Corporate Performance Analysis: Royal Bank of Scotland - Essay Example

RUNNING HEAD: Corporate Performance Analysis Corporate Performance Analysis - Royal Bank of Scotland of Date Introduction The Royal Bank of Scotland Group plc (RBS), incorporated in 1968, as the holding company of two principal subsidiaries – The Royal Bank of Scotland plc and The Westminster Bank Plc and other business segments -- is engaged in global and financial services. The company through its subsidiaries, operates in the United Kingdom and the United States and many parts of the world. Part of its big latest transactions include its sale of wholesale banking operations in Colombia last March 2010 to the Bank of Nova Scotia, the sale of entire stake in Bank of China and the sale of its retail and commercial Hong Kong operations to Australia and New Zealand Banking. As of December 2009, it had about not less than 2,200 retail branches in the United Kingdom through its subsidiaries, not less than 220 branches and network of business banking offices in Northern Ireland and Republic of Ireland and not less than 1500 retail banking offices in the United States (Reuters.com, 2009a). This paper seeks to evaluate RBS using relevant valuation models based on the company’s annual reports and other external information. This paper will analyze first the historical performance of the RBS for the past five years. This will be followed by a forecast of the short-term performance of RBS by constructing different scenarios for various competitive positions taking into consideration the current industry and company’s strategic position. This will then value cash flows beyond the forecast horizon using a continuing value by discounting cash flows to their present value using an estimated cost of capital by CAPM model. Calculation and interpretation of the results will come afterward within the strategic changes (Pearce II, Jr. and Robinson, 2004) envisioned for the firm and the required decisions that need to be taken to maximize the value of the company. 1. Analysis of the Historical performance of RBS Analysis of historical performance of RBS is accomplished by studying its revenue growth for the past five years or from 2005 to 2009 by understanding its profitability and efficiency, connecting the results with its liquidity and financial and financial advantage (Helfert, 2001). The same information need to be related further to other external information including that of its competitors from the financial services industry and other macroeconomic variables. The summary of the historical performance of RBS can be found in Appendix A. 1.1 Profitability and Management Efficiency RBS revenues, in the form of interest income because of its nature business, showed an average annual growth of 13% for the past five years from 2005 to 2015 while net profit margin averaged only 3% for same period years. Both ratios where below industry averages of 16.43% and 17.92% respectively. The company’s less superior performance than the industry proved also evident in terms of return on equity (ROE) where it had an annual average of 0% as against 2.92% as that of the industry. Even in terms of return on assets, the company exhibited an average zero rate as against 0.84% of the industry. All of the ratios show dismal past performance of the company in relation to the industry average. A range of 2.9% to 3% return on equity definitely in a certain industry still attracts investors, as it would mean that for every £100 the investors expect returns of about twenty £2.9 to £3. These rates could be viewed as something still acceptable compared with the risk free rate of 0.50% using the Bank of England base rate (Housepricecrash, 2010). This would mean that RBS investors were not able to realized expected profits as accomplished by competing companies in the industry and the company needs to do something. 1.2 Financial Condition Analysis Financial condition analysis looks at the company’s liquidity and financial gearing. Liquidity is the capability to pay a company’s currently maturing obligations. The same is measured using the liquidity risk ratio by dividing assets with maturity of not more than one by total liabilities with maturity of not more than one year. In the case of RBS, it liquidity risk deteriorated to 0.581 in 2009 from 0.61 in 2008 as computed in Appendix A-1 . Financial gearing, on the other hand, connotes long-term capacity of a company to keep up it stability over the long term. Normally measured by the debt to equity ratio, with the formula of having the total debt of the company divided by its total equity, financial gearing should inform investors that the company is not just survive in the short term but it must also in the long term long life to recover long term investments which may years to produce the needed returns (Brigham and Houston, 2002). The debt to equity ratio of RBS average at 27.18 as against industry average of 1.96. See Appendices A. The financial gearing ratio of the RBS is many times poorer than the industry average and proves of bad capital structure for the company. Viewed differently, this would mean that the company would be deemed precarious to make further expansions in the future without falling to be as riskier than its present competitors are. It is therefore a difficulty for RBS to manage its long-term risk since its profitability was not enough to provide funds to pay currently maturing obligations, and amount of dividends annually to investors if the company want to do so. 1.2.3 Investment Aspect In terms of price- to- tangible-book ratio for the latest quarter, company exhibited 0.42 as against industry average of 1.26 (Reuters.com, 2010b). This means that investors are pricing the company’ stock at less than its book value while competitors in the industry enjoy more value and confidence. This appears supported with unprofitable and inefficient financial performance of the company in relation to its competitors in the industry. Without setting a good strategic direction and applying strategies that would attain realizable financial objectives, the company may continue to find a dismal condition of its stocks and may cause further problems to the company. 