Company Financial Report - Assignment Example

Finance Assignment Introduction: Ours being a publicly traded and Stock Exchange Listed Company, it is necessary to keep current investors up d about the stock movements and pricing, which forms a crucial element of the financial aspects of the Company’s financial activities. Thus the proposed topic for discussion is the valuation of stock and its implications. Background of this study: Cash is the most liquid of all assets, but kept idle, will give no returns to the firm. Generally, more profitable investments will be less liquid and a balance has to be achieved. Another important decision is about financing the various departments of the firm. To keep its shareholders happy, decision on dividends too has to be made, taking into consideration the profitability and related factors. All the above factors have to be in alignment with the ultimate objective of any business, maximising profits and wealth. “According to this concept, actions that increase the firm’s profit are undertaken while those that decrease profit are avoided”. (Profit Maximisation, Unit 11 – Financial Management: An Introduction). Aspects of equity valuation: Equity Evaluation: the term equity evaluation can be simply termed as the value of stock owned by a company. It is this value which will reflect the profitability and investment possibilities in the company. Stock evaluation is usually done using value of future earnings in current terms which are then adjusted with the expected future growth. But what would happen in case a company is planning to issue more shares or if the company is being sold or merged with another company? Both these scenarios have been mentioned as possibilities at an earlier stage in this paper. There are basically six factors that reflect on stock value. The first one is the rate at which the firm is growing. Then comes a study of the dividends paid by the company in the past. The next factor is the current rate of return on stock. This is followed by a valuation of current and future earnings. The tax structure of the company has to be calculated. The last on is the directions of the government on this matter. There are two popular methods for stock valuation. The more widely accepted method is the Residual Income Method. The other method of valuation is through Cash Flow Analysis. This is due to the fact that the future though predicable, is uncertain and that the figures used may turn out to be in variance with the realities of the future. Payout of Dividend: Dividend is the method through which a company’s stockholders are rewarded for buying stocks in the firm. For this to happen the company should have enough earnings to show reasonable profit. The rate of dividend that a company has paid will reflect on the valuation of its stock. Here a conflict of interests may also arise. The shareholders would prefer to receive dividends, but the management may wish to use the surplus for investments beneficial for the long term prospects of the company. Circumstances might prevent a company, which had a good record for paying dividends, to find itself in a situation where it cannot do so. In such circumstances, stock holders have the option of holding on to the shares for the time being and sell them at a future date for a price which is higher than its current value. Stopping, or curtailing dividends has certain advantages because the earnings that the company made through judicial use of the surplus funds could lead to a point where the rise in dollar investments will result in higher dividends in the future. Whatever may be the case, the expert opinion on this matter is that there should exist a fine balance between earmarking surplus for investment and paying dividends to stockholders. The logic behind this statement is simple. Too high a dividend will make the shareholders happy and the value of its stock to rise. But this will leave the company short changed when it comes to fund requirements of investments for future growth and stability. In case the situation is reversed and the company pays more importance to investments rather than dividends, shareholder confidence would be negatively affected and value of stock in market place would come down. The second option of low dividend and higher investment can be considered if the market is ripe for investment and favourable returns can be expected. Rate of taxation is also a factor that affects rate of dividend. Since the rate of tax on dividends is higher than rate of taxes on capital gains, it makes sense to sell the stock andpay a lesser rate of tax instead of paying a higher rate on dividends. (Introduction to valuation). Discounted cash flow: This method of valuation is useful when planning for investing in shares of a company. Cash flow projections expected in future is used, but only after discounting to get the present value. The method usually used for discounting is by the weighted average cost of capital. The resulting value should be higher than the cost of investing in stock and in such a case an investment is bound to be profitable. This calculation is done with the help of the following formula . (Cash Flow (DCF). 