Company Valuation Model and Application On Royal Bank of Scotland Plc - Essay Example

Company Valuation Model and Application On Royal Bank of Scotland Plc By: Gavin Leake I.D: 15384569 Supervisor’s Tony Mancini Dissertation In partial fulfilment of the requirements for the degree of MASTER OF BUSINESS ADMINISTRATION - 2010 University Name: University of Liverpool Date: 28 July 2010 Acknowledgements Table of Contents: 1.1 Problem Specification 9 1.2 Context of Company Valuation and its significance 12 1.3 Research Questions 16 1.4 Aims and Objectives 17 1.5 Synopsis of the Dissertation 18 1.6 Conclusions of Chapter 1 19 2.1 Methodology of Literature Review and Documentary Study 21 2.2 Financial Valuation Techniques 21 2.2.1 Overview of Financial Metrics 21 2.2.2 The DuPont Model 21 2.2.3 Financial Valuation Techniques 21 2.2.3.1 Asset Based Valuation 22 2.2.3.2 Income Based Valuation 22 2.2.3.3 Cash Flow Based Valuation 22 2.2.3.4 Market Based Valuation 22 2.2.3.5 Fair Valuation 23 2.2.3.6 Capital Budgeting Analysis and Forecasts 23 2.2.3.7 Weighted Average Cost of Capital 23 2.2.3.8 Economic Value Added 23 2.2.3.9 Comparison of the financial valuation techniques 23 2.2.4 Interpretations from Financial Analytics – Objective Analysis of Financial Strengths and Weaknesses 24 2.3 Risk Analysis 24 2.3.1 Analysis of Systematic Risks 24 2.3.2 Analysis of Un-Systematic Risks 24 2.3.3 Interpretations from Risk Analysis 24 2.4 Strategic Analysis 25 2.4.1 Historical Analysis 25 2.4.2 SWOT Analysis 25 2.4.2.1 Analysis of Strengths 25 2.4.2.2 Analysis of Weaknesses 25 2.4.2.3 Analysis of Opportunities 25 2.4.2.4 Analysis of Threats 26 2.4.3 Michael Porter Diamond Model of Competitive Advantages 26 2.4.3.1 Firm Strategy and Rivalry 26 2.4.3.2 Demand Conditions 26 2.4.3.3 Factor Conditions 26 2.4.3.4 Related and Supporting Industries 26 2.4.4 Ansoff Analysis 27 2.4.5 Michael Porter Model of Five Forces that shape Strategy 27 2.4.5.1 Threat of New Entrants 27 2.4.5.2 Bargaining Power of Suppliers 27 2.4.5.3 Bargaining Power of Buyers 27 2.4.5.4 Threat of Substitute Products or Services 28 2.4.6 Interpretations from Strategic Analysis – Objective Analysis of Strategic Strengths and Weaknesses 28 2.5 Conclusions of Chapter 2 28 3.1 Introduction 28 3.2 Research Design 28 3.3 Research Methodology 29 3.3.1 Difference between Qualitative and Quantitative Research Methodologies 29 3.3.2 Research Methodology chosen for this dissertation 29 3.3.3 Research Instruments 29 3.3.4 Sampling technique employed 29 3.4 Reliability and Validity of the Research 29 3.5 Pilot Study before commencing the Research 30 3.6 Analytics techniques employed 30 3.7Ethical Considerations 30 3.8 Conclusions of Chapter 3 30 4.1 Development of Integrated Company Valuation Model: 31 4.1.1 Introduction 31 4.1.2 The Model Components 31 4.1.3 The Model Integration 31 4.1.4 Presentation and explanation about the model 31 4.1.5Methodology of using the model 31 4.2 Application of the Model on the analysis of RBS, UK: 32 4.2.1 Financial Analysis of RBS 32 4.2.2 Strategic Analysis of RBS 32 4.2.3 Interpretations about RBS 32 4.2.4 Questionnaire formation for field work based on the interpretations about RBS 32 4.3 Description of Field Work carried out: 32 4.4 Organisation and Presentation of Primary Data: 33 4.5 Analysis of Primary Data: 33 4.6 Critical Discussions: 33 4.7 Limitations of the Research: 33 4.8 Conclusions of Chapter 4: 34 Table of Figures: S. No. Description and link within the document Figure 1 Figure 2 Figure 3 Figure 4 Figure 5 Figure 6 Figure 7 Figure 8 Table of Charts/Tables: S. No. Word Hyperlink Chart/Table 1 Chart/Table 2 Chart/Table 3 Chart/Table 4 Chart/Table 5 Chart/Table 6 Chart/Table 7 Chart/Table 8 Executive Summary Chapter 1 Introduction In these times of turmoil in the financial market, identifying safe investments has become a complex task. The decision making for investments in businesses has therefore become a very challenging aspect for investors in more recent times. Over the past decade, there have been numerous examples of creative accounting, where the valuation of businesses has been inflated significantly above the fundamental generally accepted accounting principles or valuation principles for that matter. Recent good example is the acquisition of ABN AMBRO Group by the Royal Bank of Scotland consortium, where the transaction price was approximately €72billion and in the end, this investment was found worth nearly zero. Investors have lost billions of pounds and dollars amidst hypes of valuations in practically everything where one may look for an opportunity to invest safely and expect returns. One of the reasons for such losses is that investors are not sufficiently well informed about their investment decisions that they are making or the risks that they are taking on. Buyers tend to depend upon market information published by various organisations or rating agencies. The irony is, these agencies themselves have been inflating the values amidst their own problems. Accordingly, the valuation of companies should no longer be treated as sacrosanct. The specialised lengthy and complex process that companies carry out to make decisions pertaining to mergers and acquisitions can no longer be taken for what it is. Every investor buying shares in a listed company should have reasonable visibility into the value of the company so that he/she can judge the risks and develop balanced portfolios. This dissertation will document comprehensively the current generally accepted concepts and methodologies of company valuation techniques. In addition it will be my endeavour to propose an integrated model in which the investors can apply data and information and evaluate the company value with a reasonable level of accuracy. 