Finance - Security Analysis and Valuation - Case Study Example

RIOTINTO Your Name Goes Here Name of University Here Company Profile Rio Tinto PLC is a multinational mining company. The Company’s interests are mainly in the mining of gold, silver, diamonds, uranium, aluminum, borax, coal, copper, zinc, lead, tin, iron ore, titanium dioxide feedstock, talc and zircon. The company’s various mining operations are located in Australia, New Zealand, the United States, South America, South Africa, Europe, and Indonesia among others. Basically, its global operations span 6 continents. Rio Tinto is the third largest mining company in the world and has highly diversified portfolio of commodities. This makes it to be a very solid company with high growth prospects, especially given the company’s strong financial indicators and the improving global microeconomic environment. The company’s roots can be traced back to 1873; the Rio Tinto group makes use of a dual listed structure where two companies operate as a single entity, governed by a common board of directors. The two companies, despite operating as single entity, have two groups of shareholders. Rio Tinto plc (RIO) is listed on the New York stock exchange and the London stock exchange, while Rio Tinto Limited (RIO.AX) is listed on the Australian Stock Exchange. Global Overview Looking at the performance of the global economy, economists have highlighted a significant rift in economic growth between developed and the emerging economies. However, global GDP growth is headed for the better, as it is expected to increase by more than 4 percent in 2011. The relatively slow growth in developed economies is expected to be compensated by the comparatively fast growth in emerging economies. This bias in growth towards those key nations such as India and China shows potential for Rio Tinto because the two drive global growth pattern, especially China. This suggests that the US dollar is expected to weaken in the face of a higher real Chinese exchange rate, a position that is likely to support commodity prices. This is because; developing nations are expected to increase demand for commodities, this promises Rio a good market and enhanced overall performance over both the short and long run. However, commodity price volatility is expected on the back of policy changes in emerging economies as the effect of fiscal and monetary stimulus begins to wear off. The DDM Valuation Approach The dividend discount model (DDM) is values the stock of a company by discounting future forecasted dividends to a present value to come up with an intrinsic value of a stock. The model is often used by value investors who have interest in the DDM value; if it exceeds or is less than the current stock price in order to identify an undervalued or overvalued stock. It is significant to point out that the dividend discount model allows investors to estimate the value of a stock and that the reliability of the value given by the model is dependent on the reliability of the input data. Calculating the Dividend Discount Model Value of Rio Tinto Plc The formula for the dividend discount model can be expressed as: DDM = Dividends per Share / (Discount Rate – Dividend Growth Rate) Mathematically, this is expressed as: Value of Stock = DPS1 (r - g) where; DPS1 = Expected Dividends one year from now r = required rate of return for equity investors g = Annual Growth rate in dividends perpetually Some Important inputs for Valuation-General Shares Outstanding 1,960,848,734 Share Price $67.7 MV of Equity $144,338,075,310 Long term debt $18,495,000,000 Total Capital $162,833,075,000 % of Debt 11.36% % of Equity 88.34% Risk Free Rate 3.65% Expected Market Return 11.04% Risk Premium 7.39% Beta 1.50 EPS 6.62 DPS 1.13 ROE 28.04 Important assumptions Shares outstanding is a weighted average of RIO and RIO.AX Share Price of $67.7 as of market close May 13, 2011 Cost of debt is 7.07% (Average of cost of debt for 2008, 2009, and 2010). Risk free rate determined from 10-year bond yield Expected market return is estimated from 50 year average Beta of 1.50 from yahoo Finance. Three-Stage DDM Model For the valuation of Rio Tinto we use the three-stage model because it attempts to cross the gap between theory and reality. The three-stage model is based on the assumption that the company will experience a period of high-growth followed by a slump to a stable growth period. It is important to note that this model is based on only five years forecasting period. Also, the model makes an abrupt transition from high growth to slow growth. In other words, the model unrealistically assumes that the firm will be growing at 23.6% for five years only to then grow at 8% (stable growth) perpetually. In reality, most firms experience a relatively gradual decline in growth rates as their business continues to mature (hence, applying three-stage dividend discount model is more appropriate). Finally, as in the stable growth model, the three-stage dividend discount model is also very sensitive to the inputs used in the estimation of the value of the equity. With that in mind, it is important to note that Rio Tinto enjoys a geographic location advantage, close to the aggressively growing China and India. In addition, the