Financial Analysis and Valuation of Next Plc - Report Example

Financial Analysis and Valuation – Next PLC Valuation Total Number of Words excluding references and appendices is 3490 –Please delete this part after verification Name of Student Name of Professor Name of Subject Date 1. Introduction This paper seeks to conduct valuation of NEXT plc’s stocks, using different valuation models. Said valuation will be done after conducting industry analysis to study of risks and outlook of the company and financial analysis as a way of judging the company’s strengths and weaknesses in designing its strategies. This paper will also evaluate those valuation models used and make recommendation for the company on the basis of analysis made. 1.1. Brief Company background Next plc (or “NEXT”) is retailer based in the United Kingdom. It makes available various products in clothing, accessories, footwear, and home products. Through three main channels, the company makes distribution of its products. First is NEXT Retail, which is actually a chain of not less than 500 stores in the United Kingdom and Eire. Second is NEXT Directory, which is a home of shopping catalogue serving about not less than three million active customers and Websites around various countries. Third is NEXT international, which consist of about 200 mainly franchises stores found around the world (Reuters, 2014a). 2. 2. Industry Analysis An industry player competes with other firms selling similar good and products. NEXT is one of the industry players under the retail industry. Like any other industry, the retail industry is affected by different related industries particularly from the manufacturing sector which deliver goods to be sold by retailers. These retailers need to ensure constant supply of goods and services to allow the retailer in doing their business. Like any other customers who need affordable prices, retailer must be able to address the challenges to survive competition. NEXT is determined to be successful as it asserts its ability “to anticipate and respond to changing customers’ preferences and trends.” (Next plc, 2014b, p. 15) It is aware that a number of its products are considered as changing and discretionary and the demands for them could suffer decline in times of negative consumer confidence that may come from changes in economic situations. Economic conditions not only in the United Kingdom and around the world with which the company operates have witnessed the different crisis including that happened in 2008 and 2009. The possible result of such negative consumer confidence could come from surplus stocks that could only be sold at a loss. As such the players of the industry must be able to understand the various forces in the industry to be able to prepare for its strategies. 2.1 Competitive Environmental Analysis This part applies Porter‘s Five-Forces Model (Porter 1980) in relation to external environment with which the NEXT operates in the retail industry to determine the industry opportunities and threats. 2.1.1 Ease of entry from new entrants (high) There is high threat from new entrants in the retail industry as the latter is not capital intensive and thus economies of scale are not a bar to entry. Companies could easily come into the industry, which makes it unfavourable to present industry players because less competition generally means better profitability. 2.1.2 Bargaining power of suppliers (low) Bargaining power of suppliers may be considered low because retailers buy from them in large volume which is considered important to these suppliers. There could be many sellers or potential providers of retail good but the volume purchase by retailers makes it less favourable to said suppliers (Pearce and Robinson, 2004). This is therefore an opportunity for industry players in players in the retail industry 2.1.3 Bargaining power of buyers (high) Bargaining power of buyers is believed to be high because there are many retail customers who could be having low switching cost as they could have their needs served by other retailers as there are a good number of industry players. This is a threat to the industry as it could leave buyers shifting from one player to another or developing their own. 2.1.4 Threat from substitute products (high) Threat from substitute is high because the numbers of apparent substitutes may be numerous. The choice of having retail becomes a less preferred choice if the economy is not well. However in the case of NEXT which has been in the industry for almost a century it appears that it has survived different threats in the industry including different kinds of competitors dealing on substitute products. This may make the company strategy of differentiation clearly noticeable as compared to other players. This part of strategy allowed it to maintain its advantage as compared to seller of substitute products. 