2008). For calculation under discounted cash flow method, three factors have to be taken into account. They are price of stock and rate of dividend at the time of valuation and expected future growth in the rate of dividend payable in the future. The difficulty here lies in the fact that calculation of the future growth rate of dividends is extremely unpredictable, caused mainly by fluctuations in the market. Historical Growth Rate, Retention Growth Model and Futures growth in dividends are the three methods popular in valuation of stock under Discounted Cash Flow Method. Historical Growth Rate: If the firm’s past earnings and dividend growth rates have been consistent over the years, the investors could possibly expect this trend to continue in the future years also. This is the premise of the historical growth rate, which evaluates the future stock trends on the basis of past performance. However, this concept may not always be advisable, especially in high growth rated firms, and upstarts, where the question of past performance may not be accurately determined. Moreover, it is not always that the past would be an indicator of the future since company are often subject to fiscal vicissitudes and challenges due to the competitive environment in winch they are and would be functioning. Retention Growth Model: The retention growth model can be depicted by way of the following formulae: g = b(r) where r = expected future return in equity (ROE) b= proportion of the earnings that is retained and g= growth rate. This method bases future growth on the premise of retained growth. However, this model is based on several assumptions: 1. The retention rate is constant 2. Return on equity on new investment r is to be equal to current ROE of the firm. Future growth in dividends based on analysis: Under this method, the growth rate is determined from the values made available by specialist analysts and firms. By using the data made available from them, it is possible to determine the growth rate; however, the data need to be taken for a long period, which may not depict the correct state of financial affairs of the firm, since a correct future growth rate may not be correctly ascertained. And again, the future growth is based on certain hypothesis and assumptions which may or may not true in future context. Why is there a need for stock valuation? It is necessary for an adequate and accurate share valuation of the firm for the following reasons: 1. This is because the market value indicated in quoted Stock Exchange may not be indicative of the true financial health of the firm. This is because many intrinsic and extrinsic factors make up the share price and therefore it becomes necessary to seek correct share valuation. Moreover, in the event of unexpected firm takeover, merger or absorption, it becomes necessary to compute the correct share valuation price for ascertaining purchase consideration price. 2. The Accounting forecast is converted into the estimate of the value firm. There are different methods by which the accounting models are subdivided based on multiple based models and accounting flow based models: The different methods are: Economic Value added (EVA) Discounted Dividend model Residual Income Method (RIM) Edwards- Bell – Ohlson (EBO) approval Linear Information Dynamics approach It is now proposed to evaluate each of the above methods for detailed study and examination: Economic Value added (EVA) Economic Value added measures the firm’s profitability. In traditional accounting, the cost of capital is adjusted when net profits are determined but no effect for cost of capital are made. Therefore, net profits are strictly speaking overstated. The EVA takes into account by adjusting the yearly costs of all the capital the firm utilizes. The Economic Value Analysis (EVA) determines residual, or balance income accruing to the firm, after all the cost of capital, including equity charges have been accounted for. This is because equity has a cost, that is the opportunity cost to the shareholders, in the sense of returns available to them had they invested the funds elsewhere. When investing in the capital of the company, the shareholders have foregone their option of investing their funds elsewhere. The opportunity income that would have accrued to the shareholders, had they invested in other ventures, could be termed to be the cost of equity capital, and needs to be assessed to arrive at the correct figure of profits. The EVA takes account of this aspect too, in order to arrive at the profit figures. The Basic formula for EVA is as follows; EVA = Net operating profit after tax - After tax dollar cost of operating capital For this purpose, the operating capital could be said to be the sum of the interest-bearing debt, preferred stock, and common equity used to acquire the company’s net operating assets.” (Eugene & Michael, p. 49). However, it needs to be mentioned that EVA treats depreciation as a cost in order to arrive at net income. It is believed that the true accounting depreciation is correctly depicted as economic depreciation of the assets of the firm and therefore, there is no need for any further adjustments for depreciation to be made. The advantages of EVA are that it is closely connected with the Net Present Value, and also, it deals with factors over which the financial managers have control like preferred stock, debt etc, rather than uncontrollable items like market price/share, which is intrinsic in the case of ROE, ROC. However, short term EVA analysis needs to be exercised with caution in the following areas: 1. In the case of highly growing firms, when a large portion of the value could be related to future earning prospects. 2. Firms in which the risks are constant and are subject to regular action. 