Entrepreneurial Finance - Styles and Wood Group IPO Valuation Analysis - Case Study Example

Students Name Professor’s Name Course Name Date Styles & Wood Group IPO Valuation Analysis 1.0 Most Reliable Methodology for Valuing New Companies in Primary IPO Markets It is important to note that the underlying goals and objectives that relates to the valuation process varies significantly to the reasons deemed necessary for determining the value of a company (Berkman, Bradbury & Ferguson 72-74). There are a great deal of reasons as to why companies engage in the valuation process that includes; for purposes of mergers and acquisition; listing on financial markets; aspects related to private equity and venture capital as well as for purposes of self-diagnosis. The below is a discussion of some of the most notable valuation methods used in primary IPO of markets. A. Discounted Cash Flow Method(DCF) This is a valuation approach that is considered to be most reliable of the current corporate theories that aligns with the value of a given business to its level capabilities for purposes of generating cash flow streams that is able to satisfy the returns expectations of an existing investor (DuCharme, Malatesta & Sefcik, 370-372). DCF enjoys a great deal of advantages that include; first, it offers a closest approximation of a share’s intrinsic value. In fact, as a result of this capability, it is considered to be one of the soundest techniques when applied in almost accurate assumptions. Secondly, it is noted that since DCF relies heavily on cash flows thus it is deemed to be a reliable measurement that can easily eliminate possible subjective accounting policies. Consequently, it is considered to be influenced greatly by short-term market circumstances or even non-economic factors as a whole. Despite the DCF method being unchallenged in terms of its validity, it however; posits a significant level of issues in its overall application process. First, there are direct application issues that relate to the reliability of projected financial data. It is argued that the end results that are obtained from the method will entirely depend on the immediate value inputs hence its capacity to establish reliable future cash flows poses a great challenge altogether (Koop & Kai, 379). Secondly, there is a challenge that emanates from defining a consistent beta value; which is a crucial measurement of level of uncertainties that is essential for determination of discount rates (Koop & Kai, 400). The problem is especially even more pronounced for unlisted companies that do not enjoy a beta coefficient that is expressed by the underlying marketing conditions. Third, there is a problem posed as a result of time horizon, which should be equal to the competitive advantage period. B. Economic Value Added (EVA) Method EVA offers a unique representation of value in relation to DCF. It is adopted for the purpose of determining the overall performance of a given company in relation to the objective of maximising the shareholder’s value (Shrieves & Wachowicz Jr, 38). For most cases, it is used for purposes of measuring the value that has been created or the residual profits that have been noted after the deduction of the cost of capital employed that was used for generating it. The method is derived after the assumption that the approximating the performance of a given company simply relies on examining the accounting outcomes and possible numerous levels of limitations value (Shrieves & Wachowicz Jr, 38). Research analysts indicate that the major strength and thus, the advantage of adopting EVA and MVA methodologies lies in the fact that it provides a distinctive measurement of wealth created that is aligned with the overall goals and objectives of a division or plant managers. However, the application of the model is marred with certain restrictions that mainly attributes to size differences. It is argued that the model does not control for size differences across different forms of plants and divisions so that a larger entity will have an enormous EVA value in comparison to their smaller counterparts. 2.0 Valuation Method for The Company For this paper, the most viable methods of valuing the company will be through the Discounted Cash Flow and MVA. A. DCF Styles & Wood should adopt this valuation method given that it operates an industry that does not necessarily engage in the provision of regular dividends patterns. Given the fact that it is mainly focused on the fully integration of professional and contracting services that is entirely based on a business model that seeks to avail a rapid platform for connecting and adapting to the evolving needs of the local customers, it is evidently clear that the company’s does not enjoy a larger operational base. For this reason, DCF method can be effectively used since it is fairly-positioned to compute for the intrinsic values of both small and large-sized companies (Michailetz, Artemenkov, & Artemenkov 49-53). It is important to understand that in order to conduct valuation more correctly then there is a need for understanding the fundamental aspects of discounted cash flow valuation. To effectively engage in the application of option pricing modes to value company’s assets; then it is crucial to start with a discounted cash flow valuation method (Michailetz, Artemenkov, & Artemenkov 53). Numerous studies agree that by understanding the fundamentals of DCF; analysts are better placed to analyse and adopt the other