2.1.5 Intensity of competition or Rivalry among Existing Firms (high) Strong rivalry of among existing firms continues as evidenced by increasing competition in the United Kingdom and around the world for retail products brought by easy of entry and other factors. This level of competitions could cause retail industry players to compete heavily on prices and not generally on differentiation value on how to satisfy their clients who wanted more flexibility because of decrease purchased power. A creative and innovative player like NEXT in adopting differentiation strategy in providing highly differentiated products puts the company in different category for competition. 2.2 Strategy in Relation to Industry Opportunities, Threats and Key Risks Industry opportunities could come from low bargaining power of suppliers while industry threats came from high bargaining power of buyers, high ease of entry into industry, high intensity of rivalry among existing firms and high threat of substitute products. Strategies to be employed by company must build shareholder value by being able to defend the company from industry threats with its differentiation strategy as it shifts the competition from price-base to value-base by being continuously anticipatory of the changing needs of its customers The company faces the risks of not being able to respond correctly to these industry threats due to inappropriateness of its strategies to respond to changing needs of customers including the possible decline in customer confidence that could become negative at various times. Proper management of its liquidity and finances are also important in order to insure the building of value at it makes investing and financing activities in support to its operating activities. In so designing its strategy it must know also its resources and capabilities as would discussed in the next section – financial analysis. 3. Accounting and Financial Analysis 3.1. Profitability and efficiency Companies do sell goods and services to customers from which they generate revenues but these revenues have their costs must which must be exceeded. When revenues exceed costs the company is said to be profitable. There are several measures of profitability including directly measuring on how much the shareholders generate from the profits generated by the company through the use of gross margin, operating margin, net profit margin, return on assets (ROA) and return on equity (ROE). A summary of these ratios are shown in Table 1 below. Table 1 – Summary of Profitability and Efficiency Ratios; (Sources: Next plc, 2014a, 2014b, 2014c, 2014d , 2014e; Reuters, 2014b) 3.1.1. Gross margin, operating margin, net profit margin, return on assets (ROA) The company’ higher profitability and efficiency is very revealing compared with average competitors. Except for the gross margin above, the more important ratios average for the past five years exceeded the industry averages. Such high level and the stability of the same in the last five years could be clearer in Fig. 1 below. 3.1.2 ROE NEXT’s five-year average return on equity (ROE) of 202% indicated a more than ordinary superior performance about its past performance compared to industry average of 16%. See Table 1 below in relation to Appendix A and Appendix B. Such an ROE level definitely more than encourages investors, as it would mean that investors can virtually stop working and enjoy their return form their investments The more than 200% ROE implies that for every UK £100, the investors profits about more than twelve times that amount on the average if invested with competitors in the retail industry. These rates could be viewed as something spectacular. Considering that ROE is computed by dividing net profit to the total stockholders‘ equity to signify relation how much income or earning an investor can get from the amount of investment made (Helfert, 2001),nothing could be more evidently convincing . This rate however needs to be compared with other profitability ratios. Comparing the said ROE to an average rate of 0.50% based Bank on England base rate (Housepricecrash, 2014) or the equivalent of a risk free rate when investors just put their money in a bank, said investors could easily see the obvious difference since they could be earning in NEXT instead of losing their money the big advantage of just investing in stocks of the company. 