3. EVA also needs to be used with caution in cases where market value being a significant factor, expectations of bountiful profits or excess returns on projects are present. However, despite its operating limitations, it needs to be known that the primary objective of EVA is to increase the present value of the stock over a period of time. (Economic Value Added (EVA)). Discounted dividend model: The discounted cash flow takes into account the fact that the stock of the company is the sum total of its present and future cash flows. It can be shown as below: The above formula can be applied in the case of firms which have growing dividend payouts to stockholders, and the rate of growth is increasing, where r = returns and g = growth rate of the firm and Div. is the dividend payout. However, as mentioned by several financial analysts, the DDM methods make several assumptions, which are as follows: 1. It could be accurately applied in the cases of firms who make heavy dividend payouts, which tend to be consistently rising over the periods, predominantly, utility companies. 2. The aspect of future dividend cash payments made to stockholders assumes significance, since it may not be correctly applicable in cases where stocks are held for speculative, and not investment holdings. 3. The correct forecasting of future dividend payouts need to be done with caution, since injudicious forecasting would result in incorrect predictions and strategic decision making made on the basis of these incorrect predictions would cause the company more harm than good. The most important aspect regarding Discounted Dividend Method is when the growth rate is expected to surpass the expected rate of returns, in which case the denominator would be in the negative. For instance, in the case of a firm, where the Rate of Return is 5% but the Growth rate is 15 % , the denominator (r-g) would be (5- 15) which is a negative figure. Thus, it could be conclusively said that in cases where the growth rate is high, usage of Discounted Dividend would not be applicable. As mentioned by financial expert analysts, it would be difficult to assign values for future profitability and dividend rates in the case non-dividend paying companies. Therefore, based on the above, it needs to be said that this Model needs to make several judicious estimates about the future growth rates. The fundamental aspect that remains is that “it demonstrates the underlying principle that a Company is worth the sum of its discounted future cash flows.” (McClure 2008). “Their estimate of intrinsic value is highly correlated with contemporaneous stock prices and the ratio of computed intrinsic value to actual stock price is a good predictor of long-term security returns. The estimated intrinsic values from the RIM explain more than 70 percent of the variation in stock prices over the period of their study.” (Herz 2001). Residual Income /Dividend Model: Dividend stability comprises of two elements – dependability of growth rate and maintenance of the current rates of dividends by the Company. In the case of a stable growth rate, it has been found that the dividend yield and capital gains yield are stable in the long run and the normal stock levels are maintained. Stability could also be said to have been maintained when the Company is able to maintain the dividend rates at current levels. The Dividends paid in any particular year could be formulated as follows: Dividends = Net income – retained earnings for fresh investments Or = Net income – (target equity ration) (total capital budget) Normally, it has been seen that the cash flushed, consistently stable industries pay higher rates of dividends as compared to the growing and developing companies, especially in the software and e-commerce, computer areas, who pay lower rates of dividends in order to preserve funds for future expansion and development programmes. The next aspect relating to equity valuation is with regard to dividend payouts. There are normally three factors that contribute to the maximum dividend payment ratio and they are: 1. Whether the Investors prefers dividends to capital gains 2. The avenues of the firms in which investments could take place 3. Its perceived target capital format Under the residual dividend model, first of all the optimal capital budget is determined; next the required amount of equity needed to finance that budget is arrived at. It uses its retained earnings and reserve accounts for meeting the equity needs and the question of dividend arises only when earnings are available to support the optimal capital budget. In this context is also needs to be seen that most of the firms should have a judicious mix of debt and equity for their operational and capital needs. It this optimal levels are constantly maintained, new investment programmes could be better financed with the use of internally generated funds and reserve accounts. Thus, the dependence on outside funding would be reduced, since internally generated funds would be cheaper and safer than outside funds. When capital is derived from outside sources, its cost and availability needs to be considered. This residual method takes into account the fact that Budgeted funds are available for financing fresh investments, and only the balance, or residue could be used for dividend payment. However, if the equity demand becomes larger than the income, than the dividends would be held back, and the company would have to seek fresh capital issue for maintaining its present capital structure. Companies using the residual dividend policy choose to rely on internally generated equity to finance any new projects. As