approaches appropriately. Styles & Wood Group can also effectively adopt the DCF model because it is rather regular in its earnings and cash flows and seems not to be affected even in cases of economic booms and fall in the course of recessions (Steiger 12-15). Consequently, it can also be said that Styles & Wood Group Plc has managed to utilise most of its asset-base. For this case, adoption of DCF is deemed meaningful since the valuation will portray the value of all assets that generate into cash flows. EVA Economic Value Added valuation is a model that is strictly focuses on using the return on investment feature for purposes of analysing management’s ability to create firm value at any given moment in time. Styles & Wood Group should adopt EVA basically since it is focused on overemphasizing the overall need for producing immediate outcome. It is able to provide a disincentive for management to focus their investment plans on only innovative products or even process technologies since each and every investment in innovation possess a similar economic profile (Brewer, Gyan & Hock 3). Style & Woods Group current business model is likely to ensure that the generation of innovative technologies becomes a fundamental aspect of operation especially since professional and contracting services offered require almost immediate analysis of end results. Of particular interest to note, EVA is a valuation model that can easily be used to evaluate the overall employee performance. Given that Style& Wood Group nature of business lies in the service industry, the method is thus more applicable. It can be used to analyse the performance of the firm’s managers that are considered to be accountable for bottom-line results of the company (Brewer, Gyan & Hock 4). Together with a balance scorecard, EVA valuation model can effectively define and later analyse, certain forms of performance attributes that are considered to be critical in their long-term success. Such attributes include; immediate customer experiences; internal business process perspectives as well as financial perspectives (Brewer, Gyan & Hock 4). 3.0 Estimation of Company’s Share Price using DCF & EVA Variables; i) NOPAT: is the formula that is used for the measurement of a company’s overall earnings immediately after meeting its commitment to clear any of its debt (Liu & Magan 102). NOPAT= EBIT* (1-Tax rate) ii) Free Cash Flow; is a valuation model that expounds on the remaining cash resources that remain after paying-off expenditures for purposes of ensuring easier operations and also, foster possible expansion activities (Liu & Magan 102). It is important to note that this variable seeks to ensure that companies are able to pay-off their immediate debt levels, dividends and existing shareholders. Free Cash Flows (FCF) is computed by lessening cash resources utilised from NOPAT. A number of formulas have been devised to compute FCF and they are as below; Free Cash Flow (FCF) = NOPAT – Net Investment on Working Capital (NIOC) NIOC = Operating Capital CURRENT YEAR – Operating Capital PREVIOUS YEAR Operating Capital (OC) = Net Operating Working Capital (NOWC) + Fixed Assets Net Operating Working Capital (NOWC) = Operating Current Assets (CA) – Operating Current Liabilities (CL) The entire formulas can be summarised as below; FCF = NOPAT – ((CA2014 – CL2014) + Fixed Assets2014) – (CA2013 – CL2013) + Fixed Assets2013)) iii) Return on Invested Capital (ROIC); is the level of cash that have been provided by investors for which a company has been able to produce from a given available cash resource base. The outcome of this ratio is used for the purpose of ascertaining the overall health of a company. For most cases, a healthy operational firm is expected to indicate an ROIC that is far much greater in value than the underlying WACC. It is calculated using the formula below; 𝐑𝐎𝐈𝐂= 𝐍𝐎𝐏𝐀𝐓/𝐎𝐂 =𝐄𝐁𝐈𝐓(𝟏−𝐓𝐚𝐱 𝐫𝐚𝐭𝐞)((𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐂𝐀−𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐂𝐋)+𝐅𝐢𝐱𝐞𝐝 𝐀𝐬𝐬𝐞𝐭𝐬) Economic Value Added (EVA) Method: EVA offers a unique representation of value in relation to DCF. It is adopted for the purpose of determining the overall performance of a given company in relation to the objective of maximising the shareholder’s value (Shrieves & Wachowicz Jr, 38). For most cases, it is used for purposes of measuring the value that has been created or the residual profits that have been noted after the deduction of the cost of capital employed that was used for generating it (Liu & Magan 104). The method is derived after the assumption that the approximating the performance of a given company simply relies on examining the accounting outcomes and possible numerous levels of limitations value. It is calculated simply as; EVA= (NOPAT/CE-WACC)*CE MVA: is a metric that is fairly-positioned to show possible differences that exists between a given market value of an underlying company and its overall book value (Liu & Magan 102). It is of great importance to note that the book value for this case is the level of cash resource that the company has effectively managed to produce for its underlying shareholders immediately after its formulation (Liu & Magan 102). The following series of formulas are used for computation of this metric; MVA= MV-BV Market value of equity (MV) = Market price of share * No. of outstanding shares Book Value of equity (BV) = book value per share * no of shares outstanding Styles & Wood Group Plc. Evaluation 2015 (£1000) 