British Telecommunications Financial Statements - Essay Example

Equity Valuation Table of Contents Section I 3 Introduction 3 2.Industry and company profile 3 3.Methodology 4 Section II 5 4.Main developments in the company’s business 5 5.Cash flow projection and Terminal Value 6 Section III 7 6.Methodology of calculating cost of capital 7 7.Assumptions and limitations of calculating cost of capital 8 Section IV 9 8.Equity value calculation and conclusion 9 References 12 Section I 1. Introduction Equity valuation of a firm aims to find the upside and downside of the firm’s stock price. It acts as a tool to guide the investors in taking sound decisions. It considers the growth rate of the firm to find the future value, which is then discounted back to the present value. It tries to gauge the future earning potential of the firm. It considers the growth of a firm’s equity usually five years or ten years. Various financial metrics are used to find earnings availability to the common stockholders. It uses various financial models to find the equity value of a firm that serves as data points for managers, shareholders and prospective investors. Through equity valuation, shareholders of the firm decide whether to hold, buy or sell the firm’s stock. The long term risk of holding the share is also reflected in the valuation analysis i.e. upside and downside margin. Such critical analysis of firm’s equity leads to better financial performance evaluation and finding the growth prospects of a firm. 2. Industry and company profile The project has taken British Telecommunication’s financial statements into consideration in explaining the various processes of equity valuation. The telecom industry in UK is one of the largest in Europe that is characterised by the rising competition in broadcast, mobile communication and broadband segment. It has witnessed significant growth in the mobile communication and broadband market and it is above the European average growth rate. The digital TV penetration has risen to 90% of UK population. The operational capacity has also witnessed significant growth owing to the investments made by Virgin media, Next generation networks and British telecom. The major players in the industry are COLT telecom, BT, Virgin Media, Orange, Kcom and O2. The UK market is divided between two kinds of players’ mobile carriers and fixed line. Key players in the mobile carriers market are O2, Vodafone and Hutchison and BT dominates the fixed line carriers. British Telecom is a UK based telecom company that caters to more than 17 million customers in UK and more than 160 countries worldwide. Its main service divisions are digital TV, broadband and mobile communication. It was earlier a subsidiary of the General post office but in 1984, it was privatised and became British Telecommunication Plc. More than 50% of its shares have been sold to investors and further divestment was made in 1993. BT Plc in the current fiscal have plans to takeover EE Ltd for an amount of £12.1 billion (BT Group Plc, 2014a). 3. Methodology The stock valuation of BT Plc has been done using the discounted cash flow method. Other financial metrics have been used to find whether the stock price of BT Plc is overvalued or undervalued. The financial statements like income statement, balance sheet and cash flows of five years i.e. 2010, 2011, 2012, 2013 and 2014 have been used to value the stock price. Net income, depreciation, capital expenditure, change in working capital, net debt payments have been considered to find the free cash flow to equity (FCFE). The expected growth rate is then calculated to forecast the future FCFE which was then discounted back to the present value with the cost of equity to calculate the discounted cash flows. DCF is used to find the terminal value for 5 years ending March 2019 (Davidson, and Tippett, 2012). Section II 4. Main developments in the company’s business BT plc shows a positive cash flow return to equity. There are host of factors that have influenced the future cash projections to be positive. BT plc plans to develop a sustainable business model that is aimed at delivering greater customer value. It wants to invest in technology, network and people to create high value standard. It considers investing in strategic areas like fibre optics, digital TV and telephony to increase its future stockholders earning. It is looking forward to improve its sports content, increase its third party offerings for channel distribution, invest in employee to make them handle customer service more effectively and partnering with EE Ltd for its MVNO agreement that will offer its customers high speed internet connectivity through its 4G spectrum. Currently it is the largest service provider of fixed line connections to SMEs in Great Britain and wants to increase its penetration by targeting the SMEs in UK with its other strategic services. It plans to increase its fibre optic business by providing industry specific technology solutions. Furthermore, it will also launch new products like voice based IP and data services to drive its cloud sales. Moreover, it wants to enter in new strategic areas like hosting and security services to build its operational capacity. Its future plans include extending its network coverage and hosting more communication services. Besides that, it also aims at increasing its fibre broadband market to 90%, by increasing its fibre to the cabinet (FTTC) coverage and fibre to the premises (FTTP) availability (BT Group Plc, 2014a). 