3.2 Liquidity All companies need working capital which consists of current assets to survive in the short term to finance their operating cycle. They will need the same in delivering goods and services to their customers. For them to pay suppliers of inventories, supplies, and necessary materials to the company, they will need cash. They too will also need to pay the salaries of employees including for latter come to work. What will the managers and directors do if there are no employees to do instructions and obey order from top management? It is for this reason that management need to pay said salaries along with fees of directors. Management need to remit taxes to government as well and to pay amortizations of current portion of long-term loans. There are other short-term needs of the company which use currents assets. Thus since companies need to pay these obligations, they need to have working capital or excess of current assets over current liabilities cannot be overemphasized. The capacity to pay on time in the current period needs to be measured if management would have to know how to make effective decisions in preventing bankruptcy (Delaney, and Whittington, 2012; Kieso, et al, 20007, Johnson, et , 2003). Bankruptcy is like cancer to a human being. One may be healthy-looking but if there is no medical check-up from time to time to monitor the health or the chance of cancer, the latter is fatal. Bankruptcy simply compels closure of the business for incapability to operate in the short-run. This situation therefore prompts companies to know how much current assets are available to pay currently maturing obligations. This capacity to pay on time qualifies as liquidity. NEXT appears to have managed its liquidity well. Its current ratio registered at 1.37, 1.28, 1.54, 1.48 and 1.76 for the years 2010, 2011, 2012, 2013 and 2104 respectively or an average of 1.40 for the past five years. When compared with the industry average of 1.66, evidently, NEXT is slightly less liquid than average competitors, but it is still within level of 1.0. See Table 2 below. A current ratio above 1.0 indicates normal liquidity and to have excessive liquidity may not be good from a financial theory viewpoint. Table 2 – Summary of Liquidity ratios; (Sources: Next plc, 2014a, 2014b, 2014c, 2014d , 2014e; Reuters, 2014b) Its quick assets ratio, on the other hand, registered at 0.85, 0.72, 0.91, 0.97 and 1.30 for the years 2010, 2011, 2012, 2013 and 2104 respectively or an average of 0.83 for the past five years as against industry average of 0.95 . See Table 2 above .To have allowed too much currents assets as working capital is just like a having car engine with excessive oil and would mean waste of money. There is opportunity cost of money and excessive liquidity would be better invested in a manner that would be generating maximized profits. Thus its slightly lower liquidity may explain its substantially higher profitability as it is able to reinvest its resources well as against ordinary competitors. Return on assets (ROA) which measures both profitability and efficiency average at 22% for the past five years as against industry average of 8%. Even the gross margin, operating margin and net profit margin, NEXT is evidently more profitable than industry averages. See Table 1 above. 3.3 Gearing As revenues are generated working capital is needed and the need to invest in long-term assets occurs because of the requirement to sustain the same. As to how these assets are financed affect the capital structure of the company through debt to equity ratio. The company registered gearing of 11.68, 6.72, 7.33, 5.63 and 6.49 or an average of 8.57 respectively as against industry average of 0.69. See Table 3 below. As against industry average, NEXTs gearing ratio makes it more than 12 times riskier than the industry average. This means the value NEXT investments from stockholder is very much less compared with its average competitors. This less equity investment compared with competitors explains its more than twelve times ROE as it is a good finance theory that the higher the gearing would normally generate higher the profitability (Brigham and Houston, 2011). Table 3 – Summary of Gearing; (Sources: Next plc, 2014a, 2014b, 2014c, 2014d , 2014e; Reuters, 2014b) The need for balance through the debt to equity ratio is evident not only with individuals but also with organizations. The balance of equity financing and debt financing is a matter also decided by management if the company wants to maximize wealth for these stockholders (Brigham and Houston, 2011). 4. Valuation 4.1 Discounted Cash Flow Valuation (DCF) DCF model assumes that the business will generate cash flows from operation, financing activities and investing activities (Brigham and Houston, 2009). Under the DCF used on this paper, it is assumed that sales would grow yearly in a constant manner and would in turn produce consistent level of operating profit margin and net profit margin. Similarly tax rates are assumed to be constant for the next projected number of years. There would be incremental capital investment and incremental working capital as a result of the increased level of operation at certain point time as a result of increase revenues (Brigham and Ehrhardt, 2010;Banks, 2006). To increase revenues implies more capital investments, which