Valuation of Morrison Plc - Value of a Morrisons Share, Share Price Tracking - Assignment Example

STRATEGIC CORPORATE FINANCE By of the of the School Task Valuation of Morrison plc. a) Net asset value Net asset value per share (NAVPS) is known as the value of a single fund, or a unit, or a share. In terms of a mutual fund it indicates the price at which the shares are purchased and sold. Basically, it is defined as an expression for the net asset value which shows their value per share for a company or a fund (close-end, exchange-traded and mutual) (Correia, 2007, pg. 17). Formula= NAVPS = Net Assets / Number of Shares Outstanding Share outstanding =234,000,000/ 10 = 23,400,000shares (2Feb 2014) =235,000,000/ 10 =23,500,000 shares (3 Feb 2013) NAVPS (2014) = 4,692,000,000/23,400,000= 200.51p NAVPS (2013) = 5,230,000,000/23,500,000= 222.55p Just like stock price, the net asset vale per share indicates the value of one share. It therefore gives the investors an opportunity to compare the performance of the fund or the company in comparison with the industry or market benchmarks. It also provides a way of comparing the trend of the company from one year to the next one (Correia, 2007, pg. 17). From the above calculations, it is evident that the performance of Morrison plc. In the market has dropped or decreased from 222.55p in the year 2013 to 200.51p in the current year. The relative decrease in the company’s net assets is higher than the reduction in shares outstanding. A decrease in company’s assets implies reduction in returns. b) Cost of capital i. Calculate the cost of equity capital for Morrison’s plc. Using the Capital Asset Pricing Model. Capital Asset Pricing Model describes the relationship that exists between risk and the expected return and it is usually used in the pricing of the risky securities (Pratt & Grabowski, 2010, pg. 359). The formula for calculating CAPM is ra = rf + βa (rm-rf) (Pratt & Grabowski, 2010, pg. 359) Where: rf = the rate of return on risk-free treasuries or securities βa = the beta of the investment in question rm = the overall expected rate of return of the market (Giovanis, 2010, pg. 3) ra= 3% + 0.5(5%-3%) =4% The company expects a lower return on its investments compared to that of the market returns. This indicates that it is not performing well in the market hence it is less efficient compared to the market performance. ii. Calculate the cost of debt capital (ignore tax) The company’s cost of debt is basically based on its cost of bonds (non-current liabilities). This is because these bonds are the company’s long term debts. They are usually a little more than the long term loans of the company. The company’s cost of debt capital is usually not the cost of bonds of the company because the interest to be paid on the debt is usually tax deductible, therefore the company’s coupon rate is multiplied by the (1-tax rate) so that it can be adjusted in the following form (Lasher, 2008, pg 528). Cost of Debt Capital = Coupon Rate on Bonds (1 - tax rate) However, in this case the tax is ignored so the company’s cost of debt is just the coupon rate. Cost of Debt Capital = Coupon Rate on Bonds (1 - tax rate) =5 %( 1-0) =5% The company has a higher cost of debt capital than the cost of equity capital. This implies that it pays more to creditors than to stockholders. iii. Calculate the weighted average cost of capital (WACC). (Use the share price as at 2 Feb 2014 for the value of equity) The WACC represents the rate at which the company is expected to finance its assets by paying on average all its security holders (Brigham & Ehrhardt, 2013, pg. 389). WACC = E/V × Ke + D/V × Kd Where: Ke = cost of equity Kd = cost of debt E = market value of the company’s equity D = market value of the companys debt V = E + D = company value E/V = percentage of equity financing D/V = percentage of debt financing Value of equity= 240p/100= £2.40 Market value of debt= (3164/100)*1.00= £ 31.64 V=E+D=34.04 WACC= (2.40/34.64)*4% + (31.64/34.64)*5% WACC=4.84897% =4.85% The WACC which is the minimum return that the company should get on its existing assets so that it can satisfy its owners, creditors and capital providers. Assuming no tax the WACC is less than the cost of debt meaning the company pays more to debt holders that it gets from the returns hence most likely to experience financial distress. c) Dividend growth model Use the dividend growth model to calculate the theoretical price of a share under the following assumptions: Dividend growth model allows for the determination of the company’s stock intrinsic value without taking into consideration the current market condition. This makes investors to make apples-to-apples companies’ comparison especially for companies in different industries. (i) g = 0% Stock value= D1/ (k - g) (Hunt & Andrews, 2008, pg. 236) where: D1 = expected annual dividend per share next year k = required rate of return to investors g = the expected rate of dividend growth P=0.12/ (0.04-0.00) = £0.0048 or 0.48p (ii) g = 2% P=D1/ (k-g) (KAPIL, 2011, pg. 207) P= 0.12/ (0.04-0.02) = £0.0024 or 0.24p Brief comment As the dividend growth rate increases the intrinsic value of the stock decreases (Fabozzi, 2013, pg 10). This implies that the company’s stocks are overvalued (Brigham & Ehrhardt, 2013, pg. 304). d) Value per share using the price earnings (p/e) ratio Calculate the price earnings ratio using the share prices as at 2 Feb 2104 (240p) and 20 March 2014 (208p) using the EPS figure for 2014. P/E ratio= Market Value per Share/EPS) P/E ratio (FEB) = 240/10= 24 P/E ratio (MARCH) = 208/10= 20.8 In comparison to the retail industry, P/E ratio of 15.0, the Morrison’s is has a relatively higher P/E ratio implying that its investors are expecting relatively higher earnings than what the industry offers on average. This implies that the Morrison’s is relatively expensive basically on a relative basis. Task 2 (60 marks) Calculate the value of a Morrison’s share and advise your client a) Use the information from your calculations to arrive at the valuation of a Morrison’ share. In doing so you should critically evaluate the models used in your calculations and relate your calculations to the current and historic share price information as appropriate. There are various methods that can b used to value a company’s shares. These method include net asset value, earnings based method, cash flow methods, and dividend method (Jakhotiya, 2003, pg. 365). 1. Net asset value This is a balance sheet based model that uses the net assets to arrive at the value of a Morrison’s share. Net asset value= total assets- current liabilities-long term liabilities (Gross, 2006, pg. 34). This value is then divided by the number of shares outstanding to arrive at the company’s share price (Zyla, 2013, pg. 348). Since the asset values are indicated at their historical values, we need to adjust them to the current market values sp that the most appropriate share price is arrived at (Brechner, 2012, pg 700). From the data given about Morrison’s, the asset values should be adjusted as follows: Adjustment for 2014 due to valuation information Total net assets- 4692 Less intangible assets overstatement (40) Add PPE understatement 30 Less uncollectible trade receivables (7) Most current net assets totals 4675 Shares outstanding= share capital/ share nominal value Share outstanding (2Feb 2014) =234000000/ 10 = 23,400,000shares Share price= net assets/ shares outstanding =4,675,000,000/23,400,000= 199.786p From this method the Morrison’s market share price is found to be 199.786p per share 2. Income method: Dividend valuation The sum of future dividend is used is used to calculate the market value of a share. Share price= dividend next year/cost of equity From the data given, the company has declared a dividend of 12p while from the above calculations the cost of equity for the company is 4%. Therefore, the share price= 12/0.04 = 300p per share Earnings valuation This method values shares on the basis of normal rate of return and expected earnings. Share value= (expected earnings/cost of equity) 100 =(10/4)*100 =250p per share From the three valuation methods discussed the most relevant one is the net asset value method especially because it gives a more close value to the current and historic share price value. The calculated value is 199.786p while the current share price value is the London Stock exchange is 196.20p. This therefore makes the calculated value to be the most preferred share price. The net asset value presents the perfect value because all the adjustments have been made thereby eliminating its weakness of failing to reflect the current market condition (Levene, 2010, pg. 82). The other two methods show the range through which the share fluctuates. b) Discuss whether you would advise your client to make an investment in this company Considering the above calculations the client should invest in the company because of the following reasons. The Morrison’s performance and rating in the market is quite high hence promises more returns to the investors. This is evidenced by the company’s good value because it is trading at a value which is near its 52-week low. The company trades at £196.20 which relatively high but close to its 52-week low value of 194.80p. The investment should be done because the company value has a potential of increasing to the share price calculated 199.786p hence increasing the value further (London Stock Exchange market). The second evidence is that the Morrison’s has a higher average volume of 9.79 million which is higher than the minimum required amount of 50000 (London Stock Exchange market). This high volume ensures high liquidity and even reduces unnecessary volatility. The high sale and purchase of the share attracts more investors hence thereby increasing the returns. Further, the company offers a relatively high dividend of 6.63% which translates to 13.00p (London Stock Exchange market). The dividend is regular since it is being paid on a yearly basis. This ensures that the client gets a continuous return on the investment. The high dividend pay out means the company is doing well in terms of performance and also has a steady growth hence capable to finance the high dividend payment without financial constraint (Robbie & Wright, 2006, pg. 61). Finally, the company has a beta of less than one (0.3746) implying that its stocks are less volatile hence a bit stable. This is because if the market goes down by one percent only 0.3746 percent of the share price is lost. This represents a less significant loss to the client. The client should therefore invest in the company because it has low volatility, and high dividend payment hence will receive more return and loss little amount. Task 3 Share price tracking (20 marks) Critically analyze the movement of your chosen share during the period it was being tracked, Choose the length of time you feel most appropriate. Refer to relevant theories and academic literature to explain why and to what extent the share moved in response to new information. The Marshalls share price was tracked for a period of six weeks and from the data, the share prices moved in an inconsistent manner. The share price decreased from 174.00 to 171.50 in week two. In week three there was a further decrease to 170.00. The decrease was as a result of decrease in availability of public and private information about the company being traded on in the exchange market. However, in week four the price rose to 174.25. The increase was made possible due to increase in the demand of the stocks mainly because of the increased availability of new information in the market. The new information became readily available in the market thereby becoming less important to the investors hence causing a decrease of 1 unit to 173.25. A further introduction of new information in the market caused an increase in share price to 189.00. The main determinant of share price is new information. The new information usually give the market reasons to value the stock at a given price level. The market usually prices the stock using all the information available to the public, thereby adjusting it up and down based on market’s perception of the information. When the information is highly valued, the prices will go up while when it is lowly valued, the price level will go down as shown in the fluctuations of the Marshall’s share price (Dineen, 2013, pg. 228). When the new information reaches the public through news issuance, the buying and selling of the shares increases thereby increasing the share price because the new information is usually priced. However, in reality, the information makes it out well before the news release especially through the rumors. The share price therefore moves up or increases when positive news or information about the company is anticipated. The share price therefore takes into account all the information known about the company and the ability of the company to generate money in the future. When all the information about the prospects of a company is made public, the share prices change. Efficient market hypothesis and random walk hypothesis indicates the unpredictability of stock prices (Kevin, 2006, pg. 122). The stock price therefore fluctuates with a higher margin when the information bout the stock is not easily predictable (Kevin, 2008, pg. 149-152). However, when the information can be predicted with ease, the price changes will be minimal. Finally, Dow theory explains than price movements in the market is affected least by an individual investor (PANDIAN, 2001, pg. 258) References Brechner, R. A. (2012). Contemporary mathematics for business and consumers. Australia, South-Westen/Cengage Learning Brigham, E. F., & Ehrhardt, M. C. (2013). Financial management: theory and practice. Mason, Ohio, South-Western. Brigham, E. F., & Ehrhardt, M. C. (2013). Financial management: theory and practice. Mason, Ohio, South-Western. Correia, C. (2007). Financial management. Cape Town, Juta. Dineen, S. (2013). Probability theory in finance: a mathematical guide to the Black-Scholes formula. Fabozzi, F. J. (2013). Encyclopedia of financial models. Hoboken, N.J., John Wiley & Sons. Giovanis, E. (2010). Application of Capital Asset Pricing (CAPM) and Arbitrage Pricing Theory (APT) Models in Athens Exchange Stock Market. München, GRIN Verlag GmbH. 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