Boral Company Limited Valuation - Case Study Example

Boral Company Limited Valuation Report Name Institution Course Date EXECUTIVE SUMMARY This report provides an overview analysis of the recent financial performance of Boral Company Limited. Discussion on current issues affecting the company and the industry in which it operate globally is also addressed. More so, it approximate the value of Boral’s share price using a number of valuation models and ratios, such as dividend discount model, free cash flow to equity model, capital asset pricing model and sensitivity analysis. All the computations are shown in appendices. Boral limited recent financial performance by DuPont Roe analysis has unearthed that the company is under performing as compared to competitor performance like Brickworks limited and Fletcher building limited. This is attributed to declining profit margin in return on investment that has decrease gradually at a faster pace than competitors. This has been reviewed when analyzing the current issues impacting upon Boral future earning capabilities. Other indicator is that increasing labour costs and Boral running below capacity as well as higher input costs have lowered Boral net profit. Good future earning capacity will depend mainly on full running capacity in United States housing market and non-occurrence of global financial crisis that have at past worsen the profits of Boral limited. Based on the future prospects, the government through Australian housing markets indicates a positive future outlook for Boral Company though it depends on performance of United States housing market and the ability of the company running at full capacity. Two cash flow valuation models will be used in deriving the intrinsic value of Boral, that is, Free cash flow to equity model (FCFE) and dividends discount model (DDM). Free cash flow model aim is to uncover the amount of free cash flow that is available to be return to the stakeholders after meeting company’s liabilities in form of debts and companies investment needs. The results indicate a negative FCFE value which shows the effects of the Global Financial crisis on Boral operations. The next cash flow valuation model (DDM) also estimated a low intrinsic value, indicating that Boral’s stock price is overvalued and thus shall not win investors decision to invest on the company. DDM model applied to present stream of dividends that are growing at a constant rate for valuation purposes and it also apply a number of assumption based on financial theories (Baker & Powell 2005, p.150). Introduction The scope of Boral limited work involves manufacturing and supplying construction and building material in Australia, United States and parts of Asian countries. The companies operating segments include construction materials and cement, building products, Boral gypsum, and Boral USA. The construction material of cements is engaged in quarries, concrete, asphalt, transport, landfill, property, cement and concrete placing. The building products segment is engaged in Australian bricks, roof tiles, masonry, timber products and windows. The Boral gypsum involves Australian, Asian plasterboard. The Boral USA is engaged in bricks, cultured stones, roof tiles, fly ash and concrete (Boral Limited 2009). Strategy analysis In a dynamic industry, with a broadly commoditized products, Boral strategy is to build a strong market positions and maximize profit margin and at the same time lowering its cost of production and maintaining the quality of their products. Besides this, it should also maintain sustainable competitiveness in the industry. However labour cost, rising energy and materials remains a huge challenge while offshore expansion increases exposures to currency movements which are unpredictable to the company’s operations. The DuPont system Boral performance calculations have been done using DuPont method. Application of ROE system provides a firm with an indication of the rate of return that has been earned by shareholders invested fund in the firm (Reilly& Brown 2009, p.320) The formula is as follows: ROE=Net Income/Shareholders Equity DuPont ROE System can be further subdivided into the following categories of ratio so as to give greater and in depth understanding of the causes of the firm’s ROE. They are classified into the following formulae; Total asset turnover=Net sales/Total asset This measures how effective and efficient a firm utilizes its assets to generate revenues. Normally the higher the ratio the better the company‘s utilization of its assets to generate revenues (Gibson 2001, p. 308). Profit Margin Ratio This is calculated as follows: Profit Margin=Net Income/Net Sales This ratio gauges the efficiency with which the