company holds first class assets and its core competencies are mainly in cost minimization. As mentioned earlier, the diversification in product offering hedges Rio Tinto against dramatic falling in commodity prices. Furthermore, the company’s management has successfully managed to keep the D/E ratio low, since the Acquisition of Alcan in 2008. Nevertheless, the company is not immune to emergence of taxation policies that may be disadvantages, especially in Australia. The risks associated with currency fluctuations, natural disasters (like the tsunami in Japan) and global economic slowdown is beyond management’s control. We assume that the current dividend of $1.13 will grow at 23.6% for the next five years. The present value of those dividends is presented below. At the end of that time, the growth will slow at a linear rate for 10 years to a terminal growth rate of 8% (as per the long-term average of the S&P 500). Background Information Current Earnings / Dividends Earnings per share in 2010 = $ 6.62 Dividends per share in 2010 = $ 1.13 Inputs for the High Growth Period Length of the High Growth Period = 5 years Expected growth rate = 23.6% (Based upon analyst projections) Beta during High Growth Period = 1.50 Cost of Equity during High Growth Period = 3.65% + 1.50 (7.39%) = 14.74% Dividend Payout Ratio = 17.07% (based on existing payout ratio) Inputs for the transition period Length of the transition period = 5 years Growth rate in earnings will decline from 23.6% in year 5 to 8% in year 10 at a linear rate. Payout ratio will increase from 17.07% to 60% over the same period in linear increments. Beta will remain constant drop from 1.50 to 1.20 over the same period in linear increments. Inputs for the Stable Growth Expected Growth Rate = 8% Beta during stable growth phase = 1.00 : Cost of Equity = 3.65% + 1.0 (7.39%) = 11.04% Payout Ratio = 60% DPS = $1.13 (2211/1961) Cost of Equity = Risk free Rate + Beta (Risk Premium) = 3.65% + (7.39%) * 1.5 = 14.74% g = (1 - Payout Ratio) * ROE = 0.8293 * 0. 284 = 23.6% Three-Stage DDM PERIOD EPS Payout Ratio DPS Cost of Equity Present Value 1 7.13 17.07% 1.22 14.74% $1.06 2 8.81 17.07% 1.51 14.74% $1.15 3 10.89 17.07% 1.86 14.74% $1.23 4 13.46 17.07% 2.30 14.74% $1.33 5 16.64 17.07% 2.85 14.74% $1.43 6 19.98 25.66% 3.43 14.29% $1.51 7 23.29 34.24% 4.03 13.84% $1.56 8 26.33 42.83% 4.60 13.41% $1.57 9 28.83 51.41% 5.11 12.96% $1.54 10 30.56 60% 5.52 12.52% $1.48 *Note: Since the costs of equity change each year, the present value has to be calculated using the cumulated cost of equity. The terminal price at the end of year 10 is calculated based upon the earnings per share in year 11, the stable growth rate of 8%, a cost of equity of 12.52% (based upon the beta of 1.2) and the payout ratio of 60%. Terminal Value = $ 30.56 * 1.06* 0.60/ (.12.52-0.06) = $ 298 Present Value of dividends in high growth phase: $ 6.2 Present Value of dividends in transition phase: $ 7.66 Present Value of terminal price at end of transition: $ 79.9 Value of RIO TINTO Stock: $93.76 The value is significantly higher than the current share price of $67.7 Thus, the assumptions being made in this model – 23.6% growth for the next five years, growth slowing at a linear rate for another 5 years to a final and perpetual growth rate of 6% and a required return of 12.52% is fairly close to what the average investor expects, as reflected by the market price. FCFF Valuation FCFF DCF Valuation Assumptions Revenues: In order to forecast sales for 2011, this model assumes a growth rate of 11% as discussed in the notes accompanying Income Statement assumptions. For the period of 2012-2013, we assumed that growth would most likely decline, as the cost of commodity prices will detract from sales growth to 6%. For the period 2014-15, we forecasted that growth would level of to near GDP levels of around 3%. EBIT: EBIT was calculated by subtracting a historical cost of sales of about 65% of sales (over the past two years) and operating expenses at1.35% -- also a historical average from 2009-2010. Tax Rate: Rio Tinto has historically faced volatile tax rates, and thus we settled for a rate slightly higher than the average tax rate of 30% for the years 2011-2015. Depreciation: RIO’s depreciation has historically been about 7% of sales revenues. Therefore, this rate was applied to future predicted sales revenues projecting from 2011-2015. PPE: PPE, as a percentage of sales revenue, has been on the downward trend over the past several years. Even as the company is strategically increasing its focus more on enhancing the longevity of its existing mining assets, we decide to continue with this downward trend by 6% each year starting from 2011. NWC: NWC has on average taken about 15% of sales revenues. Assuming that no major changes will occur during the period under consideration, we forecasted that NWC would remain invariant through 2015. PV of FCFF: See Important Assumptions in Figure I. We estimated WACC to be %13.68. FCFF Model   Actual Projected   2009 2010 2011 2012 2013 2014 2015 Sales revenue 41,825.00 56,576 62,799.4 67,195.3 71,899 74,056 76,277.64 EBIT 7,506.00 19,694 21,132 22,611.2 24,194 24,919.8 25,667.42 Tax Rate 29.35% 27.19% 31% 31% 31% 31% 31% Depreciation 3,427 3,427 4,396 4,704 