2. Forecast short-tem performance of RBS. To forecast a five-year m performance for RBS, different scenarios for various competitive positions are constructed taking into consideration the current industry and company’s strategic position. The different scenarios assume three general directions of the economy and the industry. One possibility is for the company to move higher than average competitors are. Another scenario assumes that it could only rise as far as the maximum growth in revenues as experienced years before it suffered loss about three years ago. The third scenario is for the economy to still go down and suffer more losses than the past. This paper as assumed a middle ground between the most optimistic scenario and the maximum growth that if had before the downfall in making the forecast using a the Mckinsey’s DCF valuation model in Microsoft Excel (Koller, et al, 2010). 3. Estimate cost of Capital The optimal weighted cost of capital (WACC) is one that will maximize shareholder value of the company which will be used for discounting purposes. As such, it is at this point that the discount rate is at its minimum so that it will correspond with the maximum point where shareholder value is at its peak since the lower the cost of capital, the higher is the shareholder value (Brigham and Houston, 2002). To compute this optimal WACC is to assume market value for the company at its maximum but which cannot be safely assumed without verifying the intrinsic value of RBS stock. Another method is the use of the CAPM model, which uses data and certain assumptions. Historical financial report may provide an indication of how the company will perform in the future strategies to different strategic directions as made by the company. The same historical report of the past five years would be analyzed as basis for forecast drivers in estimating cash flows in the future for discounting using the estimated cost of capital. 3.2. Calculate the cost of capital for RBS. To approximate the same cost of capital for RBS the capital asset pricing model (CAPM) is used (Brigham and Houston, 2002). The model could illustrate how risk and expected return are related and balance against each other and investor use it to price securities especially if these are risky ones. The model is very simple to use since the required information includes the expected return an investment such as a stock or a bond or a group of stocks, a treasury or government bill rate, which approximates risk-free free rate plus a premium for the risk. The CAPM formula is: Required (or expected) Return = RF Rate + (Beta * (Market Return - RF Rate)). RF means for risk free rate. For the purpose of this paper assumes a risk-free rate of 0.50% for five years using as basis the Bank of England base rate (Housepricecrash, 2010). Risk free rate means that just sitting and doing nothing, the investor earns interest from treasury bills and the same investor will surely have the money invested plus interest after a period because the government is the guarantor. The beta stands for the measure of market risk, which is the extent to which the returns on a given stock move with the stock market (Brigham and Houston, 2002). For the purpose of this paper, the beta used is taken from the Reuters.com (2010). To apply the same CAPM formula, the current risk free-rate at 0.50%, beta of 2.38 and the expected market rate 7% as estimated using the reciprocal of industry price-earnings ratio (P/E) need to be combined. Applying the formula would show that RBS would have an estimated cost capital of 16% as computed below: Required (or expected) Return = RF Rate + Beta (Market Return - RF Rate) 0.50% + 2.38 (7%-0.50%) = 16% Using the reciprocal of the P/E ratio may also produce an estimated cost of capital of 7%, which is computed by dividing 1 by average P/E ratio of the industry. Using a valuation technique may reduce risk. A strategic corporation should be capable of managing risks in one or two different ways. It can take one risk at a time under “ a largely compartmentalized and decentralized basis” (Nocco, and Stulz, 2006). The same corporate can view all risks together a within a coordinated and strategic framework (Nocco, and Stulz, 2006). By properly managing its risk, RBS may still be able to produce long-run competitive advantage (Porter, 1985) for the company better than those managing and monitoring risks individually (Nocco, and Stulz, 2006). RBS therefore be asserted apply certain valuation techniques may reduce risks if a company measures and manages its risks consistently and systematically information acquired by responsible and well-informed managers from the stock market to motivate to optimize the trade off risk and return. By so doing, a company is deemed strengthened in its ability to carry out its strategic plan. Since a typically strategic corporation should be able to assess its appetite for risk, by being guided by its decision about how much risk to retain and which to lay off, it should be the same as lay off manageable risks Nocco, and Stulz ( 2006). Such strategy could afford enough flexibility or power to concentrate to defend itself from core risks. 