company can generate a given level of its profits out of its sales activities. The ratio shows how effective the firm is controlling its costs to earn more of its profits. The rationale is that the higher the profit margin, the better the company is at controlling its costs and increasing sales for more profits (Gibson 2001, p. 309). Equity Multiplier /Financial Leverage The final financial ratio on ROE System is the Equity Multiplier or Financial Leverage ratio. This is calculated as follows; Total Assets / Shareholders Equity This ratio shows how a company finances its assets using acquired debts. Generally the rationale is that, the higher the financial leverage, the more a company relies on financial obligations to finance its assets (Leach & Melicher 2014, p. 173). As a result of this financial ratio method, DuPont ROE can be calculated as follows: Net Profit Margin*Asset Turnover*Financial leverage In summary if ROE is generated by increase in profit margin or asset turnover then it is a positive trend for the company, nevertheless, if a company ROE is increased due to an increase in Financial Leverage, then this is a sign of bankruptcy and the company is term as at risk in financing its debts. Similar group selection (peer group) The performance of Boral limited can be evaluated using ratio analysis of the company’s financials using DuPont ROE Approach. In order to get adequate and effective results it is of paramount importance to compare and contrast companies that are operating the similar businesses in the same industry; that is the peer group comparison. The selected peer group is based on factors that are considered relevant to the performance of Boral in terms of its profitability and its operations. This factors include; product being sold, size of the firm, scope of operations, and their geographical operation areas. Though this variables may differ among the companies, thus making drawing solid inferences less important from the peer. Brickworks and Fletcher limited resemble Boral. The operation of the three companies and their set up looks alike in that all are operating within building and construction material industries although Boral and Fletcher building do operate on a large global basis than Brickworks limited .One basic advantage among them is that all the three companies base their operation in Australia. For this few relevant reasons it make it relevant to compare the three companies adequately. Analysis of Boral Recent ROE Performance Boral limited continues to expect weaker results over sometimes. This is due to a number of issues including; timing major projects volumes which were reduced in the first half of financial year and the 50% Gypsum joint venture taking effect currently (2014 fiscal year) and lower property earning. The company is in year two of its six-year restructuring program and expects to deliver cost saving of AUD150 million by fiscal year 2015.The shares are overvalued currently , trading at more than 20% premium to a fair value estimate. The company also delivers returns on invested capital below its cost of capital (Morning star 2010). Boral limited continues to face difficult and challenging conditions. The construction material and cement division is experiencing delays in major projects, adverse weather condition affecting building in the Eastern Estate of Australia and New Zealand. Major pricing is also impacting on some markets such as the Australia and United States housing markets. The industry is characterized by cyclical demand and high level of investment capacity and maintenance. This has resulted in a low return on capital invested. Boral operates under four divisions that is, construction material and cement (60% of Revenue), building production (11%); gypsum (18%) and United States (11% of Revenue). The 50% gypsum is a joint venture, which reduces division contribution. The downturn in Australia and U.S.A housing market has extensively reduced Boral earning. Losses in US and building products have increase Boral’s dependence on Australian construction material that stands at 90% of total income before interest and taxes (EBIT) (Morning star 2010). Return on Equity currently lies at (-2.59%) and return on investment are both disappointing. The probability that the company may liquidate lies high at 46.3% whereas profit margin also lies low at 4.01%. The high level of capital expenditures may limit dividend payment. Cost-cutting is the ongoing theme with Boral. Management must ensure gearing level remain relatively conservative given the cyclical nature of the business (Boral financial report 2009). Analysis and Valuation Using DDM Model The intrinsic value of Boral ltd is estimated using the Dividend Discount