1.1 Problem Specification In this dissertation an effort has been made to address the problems related to the methodology of valuations that has been adopted recently to predict the net worth of companies. The current financial valuation techniques of a company primarily comprise of four methods [Jacob, 2004: pp1-4 and Fernandes, 2007: pp2-19]; Asset based valuation (that includes tangible and non-tangible assets), Income based valuation, Market based valuation, and Cash flow based valuation. All four methods result in different ways of thinking and often in different valuations. The investors normally do not understand which method is more suitable for them to use for making the most informed investment decisions and hence trust the methods that are generally adopted and presented by the rating agencies and performance valuation agencies operating in the markets. Core and Guay et al. (2003: pp43-51) described that the world has witnessed a “new economy period” in which the notion of firm valuations have changed from what has been considered as “empirically supported valuations” to the latest highly inflated “forecasted cash flow valuation model” that is not empirically supported. For example, let us analyse what Enron did in the valuations of their structured finance products in 2001-2002. They signed a 20-year agreement with “Blockbuster Video” (a company that developed technology models of streaming videos) and introduced a new business concept of video on demand that could be launched in the US cities. They planned to use their optical fibre based infrastructure for broadband networking and created some pilot projects in the cities of Seattle, Salt Lake City and Portland where they provided video streaming services to some apartments from the systems installed in their basements. Based on such pilots, they projected huge cash flows with about USD 110 Million of net profits within a year using the “forecasted cash flow model” to the retail investors. Experts say that the business model was itself baseless because the legal licensing and market demands for such services were not clear. They raised huge funds by just projecting a business based on pilots and cash flow projections (Healy and Palepu, 2003: p.3-14). In the old models, well established and successful companies that have proven track records for at least five years, achieve respectable firm value (share prices) if they have been able to sustain their “residual cash” for the past five years and also have been exhibiting sustained growth of income. New companies therefore have to wait until they generate such performance data. These valuation methods have been based on sound accounting principles and have been widely supported by the past empirical theories. However, in the new economic world, a company or business having a life of less than one year can also achieve high values by virtue of their growth projections, innovations and technological capabilities. The speculators project high growth, high cash flows, attractive potential in the markets, and high value of assets (primarily intangible) to investors and are able to push equity prices upwards. Such companies begin with a high leverage ratio and are also able to gradually reduce their leverage ratio by generating investment money from the markets, which in turn is spent in the so called high growth projects. Generally there is no harm in such valuation methods, provided the speculations are not based on false hypes. The investors will need to be cautious about the false fundamentals of the speculations and reduce their investment risks by carrying out subjective strategic analysis in addition to financial analysis. It is very difficult to ascertain the feasibility of valuations of new firms (or new businesses of old firms) having very little history and performance track record, hence it is not wise to get carried away by the hypes and start investing in them. On an overall basis, the author wants to counter the popular statement made in stock markets – “past performance is not the indicator for future performance” (All mutual fund and structured finance product companies mention this in their agreements). If the historical information and performance data of a company is evaluated carefully, the future performance can be predicted with reasonable levels of accuracy. On the contrary, in the absence of such information and performance data, the valuations cannot be supported and hence investment risks remain high. The empirically proved theories and methods to carry out strategic as well as financial valuation of firms are presented in this dissertation. The outcome of this dissertation is a model that can help in carrying out valuations by applying historical data, which is vetted by the finance professionals that have worked for some of the largest banks of the world. 