The activity ratios state the number of times an asset is utilized in business to generate revenues. Thus, from the definition of activity ratios, it can be said that the higher values of activity ratios indicate improved efficiency by better utilization of assets and consequently higher profitability. It is also known as the activity ratios and helps to determine how efficiently a company utilizes the assets and liabilities of the organization. These ratios are very useful when the performance of a particular company is compared to its competitors. Liquidity Ratios The liquidity ratio measures company’s skill to meet its working capital requirements. An asset is considered liquid if it can be transformed into cash and cash equivalents in short amount of time. The current ratio and the quick ratio are examples of liquidity ratios. The standard value should be at least 1 since failure to meet external commitments may lead to liquidation of the company. The current ratio is an indicator for the firm’s short term liquidity management, hence it is also known as the working capital ratio. The two basic constituents for this ratio are the current asset and the current liabilities. The faster the current assets can be converted to cash and cash equivalents the easier it is for the firm to cover its current liabilities with current asset. Current liabilities include bill payable to creditors, income tax payable, etc. Another popular indicator for measuring company’s short term liquidity is the Quick-ratio which is same is current ratio except that since the inventories are not very liquid as other short term assets, so it is subtracted from other current assets. The rest of the formula is same as that current ratio. It is a more conservative ratio than the former because it measures the actual current asset to liabilities by eliminating the inventories. This method is widely accepted by most business concerns because the companies often find it harder to convert the inventory into cash in short time. It is more used in the automotive and realty sectors as their current ratio will not reflect true picture of the firm (Sheeba, pp.121-126). Conclusion and Recommendations The brand Apple is known for delivering high quality and reliable products to customers. The future growth of the company will mostly depend on the Consumer spending and international diversification into emerging economies. The strength of the company lies in its cash position. Apple has $107.46 billion of cash and cash equivalent for the year ending 2012 with no long term loans. This means that the company will be able to finance its long term strategies for investing in R&D and marketing activities in emerging economies with any requirement for borrowings. The current market price per share of the company is $ 519.55 and from the FCF analysis or discounted cash flow analysis it was found that the ‘Intrinsic value’ of the company is $ 666.59 which is leading at P/E multiple of 11.75 times. This implies that the company is currently undervalued and there is every possibility that the share prices of AAPL will rise in future. So, if an investor buys the shares of AAPL at CMP of $519.55 and sells it in future when the price per reaches target price of $666.59, then the investor will make profit of $147.04 per share (Gitman, pp.289-302). Works Cited Gitman, L. Principles of Managerial Finance. New Delhi: Pearson Education India, 2007. Print. Thukaram, R. Management Accounting. New Delhi: New Age International, 2007. Print. Siddiqui, S. Managerial Economics and Financial Analysis. New Delhi: New Age International, 2006. Print. Sheeba, K. Financial Management. New Delhi: Pearson Education India, 2011. Print. Appendices Table 1 – Income Statement of Apple Inc Income Statement of Apple Inc. ITEMS 2010 2011 2012 2013   all figure in millions of US dollars           Revenues 65,225.00 108,249.00 156,508.00 170,910.00 TOTAL REVENUES 65,225.00 108,249.00 156,508.00 170,910.00 Cost Of Goods Sold 39,541.00 64,431.00 87,846.00 106,606.00 GROSS PROFIT 25,684.00 43,818.00 68,662.00 64,304.00 Selling General & Admin Expenses, Total 5,517.00 7,599.00 10,040.00 10,830.00 R&D Expenses 