Model (DDM). In this model, the present value of a continuous flow of dividends that are growing at a constant rate is given (Reilly & Norton 2006, p.463). There are three categories of this model; constant growth, two-stage and the three-stage model. The constant growth model can be calculated when a company’s dividends are growing at a slow, constant rate, and can be expected to do so for a long period (Brigham & Houston 2009, p. 283). Nevertheless, if the company’s earnings are picking up more rapidly than the general rate of economic growth of the company then the two-stage or three-stage model would be applied because it’s more suitable. Boral, analysis shows greater required rate of return than the expected divided growth rate (appendix 1.3); therefore the constant growth model is more appropriate for the valuation. The constant growth DDM model has a number of assumptions that must be applied about Boral’s divided payments and growth patterns (Bodie, Kane & Marcus 2005, p. 607); Payment of dividends to shareholders and holding period of such shares is infinite. Constant growth of dividends is inevitable and rate of return on investment being greater than dividend growth rate is expected to hold for unforeseeable future. Therefore, the constant dividend growth rate allows us to predict every future dividend, as long as we have the most recent dividend (13cents for 2009 as per historic data, appendix 1.4) and the growth rate. The DDM model requires us to estimate two variables; the dividend growth rate (g) and the investment required rate of return (k), where D1 is the dividend value in period one ( Bodie , Kane & Marcus 2005, p. 618); Then the value of stock is computed as; D1 / k – g =0.13/ (0.065-0.080) =-8.666 To estimate k, the Capital Asset Pricing Model is applied based on monthly rates of return on the market and Boral’s shares over a time period of 7 years (2003 to 2009). In this step, the arithmetic mean is adopted as the averaging technique to estimate the average returns as a means of calculating the variance of the market, the covariance between the market and Boral and subsequently deriving the value of CAPM of Boral (appendix 1.2). RBLD = RFR + β BLD (R m – RFR) The data collected was specifically concentrated on the last 7 years (2003 – 2009) to determine the effects of global financial crisis in 2008. In addition, it attempted to apply a risk-free rate to the CAPM model that is considered suitable for our period of analysis, a 10 year Treasury bond rate was chosen as the closest available measure. The necessary calculations are illustrated in the appendix and demonstrate how the value of k was estimated as 6.5% per annum (appendix 1.2). To estimate the dividend growth rate the fundamental analysts approach is adopted (Bodie, Kane & Marcus 2005, p. 612) g = retention rate (b) x return on equity (ROE) To ensure consistency, ROE and variables used in the calculation of b were averaged using the arithmetic mean, and the value of g was estimated to equate to 8% (appendix 1.3). This calculation method of ROE takes into assumption that Boral’s newly acquired assets are just as profitable as old assets, which may not necessarily be the case. These estimated variables were applied to the constant growth DDM model to solve for the intrinsic value of Boral (appendix 1.5): V = D1 / (k – g) V=0.12037/0.065-0.080 =$-8.024 The constant growth DDM model suggests that Boral’s estimated intrinsic value is greater than the current market price ($5.50), therefore the company’s stock price is deemed ‘undervalued’. Stock valuation using FCFE model Free cash flow to Equity model tries to discover the amount of free cash flow that is available to be paid back to ordinary shareholders after meeting the company’s reinvestment plan and making debt payment to those who advanced to finances to the company. If the calculated intrinsic value is greater than the stock’s present market price, then the stock is considered undervalued by the marketers and therefore prudent for the company to acquire. But if the value is below the stock current market price, then the stock is overvalued by the market and thus the company should not acquire (Damodaran 2002, p. 234). In order to determine the FCFE available to stockholders, historical data of company is used to get net income and less the firm reinvestment requirement, derive as follows; Net income + Depreciation expenditure - Capital expenditure -Change in Working capital-Proceeds from Borrowing+ Net debts Then value of stock will be; Value=FCFE1/k-g FCFE Where; FCFE 1= The expected free cash flow to equity for next year k-require rate of return g FCFE-Constant rate of free cash flow to equity. Historical data of Boral limited year 2009 