5. Cash flow projection and Terminal Value FCFE and DCF of British Telecommunication Plc( In Millions except per share data) Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 Mar-17 Mar-18 Mar-19 Terminal Value PAT 1,548 2,426 3,169 2,938 3,352 Depreciation 4,577 4,813 4,703 4,288 4,477 Capital expenditure -3,779 -4,273 -4,079 -3,742 -3,914 ` Current Assets 9,465 6,351 7,169 7,050 9,478 Current Liabilities 15693 11,359 14,644 11,469 12,769 Working Capital -6,228 -5,008 -7,475 -4,419 -3,291 Change in working capital 1,220 2,467 3,056 1,128 Long term debt 14,340 15,139 12,024 12,484 13,191 Net debt repayment 799 3,115 460 707 FCFE 2,545 4,441 888 3494 3757 4040 4344 4671 5023 614599 PV of FCFE 3583 3675 3769 3865 3964 462574 Table 1: FCFE and DCF of BT plc (Gurufocus LLC, 2015). The above figure represents the FCFE and DCF values of BT plc over the years 2015 to 2019. The end value is the terminal value, which is the target value of the expected cash flows. The FCFE expected cash flows are discounted by the cost of equity to arrive at the present value of the future cash flows. The expected FCFE values were calculated using the expected growth rate of long term cash flow. The terminal value is calculated by using the terminal growth rate and the difference in cost of equity and the terminal growth rate. FCFE is calculated by using net income, depreciation, capital expenditure, change in working capital, net debt payment. Moreover DCF shows the present value of future cash flows that are available to its common stockholders and shows the expected future performance of the company (Stimes, 2011). Calculation of Ke and Growth Risk free rate 4% Risk premium 5.00% Beta 0.9 Cost of equity Ke 5% Terminal Growth 4% Average payout 35% Retention ratio 65% Average ROE 12% Expected growth rate 8% Table 2: Cost of equity and expected growth rate (Bloomberg Business, 2015) Section III 6. Methodology of calculating cost of capital Calculation of WACC Mar-14 Market value of debt 13,191 Market value of equity 363810.2 Total value 377,001 Debt to total value 0.034989 Equity to total value 0.965011 Cost of debt 4% Cost of Equity 5% Tax rate 20% WACC 4.8% Table 3: Calculation of cost of capital Cost of capital is calculated by using the WACC method for BT plc. The weighted average cost of capital is calculated by considering the debt and equity capital of the company. Data retrieved from company annual report is used to find out the debt and equity capital. WACC has two parts i.e. debt value and equity value. The market value of debt is taken from the annual report of the company and the market value of equity is ascertained by multiplying the outstanding shares with market price of the stock (Brealey and Myers, 2003). Then the total value of the firm is determined by adding the market value of debt and equity. Cost of debt is determined by calculating the annual rate of return of gilts over three years 2011, 2012 and 2013 that are traded on FTSE 100 index. Cost of equity is calculated by using beta, risk free rate and the risk premium. Risk free rate is the cost of debt. Beta is taken from the company financials and risk premium is retrieved from company data. Tax rate is assumed to be 20% on an average. Using the above metrics the weighted average cost of capital was determined for BT Plc. The formula used for calculating the cost of capital is as follows (Bruner, Eades, Harris and Higgins, 1998). 7. Assumptions and limitations of calculating cost of capital The above formula which is used to calculate WACC is based on certain assumptions. Cost of debt is the average coupon rate of gilts in UK. The tax rate is considered to be 20%. It is a flat rate, since there were changes in the tax rate, thus a uniform tax rate was taken into account for calculation purpose. Cost of equity is calculated based on the capital asset pricing model. The dividend growth model was not considered as data was not available (Arnold, 2005). CAPM considers the cost of equity, the risk free rate of return and beta value. The changes in capital structure were not considered for calculating the WACC. It assumes the risk level to be same for financing new projects. WACC is useful when the risk level of the new project is same as that of the existing. Apart from the above assumptions used in calculating WACC, there are certain limitations in calculating the cost of financing. Cost of debt keeps on changing over the time horizon, thus it might affect the company as it may incur higher cost of financing owing to a higher WACC. It only considers two sources of capital i.e. debt and equity and ignores other important sources of capital like additional capital, share warrants, retained earnings etc (Armitage, 2005). Including these items would make the calculation of WACC difficult but would also project the fair value of cost of capital. Another important factor that contributes to the drawback of WACC is consistency in capital structure. BT plc will accept future projects based on the current debt equity mix and cost of capital. If it gets an opportunity to invest in a project that has higher returns, owing to its debt equity mix it might have a higher WACC which will increase the