2014( £1000) EBIT 3512 Income tax expense 677 Income before taxation 2369 Tax rate 0.3 NOPAT 2458.4 Total current assets 34,720 38,110 Total current liabilities 31,170 37,689 Working Capital (WC) 3,550 421 Fixed Asset 813 995 Operational capital 4363 1416 NIOC 2947 FCF (488.6) RIOC 0.56 WACC 0.10 EVA 2,022,001 Styles & Wood Group Plc. Market Price 427.5 Common Stock 10,000,000 Par Value 1000 No of outstanding shares 100,000 Market value 42,750 Total stakeholder Equity 25,659 MVA 17,091 Estimation of share price; DCF/FCF= 488,600/100,000= $4.89 Market Value Added (MVA) Year/ Company Apple 2015 #shares outstanding 100,000 Book value per share 320.78 Book value of equity 32,078 Market price per share 427.5 Market value of equity 42,750 Estimation of share price MVA= 420,750/100,000= $4.28 IV. Differences between Offer Price in Prospectus and Estimated Share Price It can be noted that there is a significant level of differences between the offer price and both the estimated share prices meaning that the IPO price was undervalued (Ruud 139). The undervaluation of the offer price is likely as a result of the imminent laws of supply and demand that eventually drove it to its intrinsic value. There is also a higher likelihood that the firm financials that relate to its sales; expenses; earnings as well as cash flows were all considered while placing a fair value of the share price. It is important to note that in IPO pricing specifically looks into the overall company’s earnings and expected future earnings growth. The aspect related to the laws of supply and demand can also elaborate on this level of differences. It is possible that in the first day of trading, there was higher degree of demand for the shares thus the price going up against the offer price that was set (Ruud 145). Bateni and Asghari (69) argue that there are an imminent number of factors that could result to the difference between offer price and estimated share price. First, the difference might occur due to initial public offering methods adopted by the company. It is noted that the initial public offering method can be easily initiated in so many ways that include; public offering like auction method; fixed price and internet innovative approaches. The use of each of these methods could result to a significant level of offer prices and the estimated share price. Secondly, the difference related to long-term performance of shares within the initial offering. It is noted that the in the long, run, the relative price performance of initial share offer when compared to other companies will always be weak. It is indicated that most of the economical entities will face lots of issues and risks whenever entering a specific stock exchange platform hence the factor indicate that the initial public offering process becomes a very risky affair altogether. A short-term return of initial share offerings can also posit a significant level of difference with the estimated share prices. Numerous experimental studies note that the investors that are able to purchase their shares within the first day of offering and later sell it after a short-while; would receive a great deal of return hence, in most cases; short-term returns on shares offerings are ascertained to the aspect related to under-pricing. V. Causes of Differences between Offer Price and First-day Trading Share Prices The difference can be a result of the concepts that are adopted in the course of initial offering process. According to studies, a company’s first-day transaction postulates the share’s future performance and they are categorised into four notable phases that include; cold; cool; hot and very hot (Loughran, Ritter & Rydqvist 166). It is noted that the shares with an efficiency tendency of between 10-60% within the first-day of trading are always noted to be hot shares since they have the highest level of offering requests and thus, some of the applicants cannot easily afford them thereby pushing the demand for this shares at cold offerings that is equal to or even lower than zero figure while ascertaining that its future performance will be weaker due to possible price reduction. A very hot share offering happens whenever the initial return is more than 60% while its overall future performance is ascertained to be slightly higher. Loughran, Ritter and Rydqvist (166-69) argue that, in reality the offer prices of initial public offers will rarely ever reflect their market price. This is especially so since the process of determination of the offer price is conducted by use of numerous pricing methodologies in alignment with specific subjective considerations. These subjective considerations are first influenced by the underlying objective of the issue that can result to additional level of capital or exit of a significant investor. It can also be influenced by the market sentiments at the time of the stock issuance as well as possible conflicts of objectives of a given underwriter that seeks to raise a great deal of money while making sure to avoid under subscription of the share issue. In this regards, the differences between the IPO offer share and the first-day trading postulate a probable under-pricing. Under-pricing is a term that is taken to mean that a firm has been able to publish on the first day, shares prices lower than their relative true value, which results to enormous gains on the part of the buyers (Loughran, Ritter & Rydqvist 174). Literature review indicates that there are a quite a number of