Details $(millions) NPAT (net income) 131 Depreciation 255.1 Capital expenditure 231.5 Change in working capital employed 187.2 Repayment of Borrowed Fund 424.4 Proceeds from borrowing 188.6 Shares Outstanding 592.890530 FCFE Available to shareholders therefore; =231+255.1+231.5+187.2-424.4+188.6 = -268.4 FCFE1=FCFE* (I+ g) = -268*(1.080) = -289.44 Value of Equity=FCFE1/k-g = -289.44/ (0.0800) = -8269.714 FCFE per Share Value of shared Equity/Shares outstanding =- -8269.714/592.890530 =$13.948 Sensitivity Analysis: Sensitivity analysis is carried out to determine the change that occurs on the assumptions made on the DDM model (Jones 2010, p.270). From the analysis the DDM model is highly sensitive to the assumption made about (k) and (g) values. It is therefore justifiable to perform this analysis. Calculation on the values effects on Boral’s share price using constant growth DDM model (appendix 1.4) The upper and the lower estimates of the dividend growth model were obtained from the financial records of the company. From calculation small differences affects the variations between (g) and (k) and alter the results significantly. This is a good illustration of how sensitive the DDM model is, particularly with assuming a constant value of g, from period one throughout to infinity. This is an extremely long time period and when considering the effects of compounding over time, small changes in g will have substantial effects on the estimated stock value today. The DDM model is also very sensitive to the assumptions made regarding time frame (Martin 2011). The data collected was specifically concentrated on the last 7 years (2003 – 2009) to determine any effects and negative returns generated by the global financial crisis (GFC) in 2008. A longer or shorter time period could have been used for the analysis, however alternate time periods were not deemed appropriate based on the historic events that took place above, as they may reduce significantly the accuracy on results. The valuation of the price of Boral’s shares was obtained from financial statements based on future cash flows discounted by our estimated required rate of return. Finally, it is important to note that the dividend discount model eventually, has a tendency to underestimate the company's intrinsic value. It’s of great advantage to note that the underestimation of price per share of the company may have resulted from other factors such as assets not included in the valuation, low marketing strategy, poor public relation and the quality of the work force the company employs in its operations . The ideology behind all this is that if DDM model value obtained is high compared to the value of shares currently traded, then share value is being undervalued. Appendices: Constant Growth Dividend Discount Model 1.1 Beta Value (Boral); βBLD = Cov(BLD,AO) / Var(AO) βBLD = 21.11/16.40 = 1.29 1.2 Capital Asset Pricing Model; k = RBLD = RFR + βBLD (Rm – RFR) k = 0.0568 + 1.29 (0.0865 – 0.0568) = 0.065 1.3 Dividend Growth Rate; g = Average ROE x b Average ROE = 0.1167 Average RR = b = 0.4169 g = 0.080 1.4 Value of Dividend in period 1; D1 = D0 (1 + g) D0 = 13 cents D1 = 0.13 (1.080) = 0.12037 1.5 Intrinsic Value Estimated by constant growth DDM: V = D1 / (k – g) V = 0.12037 / 0.065 – 0.080 = $-8.024 1.6 Sensitivity Analysis: When, g = 0.064 V = 0.13832/0.0311 = $4.45 When, g = 0.032 V = 0.13416/0.0631 = $2.13 References Baker, H. K. & Powell, G. E. 2005, Understanding Financial Management a Practical Guide. Blackwell Publishers, Oxford. Bodie, Z, Kane, A. & Marcus, A. J. 2005, Investments, 6th ed. McGraw-Hill, Boston. Boral Limited 2009, ‘Concise Financial Report ‘, Retrieved 10 May 2014,. Brigham, E. F & Houston, J. F 2009, Fundamentals of financial management. South-Western Cengage Learning, Mason, OH. Damodaran, A. 2002, Investment valuation: tools and techniques for determining the value of any asset, 2nd ed. Wiley, New York. Gibson, C. H 2001, Financial reporting and analysis: using financial accounting information, 8th ed. South-Western College Publishers, Cincinnati, Ohio. Jones, C. P. 2012, Investments: analysis and management, 12th ed. John Wiley & Sons, Hoboken, NJ. Leach, J. C & Melicher, R. W. 2014, Entrepreneurial finance, 5th ed. Thomson/South-Western, Mason, Ohio. Martin, G. 2011, How to value shares and outperform the market: a simple, new and effective approach to value investing. Harriman House Limited, Petersfield. Morning star 2010, ‘Boral limited’, Retrieved 12 May 2014. . Reilly, F. K & Norton, E. A 2006, Investments, 7th ed. Thomas South-Western, Mason, Ohio. Reilly, F. K. & Brown, K. C, 2006, Investment analysis and portfolio management, 8th ed. 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