1,782.00 2,429.00 3,381.00 4,475.00 OTHER OPERATING EXPENSES, TOTAL 7,299.00 10,028.00 13,421.00 15,305.00 OPERATING INCOME 18,385.00 33,790.00 55,241.00 48,999.00 Interest Expense -- -- -- -136 Interest And Investment Income 311 519 1,088.00 1,616.00 NET INTEREST EXPENSE 311 519 1,088.00 1,480.00 Currency Exchange Gains (Loss) -- -- -655 -300 Other Non-Operating Income (Expenses) -156 -104 89 -24 EBT, EXCLUDING UNUSUAL ITEMS 18,540.00 34,205.00 55,763.00 50,155.00 EBT, INCLUDING UNUSUAL ITEMS 18,540.00 34,205.00 55,763.00 50,155.00 Income Tax Expense 4,527.00 8,283.00 14,030.00 13,118.00 Earnings From Continuing Operations 14,013.00 25,922.00 41,733.00 37,037.00 NET INCOME 14,013.00 25,922.00 41,733.00 37,037.00 NET INCOME TO COMMON INCLUDING EXTRA ITEMS 14,013.00 25,922.00 41,733.00 37,037.00 NET INCOME TO COMMON EXCLUDING EXTRA ITEMS 14,013.00 25,922.00 41,733.00 37,037.00 Table 2 – Balance Sheet of Apple Inc Balance Sheet of Apple Inc. ITEMS 2010 2011 2012 2013 Assets: Currency in Millions of AUD           Cash And Equivalents 11,261.00 9,815.00 10,746.00 14,259.00 Short-Term Investments 14,359.00 16,137.00 18,383.00 26,287.00 Trading Asset Securities -- -- -- 44 TOTAL CASH AND SHORT TERM INVESTMENTS 25,620.00 25,952.00 29,129.00 40,590.00 Accounts Receivable 5,510.00 5,369.00 10,930.00 13,102.00 Other Receivables 4,414.00 6,348.00 7,762.00 7,539.00 Inventory 1,051.00 776 791 1,764.00 Other Current Assets 3,002.00 4,529.00 6,180.00 6,674.00 TOTAL CURRENT ASSETS 41,678.00 44,988.00 57,653.00 73,286.00 NET PROPERTY PLANT AND EQUIPMENT 4,768.00 7,777.00 15,452.00 16,597.00 Long-Term Investments 25,391.00 55,618.00 92,122.00 106,215.00 Goodwill 741 896 1,135.00 1,577.00 Other Intangibles 342 3,536.00 4,224.00 4,179.00 Other Long-Term Assets 2,263.00 3,556.00 5,478.00 5,146.00 TOTAL ASSETS 75,183.00 116,371.00 176,064.00 207,000.00           LIABILITIES & EQUITY:         Accounts Payable 12,015.00 14,632.00 21,175.00 22,367.00 Accrued Expenses 3,641.00 4,829.00 6,749.00 8,427.00 Other Current Liabilities 761 1,240.00 1,638.00 2,967.00 TOTAL CURRENT LIABILITIES 20,722.00 27,970.00 38,542.00 43,658.00 Long-Term Debt -- -- -- 16,960.00 Other Liabilities, Total 6,670.00 11,786.00 19,312.00 22,833.00 TOTAL LIABILITIES 27,392.00 39,756.00 57,854.00 83,451.00 Common Stock 10,668.00 13,331.00 16,422.00 19,764.00 Retained Earnings 37,169.00 62,841.00 101,289.00 104,256.00 Comprehensive Income And Other -46 443 499 -471 TOTAL COMMON EQUITY 47,791.00 76,615.00 118,210.00 123,549.00 TOTAL EQUITY 47,791.00 76,615.00 118,210.00 123,549.00 TOTAL LIABILITIES AND EQUITY 75,183.00 116,371.00 176,064.00 207,000.00 Table 3 – Cash Flow Statement of Apple Inc Cash Flow Statement of Apple Inc. Activities 2010 2011 2012 2013   Currency in Millions of AUD NET INCOME 14,013.00 25,922.00 41,733.00 37,037.00 Depreciation & Amortization 958 1,622.00 2,672.00 5,797.00 Amortization Of Goodwill And Intangible Assets 69 192 605 960 DEPRECIATION & AMORTIZATION, TOTAL 1,027.00 1,814.00 3,277.00 6,757.00 Other Operating Activities 1,440.00 2,868.00 4,405.00 1,141.00 Change In Accounts Receivable -2,142.00 143 -5,551.00 -2,172.00 Change In Inventories -596 275 -15 -973 Change In Accounts Payable 6,307.00 2,515.00 4,467.00 2,340.00 Change In Unearned Revenues 1,217.00 1,654.00 2,824.00 1,459.00 Change In Other Working Capital -3,550.00 1,170.00 -2,024.00 5,824.00 CASH FROM OPERATIONS 18,595.00 37,529.00 50,856.00 53,666.00 Capital Expenditure -2,005.00 -4,260.00 -8,295.00 -8,165.00 Cash Acquisitions -638 -244 -350 -496 Sale (Purchase) Of Intangible Assets -116 -3,192.00 -1,107.00 -911 Investments In Marketable & Equity Securities -11,075.00 -32,464.00 -38,427.00 -24,042.00 CASH FROM INVESTING -13,854.00 -40,419.00 -48,227.00 -33,774.00 Long-Term Debt Issued -- -- -- 16,896.00 TOTAL DEBT ISSUED -- -- -- 16,896.00 Issuance Of Common Stock 912 831 665 530 Repurchase Of Common Stock -- -- -- -22,860.00 Common Dividends Paid -- -- -2,488.00 -10,564.00 TOTAL DIVIDEND PAID -- -- -2,488.00 -10,564.00 Other Financing Activities 345 613 125 -381 CASH FROM FINANCING 1,257.00 1,444.00 -1,698.00 -16,379.00 NET CHANGE IN CASH 5,998.00 -1,446.00 931 3,513.00 Read More