4. Valuation using the McKinsey DCF model Using the Mckinsey’s DCF valuation model in Microsoft Excel to value RBS, financial data from the financial statements of the company for years 2005 to 2009 is used as basis to forecast performance of the company in the future. Forecast drivers were also assumed using different scenarios as explained earlier. After that most reasonable assumption, the computed value per share of company is £17.53 per share as against stock market price per share high at £11.06 and low at £5.57 from the New York Stock Exchange (Reuters.com, 2010a) as converted from US$. The next section will discuss more about the results and analysis made in relation to strategic directions. 5. Calculate and Interpret results To calculate and interpret the results within the strategic changes envisioned for the firm, and the required decisions that need to be taken to maximize the value of the company, the effects of the forecasting drivers taken together should be analyzed on which should maximized the cash flows per period. Compared with the present stock price from the stock market, it would appear that the company is undervalued by about 58.5% compared with high assumption and more than 200% using the low assumption. See Appendix B. The valuation however has to depend on forecast drivers in order to attain the valuation that is higher than the present market reflects. This includes a prediction that revenues should increase for at least 50% per year from 2009 level for about 15 years afterwards. This would also require the reduction of cost of capital or WACC from 16% to 5% for the next fifteen years. The long-term strategic direction of the company assumes further the EBITDA growth will have be 41.1 % from 2015 to 2019 and 50% from 2020 to 2024. NOPLAT growth should be 31.14% from 2015 to 2019 and 50% from 2020 to 2024. It is further required that although invested capital growth may be allowed to decline by 235 from 2015 to 2019 it should have growth of 98% from 2010 to 2014 and 49% from 2020 to 2024. It also required that the adjusted EBIT to revenues not less than 57% from 2010 to 2014 and should grow by 30% from 2015 and afterwards up to 2025. See Appendix C. The result of the valuation done under McKinsey’s DCF model revealed undervaluation of RBS stock. The strategic changes envisioned by the company are of course based on estimates and therefore the chances of the happening of these forecasts and assumption are governed by the laws of probability. Assuming that these strategic directions will happen, the decisions to be made by RBS in order to maximize value will include improving its profitability and efficiency, which were found less superior as against industry averages. The company should have to improve further its liquidity to be able to prevent the firm from bankruptcy and its financial gearing to ensure long-term financial health, which is very important to sustain its strategic directions. Conclusion To conclude, it appears the company appear undervalued by comparing its intrinsic value as against its value in the stock market. In order to maximize the value, the company should be able to maintain and make effective the good value drivers that could increase the cash flows to the company. This would include increasing its revenues, improving is profitability and efficiency, strengthening its liquidity and keeping them company stable with better financial gearing ratios. Improving its revenues may take the form of increasing the volumes of its sales revenues, which may come from expansion into broader markets or diversification of its products. Improvement of revenues however should not sacrifice profitability in terms of high costs. Appendices Appendix A – Summary of Financial Data and Ratio vs. Industry ; Sources (Royal Bank of Scotland, 2010, Reuters.com, 2010b, 2010c) Appendix A-1. Comparative liquidity risk for the past two years; Source (Royal Bank of Scotland, 2010) Appendix B – Resulting Valuation –DCF model. See Excel File Appendix C – Comparison of Ratios from DCF Model . See attached Excel File. References: Brigham, E. and Houston, J. (2002). Fundamentals of Financial Management. Thomson South-Western Helfert, E. (2001). Financial Analysis: Tools and techniques: a guide for managers. McGraw-Hill Professional Housepricecrash (2010). Bank of England based rate. Retrieved 5 November 2010 from http://www.housepricecrash.co.uk/base-rates.php Koller, et al (2010). Valuation- User’s Guide, fifth edition. McKinsey and Company Nocco, and Stulz (2006). Enterprise Risk Management: Theory and Practice. Journal of Applied Corporate Finance • Volume 18 Number 4. A Morgan Stanley Publication Pearce II, J._ and Robinson, Jr. R. (2004), Strategic Management. Ninth Edition, London: McGraw-Hill Porter (1985) Competitive Advantage. London: Free Press Reuters.com. (2009a) . Company Profile of RBS. Retrieved 5 November 2010 http://www.reuters.com/finance/stocks/companyProfile?symbol=RBS Reuters.com. (2009b). Industry ratios. Retrieved 3 November 2010 http://www.reuters.com/finance/stocks/financialHighlights?symbol=RBS Reuters.com. (2009c). Financial Statements – 2005 to 2009. Retrieved 3 November 2010 http://www.reuters.com/finance/stocks/incomeStatement/detail?stmtType=CAS&perType=ANN&symbol=RBS Royal Bank of Scotland (2010). Annual Report 2009. Retrieved 3 November 2010 from http://www.investors.rbs.com/ ‑­ Read More