1.2 Context of Company Valuation and its significance Dahl (2008: pp1-2) and Tibergien and Dahl (2006: pp3-34) presented the fundamental considerations and challenges in company valuations. A process that should have ideally appeared as simple strategic and financial accounting analysis has become very complex because of agency problems in the industry. They stated that the challenge is not in the techniques of company valuation but it is in the process of incorporation of the interests of all parties involved. Accordingly, the overall valuation methodology has to take the side of at least one party. The author appreciated this fact and accordingly presents that the valuation model developed in this dissertation is from the perspective of general market participants (retail investors) who lose their hard earned money amidst hyped growth projections. In the current economic crisis, the credit derivatives business projections went wrong and the retail investors received the maximum penalty, in loosing significant amount on their investments. It was, probably, important for them to look into the way these products were formed from a strategic perspective. The valuations carried out were asset based whereby the high growth and supposedly secured tranches (especially the mortgage backed securities) were all intangible assets. On an overall basis, the investors lost money due to lack of a bigger picture about the business and financials of the company where they had invested as well as the lack of transparency in asset pricing. There were clear signals of high risks, which were not captured by the investors – for example significant variations in the ratings by rating agencies where one product from one company was rated at AAA by one rating agency and BBB by another rating agency. A “think out of box” approach could have saved the investors and probably the current global financial crisis itself could have been avoided. Valuation processes works well from the investor’s perspective if they adopt conservative accounting principles. Optimism in valuations by underwriters and the credit rating agencies was natural because they were on the selling side. The people or entities on the buying side cannot be optimistic in valuations. As described by Zhang (2000: pp125-149) conservative processes of accounting can form the fundamentals of valuation of firms, thus making the investors more secure. Too much optimism on the buyers’ side could end up like the RBS Consortium and their acquisition of ABN AMBRO. As warned by Dahl (2008: pp1-2), the methodology used for company valuations cannot be trusted if it is not auditable and repeatable. For example, the highly hyped “forecasted cash flow valuation model” has been highly preferred and exploited in the recent past but data points and historical analysis have been missing largely because all the data was internally generated by companies. To some extent, even the discount rates taken in the “discounted cash flow” valuation were flawed, in the sense that they did not adequately reflect the risks embedded within a particular investment under consideration. If there is a merger and acquisition decision being taken, the experts prefer to compare the entity against benchmarks that are similar to companies that are on sale or have been sold earlier. However, these privileges are not available to the retail investors. Accordingly, as recommended by conservative accountants like Plenborg (2002: pp303-318), the investors should take into account the residual income of the company and discounted cash flow approaches in parallel. Residual income is the projection of real (on the ground) performance of the company, which is defined as the surplus profit after the opportunity cost (capital charge) has been deducted. The residual income can also be viewed as the profit carried forward to the next year, given that cash management remained within budget without burning the pockets of the shareholders for extra money. The significance of residual income was recognised many decades ago and all conservative accountants consider this as the major metric for performance valuation of the company. The residual income combined with the share capital reserves of the company at the end of financial year is considered as the Net Equity that the company has been successful in accruing – year on year. It may be noted that the true “on the ground” performance of a company is determined by the performance ratio called “Return on Net Equity” which is also called “Return on Shareholders’ funds invested”. This is calculated as Net Profit/Net Equity and is one of the most important performance indicators for the investors. Its application can be recognised in many areas like project and firm valuation, performance measurement, capital budgeting decisions, tax planning and management compensation (Magni, 2009: pp1-22; Dechow and Hutton et al, 1999: pp1-32). In general this dissertation presents an integrated practical valuation model of a company