5,033 5,184 5,339 PPE 45,803 56,024 59,659.4 60,475.8 61,114.1 59,244.8 57,208.23 PPE as % Sales 109.51% 99.02% 95.00 90.00 85.00 80.00 75.00 NWC 5,403 9,664 10,047.9 10,751.3 11,503.8 11,848.9 12,204.42 NWC as % Sales 12.92 17.08 16.00 16.00 16.00 16.00 16.00                 EBIT(1-tax rate) 5,303 14,339 14,581.1 15,601.7 16,693.9 17,194.7 17,710.52 Plus Depreciation 3,427 3,437 4,356.00 4,792.00 5,175.00 5,589.00 5,785.00 Less Change in NWC   4,261 384 703 753 345 355 Less PPE   1,698 6,594 7,055 7,549 7,776 8,009                 FCFF   11,817 11,959 12,635 13,567 14,663 15,131 PV of CF     $10,520 $9,777.3 $9,242.4 $8,788.9 $7,969.83 Sum of PV of FCFF             $46,298.44 PV of RV             $145,926.83 FCFF Valuation Model PV of FCFF 2011-2015 $ 46,298.44 PV of RV $ 145,926.83 Plus CASH $ 9,948 Less LT Debt $ 18,495 Market CAP $ 183,678.28 Shares Outstanding $ 1,927 Estimated Price $ 95.32 Current Price $ 67.70 Margin of Safety 40.8% Three-Stage H-Model DCF Valuation Assumptions FCFF Growth Rate: To predict FCFF Growth rate, historical rate of growth observed in the trend of our FCFF model is used. It was assumed that the growth rate of 11% will continue until 2014, when the growth rate would be set on a downward trend (for five years) to 3.5%-- to be reached by 2018. Cash: The amount of cash utilized in this valuation was equivalent to that indicated in the financial statements in 2010. Debt: The amount of long term debt used in our valuation was also equivalent to 2010 levels, though an expected decline in future years is very much anticipated. All the same, we decided to maintain debt at the historical level because it is relatively uncertain if the management intends to do increase or decrease debt, there is no observable trend in recent years. RV=FCFF (1+g)/ (WACC-g) 3 Stage H-Model Valuation   2010 2011 2012 2013 V3 FCFF Growth Rate   11% 11% 11% 3% FCFF 11,817 11,959 12,635 13,567 195,454 WACC 13.68% 13.68% 13.68% 13.68% 13.68% PV of CF   $10,519.88 $9,777.03 $9,234.89 $133,043.10 Number of Periods   1 2 3 3 3-Stage FCFF Valuation Model PV of FCFF 2011-2015 $29,531.80 PV of RV $133,043.10 Plus CASH $ 9,948.00 Less LT Debt $ 18,495.00 Market CAP $ 154,027.91 Shares Outstanding $ 1,927.00 Estimated Price $ 79.93 Current Price $ 67.70 Margin of Safety 18.1% Competition Rio Tinto is the world’s third largest mining company, behind Australia’s BHP Billiton and Brazil’s VALE. As demonstrated below, the stock prices of RIO Tinto and BHP are extremely correlated (0.6357), this is mainly due to their similarly diverse commodity asset bases. With such a high correlation, competitive advantage between the companies is highly minimized, and any slight advantage noticed arises only from alternative sustainability practices, detailed commodity diversification and managerial decisions. On the other hand, RIO’s stock price are weakly correlated with VALE’s, at 0.12, whereas BHP and VALE’s are strongly correlated, with correlation coefficient of 0.55 Correlation Analysis   BHP RIO VALE BHP 1     RIO 0.635664 1   VALE 0.550485 0.12961 1 BHP Billiton BHP is the world’s largest mining company employing about 40,990 people, working in more than100 operations in 25 countries. BHP occupies significant positions in foremost commodity businesses, including uranium, aluminum, titanium, silver, copper, energy coal and metallurgical coal, manganese, iron ore, nickel and diamonds, also BHP has considerable interests in oil, natural gas, and LPG. The company thrives on a highly diversified portfolio of major assets, providing the company with stable cash flows and enhancing its capacity to drive growth. In the financial year 2009, the company generated revenue of US$50.2 billion, profit (excluding exceptional items) of US$10.7 billion and a high net operating cash flow of US$18.9 billion. VALE Vale is the world number two mining company, with its major businesses in logistics and power generation. Vale operates in five continents and in 38 countries, and enjoys a team of highly qualified individuals working together with responsibility and commitment towards sustainable development. Headquartered in Brazil, VALE employs over 115,000 people-- direct employees and contractors. In 2010, VALE accounted for about 11.2% of Brazil’s total exports. Regression Analysis Performing regressions on the stock prices of the three companies, it is clear that the model (Output summaries are presented in the Appendices); RIO Stock Price = 43.50 -0.5965 VALE Stock Price + 0.4963 BHP Stock Price: R2 = 0.4737 RIO Stock Price = 33.57 + 0.3896 BHP Stock Price: R2 = 0.4041 The regressions above indicate that changes in VALE and BHP’s stock are not reliable in predicting changes in RIO’s Stock. Conclusion RIO is on course to benefit from increasing demand in emerging economies such as China and India. The company is expected to experience a season of heavy pricing of commodities increases in 2011; this will in turn help to sustain its long term growth. Valuation Model Three-Stage DDM Three-Stage FCFF Share Price $93.76 $79.93 Current Price $67.7 $67.7 Margin of Safety 38.5% 18.06% APPENDICES Please see the excel Spreadsheets for calculations and tables. You make copy and paste tables and figures here as you wish. Read More