a result, dividend payments can come out of the residual or leftover equity only after all project capital requirements are met. These companys usually attempt to maintain balance in their debt/equity ratios, before making any dividend distributions, which demonstrates that such a company decides upon dividends only if there is enough money left over after all operating and expansion expenses are met. Illustration: Let it be considered that a company named CBC has recently earned $1,000 and has a strict policy to maintain a debt/equity ratio of 0.5 (one part debt to every two parts of equity). Now, say this company had a project with a capital requirement of $900. In order to maintain the debt/equity ratio of 0.5, CBC would have to pay 1/3 by using debt ($300) and 2/3 ($600) by using equity. In other words the company would have to borrow $300 and use $600 of its equity to maintain the 0.5 ratio, leaving a residual amount of $400 ($1,000-$600) for dividends. On the other hand, if the project had a capital requirement of $1,500, the debt requirement would be $500 and the equity requirement would be $1,000, leaving zero ($1,000-$1,000) for dividends. Should any project require an equity portion that is greater than the companys available levels, the company would issue new stock. (How and why do Companies Pay Dividend? Residual. 2008). It may be said that Penman and Sougiannis (1998) have made a comparative analysis of the discounted dividend model, the residual income method and the discounted cash flow method for valuation of equity models, by utilizing the actual disbursement of dividends, smooth cash flows etc. as the major instruments for the study. The result of this study shows that the Residual income method has a lower margin or error when measured against the movement of stock prices (Herz 2001). Again, the works of Lee (1999) has also advocated the use of Residual Income Method by making comparison by using the intrinsic value prediction of the future value of the DOW and the stock return of the DOW over a period of time. In this context, it is also necessary to consider the works of Lee and Frankel (1998) using the residual income method which considers the DOW average at a point of time rather than over a period of time as advocated by Lee (1999) “Their estimate of intrinsic value is highly correlated with contemporaneous stock prices and the ratio of computed intrinsic value to actual stock price is a good predictor of long-term security returns. The estimated intrinsic values from the RIM explain more than 70 percent of the variation in stock prices over the period of their study.” (Herz, Robert H : equity valuation models and measuring goodwill impairment (2001) Claus and Thomas (1998) have used the residual income model to evaluate the total implied market risk premium. They have shown that the market risks premium taking RIM is lower as compared to traditional returns. Their idea of equity risk premium in the US and International markets is based on the premise that the basic value of equity investments is seen in the context of their book values also accompanied with the present value of future special gains. By the use of perceived market data and by making analytical forecasts, Claus and Thomas have calculated the equity risk premia. According to their analysis, the Risk Premia (rp) is: US- 3.40%, Japan – 0.21%, UK- 2.81%,France- 2.60%, Canada – 2.23 % (Expected Returns & Measuring the Risk Premium. 2007). Further, coming to the US markets, it is said that the actual returns to stocks consists of three main aspects, firstly, dividend outcomes, the growth rate of the dividends and the change in the equity valuations. Therefore, it could be said that the historical real stock returns have been increasing exponentially over the years and this may remain unprecedented in future years also. (Expected Returns & Measuring the Risk Premium. 2007). Edwards-Bell-Ohlson Method (EBO) This method is said to provide the financial managers with a simple yet powerful method for calculation of basic values of publicly traded stocks. It allows even investors with no previous background knowledge of financial appraisals to speedily calculate the equity valuation. However, unlike the other methods, the EBO concentrates only on equity investments. The DCF (discounted cash flow) method ascribes all the company’s values to its future earnings, and thereby ignores the true value aspect. The results are that the later years would have “to bear the larger proportion of Company’s value, and this causes significant problems with Terminal value estimates.” (Spivey & McMillan). EBO obviates this need since it concentrates only on residual income. Besides this, the other values could be readily accessed from accounting data. It is necessary to consider the model of Ohison (1995) based on the assumption of the Dividend Irrelevance Proposition. propounded by Miller and Modighiani (1961) The notion that dividend payouts go to reduce the current book value of equity but not of earnings, seem far-fetched since nowadays, dividends are normally linked to earnings. To examine the relationships between earnings and dividends, there are three Models: 1. Dividends are considered as a proportion of the permanent component of earnings. 2. Dividends are considered as a proportion of the present discounted value of future expected earnings. 