Company Valuation: Oakton Limited in Australia - Case Study Example

Running heading: Company Valuation Assignment Company Valuation Assignment Name Course Tutor Task Date Company to be analyzed: Oakton Limited ASX Code: OKN Executive summary The following business report is a case study on Oakton Limited in Australia. It is an information technology (IT) and consulting company. It is listed in Australian stock exchange market. The study main aim is to analyze the current issues facing the company and the industry at large. The impacts of these issues on the future earnings of the firm are also analyzed and possible solutions. There is also he inclusion of a detailed coverage of the evaluation of the company’s performance based on DuPont analysis method. The study goes further to determine the valuation of the company’s shares using the dividend valuation method, free cash flow to equity model, price/earnings ratio model, price/book value ratio model and net tangible asset backing method. Current issues facing Oakton limited and the industry at large 1. Competition With the passing of each and every day, many business oriented individuals are looking for opportunities to exploit and start earning. As a result, many new comers into the market are quite ambitious and end up entering the industries that are thriving at the moment. With the rise of globalization, the information and technology industry is growing rapidly. The more people indulge themselves into the industry, the more competition rises for the already existing companies. Oakton Limited has been a leading company in the industry. The competition that it is being subjected to is a problem that the management must come up with strategies so as to counter it. This is because as the companies in the industry increase, the overall market share reduces gradually. The impact of this on the future earnings of the company is that their earnings will decrease. This implies that the profits realized will be lesser than before. This impact is transferred to the shareholders directly. Their earnings per share will decrease and the shares will not be marketable. The company’s management, therefore, has a duty of ensuring that they are not caught off guard only to loose their credibility and profitability. The management must come up with the necessary strategical measures to solve the impending problem. 2. Agency theory related problems Agency theory defines the existing relationship between the shareholders and the management of the company. The management of the company is the agent of the shareholders. The management carries out the activities of the company on behalf of the shareholders. Their behavior must comply with the contents of their contractual agreement. The main problem arises where the issue of mistrust arises. This is mainly if the shareholders cannot comprehend the financial statements of the company. This may end up being cases of fraudulent activities in the company. Oakton Limited, like any other firm in the industry, is faced with this agency problem. The shareholders tend to always think that their dividends should be more than they are offered. Some shareholders, however, may put forward arguments that are baseless and which cannot be accounted for to the management. As a result, there may be tension in the course of carrying out the activities of the firm. This in return puts undue pressure on the management and wastage of time. However, the only solution to the agency problem is accountability on the part of the management. This is because persistence of disputes may give rise to poor performance in the industry. This in return reduces the future earnings of the company. 3. Counterfeiters of products Oakton Limited deals in data management and software risk management among others. Therefore, responsibilities are very sensitive and should be handled with care. I case of any sabotage, their customers may loose a lot of confidential information. This implies that employees who are assigned certain responsibility must abide too the required confidential levels. However, with the increasing rate of corruption and lack of work ethics, the employees may be tempted to leak out the information (Sanwal, 2007). Leaking out confidential information poses the risk of counterfeiting products. As a result, customers are not aware of what is original and what is counterfeit. This means that the sales within the company are lower than normal and the overall earnings decline. Eventually, customer’s loose complete trust in the company’s products and services and the consumer base reduces and future earnings are greatly tampered with. Evaluation of the company’s financial performance based on DuPont roe approach DuPont analysis is a method of estimating a company’s return on equity (ROE).It is commonly referred to as DuPont identity. This analysis breaks down a company’s return on equity by analyzing the turn over ratio and the company’s financial leverage. The main difference between this analysis method and others is the fact the analysis is based on the gross value in relation to the assets. Other methods of analysis make comparisons between net value and assets. However, DuPont analysis method is preferred because it is more appropriate. Using the traditional DuPont model, there are three components in coming up with a company’s return on equity. These are: Net profit margin This refers to any profit earned by a company after tax: any dollar earned from any revenue. It is calculated as follows: Net Profit Margin= Net Income/ Revenue From the Australian Stock Exchange records, the net profit margin for Oakton Limited is 10.85. This is the highest net profit margin as compared to other related companies, for example, Technology One had a net profit margin of 13.11. The firm that came closest to the net profit margin was Objective Corporation Limited with 5.10. Based on the information above, Oakton Limited is doing well financially in the market. This is because a high net profit margin, indicates good performance of a company. The company is in a good position as compared to its competitors. Asset turn over ratio This refers to how effectively a company can convert assets into sales. It is calculated as: Asset turnover ratio= Revenue/Assets Asset turn over ratio is inversely related to net profit margin. This implies that the higher the net profit margin, the lower the assets turn over ratio. A financially stable company has a low turn over ratio. Equity multiplier Equity multiplier is a measure of a company’s financial leverage, that is, it clearly shows interested investors the portion of return on equity that is as a result of debt. It is calculated as: Equity multiplier= Assets/ Shareholder’s equity Having already gotten the values of the three components of DuPont analysis, it is now possible to calculate the company’s return on equity. This is calculated as follows: Return on Equity= (Net Profit Margin) (Equity Multiplier) (Asset Turn Over Ratio) From the Australian Stock Exchange records, the return on equity for Oakton Limited is 23.66. This is relatively high as compared to the return on equity for Objective Corporation limited which is at 13.96. Generally, the overall financial performance of Oakton Limited is relatively good. This implies that the company is likely to attract investors. This in turn means that the revenues expected