propositions made to explain possibility of under-pricing. These theories are expounded based on conventional models and range from incommensurability of information to such modern theories that relate to behavioural, formed and proposed theories (Loughran, Ritter & Rydqvist 179). Incommensurability of information is a theory that greatly relies on three fundamental factors; the asymmetric information that exist between informed and uninformed investors; asymmetric information that exists between publishing companies and investment banking institutions as well as the asymmetric information that exists between publishing firms and investors. In relation to this factors, under-pricing of shares within the initial public offering is thus as a result of asymmetric information between suppliers and share buyers. Winner’s curse theory is focused on expounding on why buyers are entirely focused on offering prices that are in fact higher than the overall intrinsic value of stocks on offer (Loughran, Ritter & Rydqvist 180-83). This difference is further expounded by institutional considerations where the under-pricing of shares is perceived to be legal responsibility of share supplier as well as on theories focused on behavioural considerations (Loughran, Ritter & Rydqvist 184-87). Theories based on behavioural considerations rely on the rationale behind investor’s immediate assumptions that is clearly focused on financial knowledge and the overall promiscuity of the stock market as a whole. V. Long-term Performance after 1-Year of Trading After the 1-year of trading, the offer price shifts from $2.86 to 3.31.The change indicates a significant movement in the level of demand and supply of the shares. In fact, it can be noted that the share value increased over the 180 days after the IPO and then decreased to its intrinsic value (Ruud 145). It is assumed that the demand for the share price reduced over time as compared to the number of shares in supply within the market thereby decreasing its overall value altogether. Such external possible effects of the company’s internal operations can also be a reason for the slow growth of the shares due to inefficient sales and earnings growth that kept potential investors away from purchasing the stocks in large quantities- a phenomenon that would indicate higher demand for the shares. The long-term performance of share initial offering whenever it is compared to that of its immediate counterparts in the same industry is considered to be weak. The differences in the long-term share price differences can be a result of a possible issues that the firm faces when making entrance and stabilising within the stock exchange market. Experimental studies into the stock exchange market indicates that investors that engage in the purchasing of shares in the first-day and hold onto them for purposes of enjoying dividends in the near future would also receive a great deal of investment returns in the future (Ruud 149). Further financial literature indicates that long-term returns of shares’ initial offerings are mostly a result of over-pricing. The long-term performance of the share is also attributed to the factors that cause a rise and fall in prices over the 1-year in operation. These factors are referred to as catalysts. Catalysts that resulted to the rise in the share price of Styles & Wood Group within the period relates to a better than was expected earnings in the period ending 2016. It can also be attributed to the announcement of new products that will cause an imminent amount of additional income to the company thereby pushing profits and share prices to a higher level (Ruud 146). The current improvement of the UK legislation policies have also played a key role in rising the profitability levels of the firm hence propelling its shares prices higher for existing investors. The fall of the share prices have been caused by the opposite of these factors; that include; loose of products and competitors improving on their immediate operational processes to adopt new and modern technological advancements. It can also be attributed to slower growth in the period between 2010 and 2011; a period when the firm was making enough efforts to break-even and stabilise in the public operational domain. Works Cited Alford, A W. "The effect of the set of comparable firms on the accuracy of the price-earnings valuation method." Journal of Accounting Research (1992): 94-108. Berkman, H, Bradbury, M, E & Ferguson, J. "The Accuracy of Price‐Earnings and Discounted Cash Flow Methods of IPO Equity Valuation." 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Journal of Financial Economics 34.2 (1993): 135-151. Michailetz, V. B., Artemenkov, A. I., & Artemenkov, I. L. Income Approach and Discount Rates for Valuing Income-Producing Illiquid Assets. The ICFAI Journal of Applied Finance, (2007); 43-80. Shrieves, R E. & Wachowicz Jr. JM. "FREE CASH FLOW (FCF), ECONOMIC VALUE ADDED (EVA™) AND NET PRESENT VALUE (NPV): A RECONCILIATION OF VARIATIONS OF DISCOUNTED-CASH-FLOW (DCF) VALUATION." The Engineering Economist 46.1 (2001): 33-52. Styles & Wood Group Plc. 2016 Annual report. Retrieved from http://www.stylesandwood-group.co.uk/wp-content/uploads/2017/03/Annual-Report-2015.pdf Steiger, F.The validity of Company valuation using discounted cash flow methods, Seminar Paper-Fall (2008): 1-18 UK Yahoo Finance. Styles & Wood Group Plc Share price history. Retrieved from https://uk.finance.yahoo.com/quote/STY.L/financials?p=STY.L Read More