3. Dividends are a proportion of current earnings. It is worthwhile to mention in this context, that the second theory mentioned above, that is dividends being considered as a proportion to PDV of future earnings seems correct “Furthermore, a comparison of the models predictive abilities reveals that Model 2, considering dividends as proportional to the present discounted value of future expected earnings, performs better than the other two models not only for the whole sample but also for the manufacturing industry and the service industry sub-samples. Taken together, our findings provide further evidence that accounting numbers are important determinants of the firm value and dividends are closely related to the present discounted value of future earnings and the firm value. (Lin 2008). Residual Income /Dividend Model: Dividend stability comprises of two elements – dependability of growth rate and maintenance of the current rates of dividends by the Company. In the case of a stable growth rate, it has been found that the dividend yield and capital gains yield are stable in the long run and normal stock levels are maintained. Stability could also be said to have been maintained when the Company is able to maintain the dividend rates at current levels. Normally, it has been seen that the cash rich, stable industries pay higher rates of dividend, whereas the growing and developing companies, especially in the software and computer areas, pay lower rates of dividends, in order to preserve funds for future expansion and development programmes. There are normally three factors that contribute to the maximum dividend payment ratio and they are: 1. Whether the Investors prefers dividends to capital gains 2. The avenues of the firms in which investments could take place 3. Its perceived target capital format 4. When capital is derived from outside sources, its cost and availability. The Dividends paid in any particular year could be formulated as follows: Dividends = Net income – retained earnings for fresh investments Or = Net income – (target equity ration) (total capital budget) It may be said that Penman and Sougiannis (1998) have made a comparative analysis of the discounted dividend the residual income and the discounted cash flow methods for valuation of equity models, by utilizing the actual disbursement of dividends, smooth cash flows etc. as the major instruments for the study. The result of this study shows that the Residual income method has a lower margin or error when measured against the movement of stock prices ( Herz, Robert H : equity valuation models and measuring goodwill impairment (2001) Linear Information Dynamics approach: This theory was first propounded by Ohlson, where forecast analysis made by financial or market analysts served as an alternative to other unavailable information. According to Ohlson, Ohlson (1995) models firm value as a linear function of earnings, book value and other unspecified information (Bryan & Tiras 2006). Upon empirical analysis, it has been found that market prices could be linked with the forecasted analysis made, after considering the increases to the linkage of market prices with the accounting data. However, this approach is not without limitations. This can be used effectively only in well-documented markets where data is profuse and readily available, in which case, it would be able to correctly predict firm values. Ohlson further predicts that the extent to which the market prices could be determined by the current earnings It also needs to take into account, its future earnings. Therefore, according to Ohlson, valuation needs to consider the forecasting powers of future incomes and also account for the nexus between current earnings vis-a -vis future earnings. Therefore, according to his theory, valuation needs to consider the forecasting power of its future incomes. However, in situations where the data is insufficient, the forecasting abilities would be inaccurate as compared with the situations where the data are abundant. Therefore, in situations where inadequate data is present, it could be said that the analyst forecasts have less cohesion with earnings and book value. One of the major constituents of the model depends upon its predictive value based on availability of market data. Otherwise, analysts would be constrained to place reliance on other value-relevant factors, which are not reflected in earnings or book values. Therefore, it needs to be said that this model could be best explained by determining the significance to be attached to Incomes, Book Values and other relevant market data, in the absence of which the results would be inaccurately depicted. Conclusion: It is seen from the study above that stock valuation is an important aspect of financial management and needs to be constantly monitored by the management. This is because there are a lot of factors, financial or otherwise that could impact upon it, and for a progressive and growth oriented company it is necessary to take stock valuations seriously and take the necessary remedial measures in cases of severe falls in stock pricing after proper evaluation of its causes and consequences. Bibliography BRYAN, Daniel & TIRAS, Samuel L (2006). The Influence of Forecast Dispersion on the Incremental Explanation Power of Earnings, Book Value and Analyst Forecast on Market Price. Last accessed 10 March 2008 at: http://www.mgt.buffalo.edu/departments/aandl/research/bryan/FDTARMS2004-261.doc Cash Flow (DCF). (2008). [online]. Investopedia. Last accessed 10 March 2008 at: http://www.investopedia.com/terms/d/dcf.asp Economic Value Added (EVA). [online]. 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