are bound to increase with time. These analyses are also based on a comparison made with other competitors in the market. Estimation of the value of company’s shares Dividend valuation model (DDM) It is a valuation method that is based on the theory that the worthiness of stock is equivalent to the sum of all discounted future dividends. The valuation of stock is calculated on the basis of the net present value of the future dividends. The value of company’s shares is calculated as follows: Po= D1/ r-g Where; Po is the price of company’s share D1 is the expected dividend r is the required rate of return g is the expected growth rate To determine the valuation of the firm using Dividend discounted model, the discounting rate is determined using CAPM (Capital Asset Pricing Model). To implement this model, a beta value must be estimated. The beta indicates the amount of risk that the investment faces in the case of a diversified portfolio. The discount rate as per CAPM, therefore, is: r = rf + (β* (rm-rf) Where; rf is the risk free rate rm the expected market return β the beta of the cash flows Therefore, the discount rate is for Oakton Limited; r= 13.66+ (10.2*(23.46-13.66) =113.62 Therefore, from the Australian stock exchange, the value of company shares based on dividend valuation model is: = 2.85/113.62-0.05 = 0.025 Free cash flow to equity model Free cash flow to equity refers to the amount of cash payable to the equity shareholders after all the debts payable have been paid, reinvestment has been done and all the expenses due in the company have been met. It is commonly used by financial analysts in determination of a company’s value. It is preferred to the dividend discounting model because the latter is questionable to some extent. It is calculated as follows: Free cash flow to equity= Net income- change in net working capital- net capital expenditure+ new debt – debt repayment The value of shares of Oakton Limited according to free cash flow to equity model is: =210.69-56.32-80.45+100.36-40.36 =133.92 This implies that the amount payable to the shareholders of Oakton Limited is equivalent to 133.92M. Since this is a very high amount, it means that the company is doing well in the market. The company is competitive in the industry it operates in because the value of shares is relatively high. Price/ Earnings ratio model The price/ earnings ratio model shows the amount paid per share in relation to the all earnings per share based on annual earnings and profits in a firm. The ratio shows the demand for company’s stocks by investors. A high ratio indicates that the stock is being paid for more amount that its net income. It therefore means that the stock is relatively expensive as compared to other stocks in the market. The earnings showed by this ratio are an indication of the expected return if one decides to hold this stock relative to certain assumptions. Such an assumption is the fact that the price/book value at the beginning of the period is constant. The price/earnings ratio is calculated as: P/E Ratio= price per share/ annual earnings per share The price per share, for a public company is determined by forces of demand and supply (market mechanism) P/E Ratio= 0.025/0.45 = 0.05 This P/E ratio is low. This implies that the values of the stocks of Oakton Limited are relatively cheap compared to other stocks in the market. It may, therefore, not be attractive to investors. Price/Book value ratio model The price/book value ratio is a financial ratio used to compare the value of books of a company and the value of the market at a particular time. The company’s book value is the company’s total assets; the assets less the liabilities. The P/B ratio is dependent on the industry that a company operates in. A P/B ratio shows whether the investors are being charged too much in comparison to what they would gain if the company was to become bankrupt. However, it should be noted that this ratio does clearly indicate the firm’s ability to generate profits and cash for its shareholders. Therefore, the Price/Book value ratio is=245.45/200.45 =1.22 The value of the P/B ratio indicates that the values of the stocks of Oakton Limited are not overcharged. This is because for every stock the difference in the charge is only 0.22. This means that the risk involved in purchasing these stocks is relatively low. Net tangible asset backing model The net tangible asset backing model is also known as book value per share. It is a financial ratio that is used in financial analysis of a company. It shows the actual net amount of tangible assets represented by each ordinary share. It is used in the calculation of price/book value ratio. It is calculated as follows: Net tangible asset backing= (shareholder’s equity- intangible assets- preference shares)/ total shares = (100.25-25.55-30.45)/100.25 = 0.44 The net tangible asset backing is very small. This is not profitable to the company as investors will avoid investing in this company. This is because in case of liquidity, they have very minimal assets to fall back on. This, therefore, implies that the investors would suffer major losses in case they invested in his company. The valuation methods used above provide different values. This is because of the difference in the assumptions that are implemented in each and every method. However, the final financial analyses complement each other. This means that they provide the required assessments. The valuations provided by the different models differ from the current share price; 2.28. This is because the models values’ are based on ideal situations and assumptions. However, the current share price is subjected to all the factors affecting the company. For example, they are subject to competition among other constraints. As a result, there is a notable divergence. However, it should b noted that the conclusions drawn from all the values, both current and estimates, are similar. It should also be noted that the issue of economic condition at this particular time is not necessarily ideal. As a result, the values of estimates and actual prices at the moment may vary. The models described above are highly recommended in valuation. However, some are preferred to others. For example, it should be noted that DuPont analysis method is highly recommended because it is all inclusive and is not based on estimates. However, the dividend discounted model is not mostly preferred. This is because it is highly questionable. This is because the risk free assets are an estimate and the beta. As a result the valuation values derived from this model remain questionable. The fact that the company is in a competitive market, it is impossible to have any risk free assets. From the above analysis, I would suggest the DuPont analysis model for valuation of Oakton Limited. As already established, this analysis model analyses the company on the basis of gross value. As a result, valuation using this method is more appropriate. Also, in an industry that is expanding at a high rate, it is important that the analysis made is accurate so as to ensure that the right decisions are made in relation to the company. This will ensure that the company is competitive in the industry. References Sanwal, A. K. (2007). Optimizing corporate portfolio management: aligning investment proposals with organizational strategy. New York: John Wiley and Sons Read More