may be financed either by debts or equity depending on what will maximize wealth for shareholders. The shareholder value could be derived from the activities of a company by bringing cash flows them to their present values by discounting them. Discounting uses the stream of cash flows or benefits to bring them to present values. There is need to have discount factor which is the weighted average cost of capital the computed cost of capital at 4.7% for NEXT would bring future values to their values at present. See Appendix C for weighted average cost of capital (WACC) computation. This discount rate explains the time value of money concept where US$1000 today should have more value than US$1000 in the future. The discounting considers the possible gains and losses in value arising from inflation and other economic realities. A summary of assumptions is shown below: After the getting the revenue increases, it was necessary to forecast also the operating costs. The operating costs consist of the cost of materials and supplies, used, the payment for its employees ‘salary, the costs of maintaining and repairing assets, including those used in marketing and administration (Banerjee, 1987) . Average of the cost items for the past years in relation to revenues was used for purposes of estimating the behaviour of these costs in relation to the projected sales revenues using a model in Microsoft Excel. As computed under the DCF model, NEXT is found to have intrinsic value of £152.49 per share computed using Microsoft Excel. See Appendix D. Comparing the same £152.49 as computed above with the existing market price per share in the stock market of £65.26 as converted from US$108.33 (Reuters, 2014c), it would appear that there is undervaluation. Note however that computer value depends on many factors or drivers as assumed earlier. Changing the assumptions could change the values. However for the purpose of this paper, it is assumed that the values or are most realistic. Another factor that could change the computed value is the cost of capital. Increasing the WACC or cost of capital could definitely reduce the computed intrinsic value. 4.2 Asset and Market Basis Valuation Valuation of NEXT is also prepared using the following price multiples: price-earnings ratio (P/E), price to book value (P/B), Net Asset Value (NAV) and Dividend Yield (Brigham and Houston, 2011). Price-Earnings Ratio To compute for the price per share of £39.36 under P/E, the industry P/E of 10.75 is used and multiplied by EPS of £3.661 for 2014. Price-Book Ratio Under the price/book formula, the total book value is extracted from the Total Equity of 2014 balance sheets, which is made as a divisor and extracting for price per share of £67. Note that there is need to get first the total valuation and dividing the result by the outstanding shares as of 2014 for 155.03 million shares (Next plc, 2014a). NAV The NAV is most conservative amount of the models at it merely uses the book values as recorded and dividing the amount by the 155.03 million outstanding shares would produce a value of £.85 per share.. Dividend yield There is no date available on industry dividend yield to estimate the price per share of the company; hence no value was generated under the said model. A comparison of the values generated using these models are presented in Appendix E. 5. Comparison of Valuation Models and Recommendation The various valuation models present different values of the company and since they are guide for decision makers about on how they will respond to what company can offer, the most correct value will have to determine whether there is overvaluation or undervaluation. As to whether which of the models is more believable there is need to look into the assumptions used in applying the model to the determination of the shareholder valuation. Among the different valuation models, DCF appears to have the most reliable basis since cash flows are estimated based on the projected profitability. Given that the aim of every company is create value, there must a way of properly determining the said value is correct or not to guide decision-makers. Hence the valuations models are employed in this paper were applied to determine the most appropriate value. To believe as correct an undervalued stock, when in fact it is not would be to keep the investor misled in keeping his or her investment in the company. On the other hand, to believe as correct an overvalued stock, when it fact it is not would be to tell the investor to sell its shares in the stock market when the proper thing to do is to keep. However, valuations used different assumptions of the future and since nobody could be sure of what will happen in the future, any basis for making decision would rely on the reliability of the assumptions used in the model.. Just like many other companies, NEXT aims