and makes recommendations on how to avoid these hyped valuations. This dissertation is focusing on the valuation of firms that possess at least three years of track record in the markets. This is because it is quite difficult to practice conservative valuation techniques of companies that are new to the markets and do not have historical data. A new company will always begin with high leverage, which would be lowered down as the investors start buying its shares so that the initial investors can reduce their stress. This is possible only by generation of internal data that is used to carry out Net present Value analysis of the projects that the company plans to execute in future. Such valuations have high risks of hypes and cannot be addressed by the conservative techniques given that the discounting factor cannot be calculated accurately (Dahl, 2008: pp1-2) There is no harm in investing in new projects; however they should be sponsored by companies having a proven track record of at least three years (conservatively, the author recommends that ideally data of five years should be collected for trusted valuation). By carrying out such analytics, the investors should look for traces that ascertain growth of the company in future (Barth and Cram et al, 2001: pp27-34). They need to be careful in differentiating between growth oriented or damage control strategies. Sometimes a company appearing to be running smoothly may be supported by damage control strategies that are not visible to the investors. For example, not all companies paying dividends may be high growth oriented companies. There may be a possibility that the company is paying dividends to maintain share prices and positive sentiments in the market and burning funds from debts or shareholder’s money and not from the retained profits (Ghosh and Woolridge, 1989: pp25-35). It is not difficult to analyse such facts – some smart analytics can reveal everything. This is the significance of company valuation techniques from the perspective of the investors. This dissertation shall serve as the handbook of company valuation techniques for all retail investors and a guide to the application of these techniques to ensure safe investments balancing risks and returns. The outcome model shall be applied in valuations of Royal Bank of Scotland Plc. (RBS) to assess the future outlook of the bank from the perspective of investors. The author has chosen RBS to test the model because it is one of the largest banks of the world that is diversified in many business segments and hence the tangibility of valuations of complex organisations for investment decisions can be demonstrated. The author perceives that if it works for valuation of RBS, it can work for any organisation of the world. The data used to conduct analytics are taken from published annual reports, CNN Money, Yahoo Money and London Stock Exchange. No internal data or information has been obtained to conduct the analysis demonstrated in this dissertation. 1.3 Research Questions The author has proposed an interpretive philosophy of research using a phenomenological approach of qualitative research methodology. Such research usually begins with research questions rather than Hypotheses. Hence, the following research questions have been formulated for this dissertation: Q1. What are the various valuation techniques for analyzing the financial standing of a Company? Q2. What are the various theories and techniques that can help in strategic analysis of a Company? Q3. How can strategic and financial valuation of companies be carried out from investors’ perspective? Q4. What are the future projections of RBS based on the outcome of valuations? Q5. What do the financial and strategic analyses of RBS reveal about their current and future outlook? As is evident from the above research questions, the author intends to apply the company valuation model to RBS and tangibly demonstrate how it works to analyse the future growth prospects of the Bank. 1.4 Aims and Objectives Following are the aims and objectives of this research: Aims: Aim 1: The research aims at establishing a company valuation model that shall be based on proven empirical techniques presented by professionals and scholars in the past. Aim 2: The research further aims at applying the model in the case study of Royal Bank of Scotland Plc. to demonstrate the applicability and feasibility of the model. Objectives: Objective 1: To collate and analyse all the empirically proven company valuation techniques pertaining to strategic valuation as well as financial valuation. Objective 2: To integrate all the learning from various company valuation techniques and develop a model that can ensure that the users are able to understand the bigger picture of the business of the company under valuation from many perspectives. Objective 3: To explain how the company valuation model can be used. Objective 4: To demonstrate the applicability of the valuation model by applying it in the case study of Royal Bank of Scotland Plc. Objective 5: Carry out analysis of past performance (historical analysis) and future performance (projection analysis) of RBS. Objective 6: To generalise the outcomes of the RBS analysis for the readers to help them understand the applicability of the model in any company of the world from the perspective of investors. Objective 7: To get the outcomes of the model (pertaining to RBS case study) vetted by experts that has worked for world-class banks (including RBS). 