overall cost of capital, resulting in lower EBT. (Poitras, 2010). Section IV 8. Equity value calculation and conclusion Total equity value 481,431 Share outstanding 823 Price target 585 Final Target Price Price / value Firms intrinsic value 481430.6 Final price target 584.9 Current market price 442.0 Upside 32.33% BT plcs stock price is undervalued by 15.89% Recommendation Hold/ Buy Table 4: Equity Valuation of BT plc The above figure is representative of BT plc’s target share price and the current market price of its stick. It shows that its final price target is $584.9 whereas its current stock price is $442, which implies that the share price should be $584.9. It signifies that the stock price is undervalued by 15.89%. It acts as a guiding tool for the company’s manager, shareholders and prospective investors for making sound investment decisions. The target firm’s value or the enterprise value stands at $481430.6 (in Millions). Current shareholders can hold their shares and should sell it when the current market price reaches the target price. As for the prospective investors the target price acts as an incentive to buy the shares of BT plc at $442 and sell it when it reaches the future price. The target equity price is calculated by dividing the firm’s total equity value by outstanding shares for FY 2014. The target price of equity is $584.9. Total value of equity is calculated by taking the cumulative figure of the present value of future FCFE. The future FCFE is calculated by using the expected growth rate i.e. 8% from table 2. The discounted cash flow of FCFE is then calculated by discounting the expected FCFE with cost of equity i.e. 5% from table 2. Thus, it shows a favourable valuation of BT plc’s equity position. It incentivises shareholders and prospective investors an upside of 15.89% (Benninga, 2008). Mar-11 Mar-12 Mar-13 Mar-14 DPS 1.1 1.15 1.27 1.6 EPS 2.99 3.86 3.57 4.07 Dividend payout 37% 30% 36% 39% Average Payout 35% Table 5: Calculation of average payout (London Stock Exchange, 2015) Mar-12 Mar-13 Mar-14 Retained earnings 1,756 1,948 2,018 Total equity 14,693 17275 17211 ROE 12% 11% 12% Average ROE 12% Table 6: Calculation of average ROE (BT group plc, 2014) The above tables show the calculation of average dividend payout and average return on equity. Dividend payout is calculated by dividing the dividend per share by earnings per share of 2011, 2012, 2013 and 2014. From the resultant payout the average payout is determined. Similarly the average ROE is also calculated. ROE is calculated by dividing the retained earnings by total equity (does not include preferred stock) for 2012, 2013 and 2014. The data for calculating ROE is taken from the annual report of BT plc. The ROE for the mentioned period is then averaged to get the average return on equity (Kantor, 2008). Likewise, firm’s equity valuation is also characterised by certain drawbacks that might affect the investors’ confidence level. The DCF valuation of firm’s equity considers a uniform growth rate. It rules out any strategic and negative externalities on the growth rate and future earnings of the company. It assumes the level of risk to be same and uses a constant discounting rate over the future period. It gives positive results when the accuracy of future projections have zero errors or done with high level of confidence (Kantor, 2008). References Armitage, S, 2005. The Cost of Capital: Intermediate Theory. Cambridge: Cambridge University Press. Arnold, G, 2005. Corporate Financial Management, Third Edition. Chpter 19. New York: Prentice Hall. Benninga, S., 2008. Financial Modeling, Third Edition. Massachusetts: The MIT Press. Bloomberg Business, 2015. United Kingdom Government Bonds. [online] Available at: http://www.bloomberg.com/markets/rates-bonds/government-bonds/uk/ > [Accessed 3 April 2015]. Brealey R.A. and Myers S., 2003. Principles of Corporate Finance, Seventh Edition, Chapter 19. New York: McGraw Hill. Bruner R., Eades K., Harris R. and R. Higgins, 1998. Best practices in Estimating the Cost of Capital: Survey and Synthesis. Financial Practice and Education, Spring/Summer, pp.13-28. BT group plc, 2014. BT Group Plc, Annual Report. [online] Available at: < http://www.btplc.com/Sharesandperformance/Annualreportandreview/pdf/2014_BT_Annual_Report.pdf> [Accessed 3 April 2015]. BT Group Plc, 2014a. Annual Report - Purpose and strategy. [online] Available at: < http://www.btplc.com/Sharesandperformance/Annualreportandreview/pdf/2014_BT_Strategic_Report.pdf > [Accessed 3 April 2015]. Davidson, I. and Tippett, M. 2012. Principles of Equity Valuation. USA: Routledge. Gurufocus LLC, 2015. BT Group PLC. [online] Available at: < http://www.gurufocus.com/financials/BT> [Accessed 3 April 2015]. Kantor, M., 2008. Valuation for Arbitration: Compensation Standards, Valuation Methods and Expert Evidence. Netherland: Kluwer Law International. London Stock Exchange, 2015. BT.A BT GROUP PLC ORD 5P. [online] Available at: < http://www.londonstockexchange.com/exchange/prices-and-markets/stocks/summary/company-summary.html?fourWayKey=GB0030913577GBGBXSET0&lang=en > [Accessed 3 April 2015]. Poitras, G., 2010. Valuation of Equity Securities: History, Theory and Application. Singapore: World Scientific. Stimes, C.P. 2011. Equity Valuation, Risk and Investment: A Practitioners Roadmap. New Jersey: John Wiley & Sons. Read More