for wealth maximization which is measured by the amount of shareholder value. To attain this goal, the company needs to maintain good level of financial performance as measured in terms of profitability, liquidity, and solvency ratios (Helfert, 20012; Higgins, 2007). As found in the analysis of financial performance of the company for the past five years as against industry averages, NEXT appeared better and the same should translated into better shareholder values. As to whether this is correct could be seen in comparing the companys investment and market ratios, which show that company was doing a good as the average competitors with average P/E of 9.32 as against industry average of 10.75 (Reuters, 2014b). However a valuation under the DCF model, prepared for the purpose the company’s stock was found to be indeed undervalued and investors may not be responding well in the stock market. From the point of view therefore of investors, there is still much value that could be taken advantage if the DCF valuation model is to be believed. The EPS valuation model essentially relied on market ratio or price-earnings ratios which is response of investors for the industry in general and this may over-all uniqueness of one company over the other. The price/book method essentially establishes a relationship using other companies as standard and this may have the same limitations as in P/E method where uniqueness of one company over the other is overlooked. The NAV is too conservative to be seriously considered and to believe the same would to lose opportunities for more wealth for investors ((Fridson, and Álvarez, 2002; Gitman, 2006). This paper recommends making investment with NEXT consistent with the result of financial analysis revealing much strengths of company in terms of profitability and liquidity with the level of manageable risk in terms of its gearing. The opportunities revealed in the industry analysis applying the five-force model and the differentiation strategy which the company has successfully maintained and implemented justifies the reasonable undervaluation and investors of NEXT could become wealthier as a result. Between buy and sell decisions, this paper recommends the former. References: Banerjee, B (1987). Financial Policy and Management Accounting. PHI Learning Pvt. Ltd. Banks, E. (2006). Finance: The Basics. Routledge Brigham and Houston (2011). Fundamentals of Financial Management, Concise Edition. Cengage Learning Brigham, E. & M. Ehrhardt (2010). Financial Management: Theory and Practice. Cengage Learning Brigham, E. and Houston, J. (2009). Fundamentals of Financial Management, London: Thomson South-Western Delaney, P. and Whittington, R. (2012). Wiley CPA Examination Review, Problems and Solutions. John Wiley & Sons Fridson, and Álvarez (2002). Financial statement analysis: a practitioners guide. John Wiley and Sons Financial statement analysis: a practitioners guide. John Wiley and Sons Gitman, L. (2006). Principles of Managerial Finance. New York: Addison Wesley Helfert, E. (2001). Financial Analysis: Tools and techniques: a guide for managers. McGraw-Hill Professional Helfert, E. (2011). Techniques of Financial Analysis: A Mode. McGraw-Hill Education (India) Pvt Limited Higgins (2007). Analysis for Financial Management, Eighth Edition. The McGraw−Hill Companies Housepricecrash Johnson, et al (2003). Financial Accounting. Tata McGraw-Hill Kieso, et al (2007). Intermediate Accounting. John Wiley and Sons NEXT plc (2014a). Full report year 2014. Retrieved 28 March, 2014 from < http://www.nextplc.co.uk/~/media/Files/N/Next-PLC/pdfs/reports-and-results/2013/Full%20Year%20January%202014%20PDF.pdf > NEXT plc (2014b). Annual Report year 2013. Retrieved 28 March, 2014 from < http://www.nextplc.co.uk/~/media/Files/N/Next-PLC/pdfs/latest-news/2013/ar2013.pdf > NEXT plc (2014c). Annual Report year 2012. Retrieved 28 March, 2014 from < http://www.nextplc.co.uk/~/media/Files/N/Next-PLC/pdfs/latest-news/2012/ar2012.pdf > NEXT plc (2014d). Annual Report year 2011. Retrieved 28 March, 2014 from < http://www.nextplc.co.uk/financial-information/reports-and-results/Archive.aspx> NEXT plc (2014e). Annual Report year 2010. Retrieved 28 March, 2014 from < http://www.nextplc.co.uk/~/media/Files/N/Next-PLC/pdfs/reports-and-results/2009/jan10-c.pdf > NEXT plc (2014f). Company history 28 March, 2014 from < http://www.nextplc.co.uk/about-next/our-history.aspx). > Pearce, J._ and Robinson, Jr. R. (2004), Strategic Management. Ninth Edition. New York: McGraw-Hill Porter (1980) Competitive Strategy. London: Free Press Reuters (2014a). Company Profile. Retrieved 28 March, 2014 from < http://www.reuters.com/finance/stocks/companyProfile?symbol=NXGPF.PK > Reuters (2014c). Stock price per share per period. Retrieved 28 March, 2014 from < > Reuters, (2014b). Industry Ratios. Retrieved 28 March, 2014 from Appendix C Read More