1.5 Synopsis of the Dissertation This dissertation has five chapters. You are currently at the end of chapter 1 that has set the context and scene for the further chapters of the dissertation. Chapter 2 comprises of a detailed literature review of all the strategic and financial company valuation techniques. Evidences have been taken from books, journals, company white papers, expert advices, conference proceedings, web sources, etc. The outcome of this chapter has been used to develop and explain the valuation model later in Chapter 4. Chapter 3 comprises of detailed literature review of the research design and methodology aspects and the corresponding choices made by the author to conduct this research. The references for Chapter 3 have been taken primarily from books and journals. Chapter 4 comprises an analysis and interpretations of results. The preparation and explanation of a company valuation model, application of the model to RBS, conclusions pertaining to RBS, primary data presentation related to the outcomes of the interview, and critical analysis of primary data to derive conclusions are all included in Chapter 4. From the reader’s perspective, this is the most important chapter of this dissertation. The last chapter (Chapter 5) presents the overall conclusions of this research in the form of generalisations that can be taken away as the final learning from this dissertation. This chapter also presents how the research questions have been answered and the objectives have been fulfilled. 1.6 Conclusions of Chapter 1 The scene has been set for the dissertation. The research questions, aim and objectives, research context and significance and the structure of rest of the dissertation have been presented herewith. The next chapter deals with detailed literature review of company valuation techniques from strategic and financial perspective. 1. Literature Review and Documentary Study: 2.1 Methodology of Literature Review and Documentary Study 2.2 Financial Valuation Techniques 2.2.1 Overview of Financial Metrics 2.2.2 The DuPont Model 2.2.3 Financial Valuation Techniques 2.2.3.1 Asset Based Valuation 2.2.3.2 Income Based Valuation 2.2.3.3 Cash Flow Based Valuation 2.2.3.4 Market Based Valuation 2.2.3.5 Fair Valuation 2.2.3.6 Capital Budgeting Analysis and Forecasts 2.2.3.7 Weighted Average Cost of Capital 2.2.3.8 Economic Value Added 2.2.3.9 Comparison of the financial valuation techniques 2.2.4 Interpretations from Financial Analytics – Objective Analysis of Financial Strengths and Weaknesses 2.3 Risk Analysis 2.3.1 Analysis of Systematic Risks 2.3.2 Analysis of Un-Systematic Risks 2.3.3 Interpretations from Risk Analysis 2.4 Strategic Analysis 2.4.1 Historical Analysis 2.4.2 SWOT Analysis 2.4.2.1 Analysis of Strengths 2.4.2.2 Analysis of Weaknesses 2.4.2.3 Analysis of Opportunities 2.4.2.4 Analysis of Threats 2.4.3 Michael Porter Diamond Model of Competitive Advantages 2.4.3.1 Firm Strategy and Rivalry 2.4.3.2 Demand Conditions 2.4.3.3 Factor Conditions 2.4.3.4 Related and Supporting Industries 2.4.4 Ansoff Analysis 2.4.5 Michael Porter Model of Five Forces that shape Strategy 2.4.5.1 Threat of New Entrants 2.4.5.2 Bargaining Power of Suppliers 2.4.5.3 Bargaining Power of Buyers 2.4.5.4 Threat of Substitute Products or Services 2.4.6 Interpretations from Strategic Analysis – Objective Analysis of Strategic Strengths and Weaknesses 2.5 Conclusions of Chapter 2 3 Research Design and Methodology: 3.1 Introduction 3.2 Research Design 3.3 Research Methodology 3.3.1 Difference between Qualitative and Quantitative Research Methodologies 3.3.2 Research Methodology chosen for this dissertation 3.3.3 Research Instruments 3.3.4 Sampling technique employed 3.4 Reliability and Validity of the Research 3.5 Pilot Study before commencing the Research 3.6 Analytics techniques employed 3.7 Ethical Considerations 3.8 Conclusions of Chapter 3 4. Presentation, Analysis and Interpretation of the Results: 4.1 Development of Integrated Company Valuation Model: 4.1.1 Introduction 4.1.2 The Model Components 4.1.3 The Model Integration 4.1.4 Presentation and explanation about the model 4.1.5 Methodology of using the model 4.2 Application of the Model on the analysis of RBS, UK: 4.2.1 Financial Analysis of RBS 4.2.2 Strategic Analysis of RBS 4.2.3 Interpretations about RBS 4.2.4 Questionnaire formation for field work based on the interpretations about RBS 4.3 Description of Field Work carried out: 4.4 Organisation and Presentation of Primary Data: 4.5 Analysis of Primary Data: 4.6 Critical Discussions: 4.7 Limitations of the Research: 4.8 Conclusions of Chapter 4: 5 Conclusions and Recommendations: References Ansoff, H. Igor. (1958). A Model for Diversification. Management Science. Vol. 4. Issue. 4. INFORMS. Pp 394-399. Barnett, William P. and McKendrick, David G. (2004). Why Are Some Organizations More Competitive than Others? 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