— Finance Theory and Practice
Stock Valuation project
The purpose of the project is to estimate and justify: (1) an intrinsic (fundamental) value for the company of your choice and (2) the fundamental price/share of equity in the firm. You should attempt to justify that you have calculated your best estimate of the firm’s stock price. You may compare your values (ratios/prices/calculations, etc.) to those you find on the internet, but your work should be your own and your job is to calculate these figures. All calculations/ratios/values are assumed to have been calculated by you own. You should not substitute those figures for yours and using such figures from other sources is plagiarism. All of your reports (including table, graph, figures, reference, etc) should not be longer than 25 pages.
You may use up to three different methodsto calculate firm stock value (the FCF method is most important and you have to include this analysis in your project). The three methods that we study for valuing corporations include:
1. Free Cash Flow Method (or discounted cash flow method). This method requires you to produce pro forma financial statements as based upon the additional funds needed, percentage of sales and constant ratio methods (see “Financial forecasting” in the index). The pro forma statements are then used to calculate the free cash flow as based upon the formulas/examples in the: “Financial Statements, Cash Flow and Taxes,” “Financial Planning and Forecasting Financial Statements,” and the “Corporate Valuation,” chapters in the text. The FCF is discounted back to the present by the WACC, which leads to the firm value as follows. Note that the present value of the FCFs = the Value of Operations (see the CH 7 and the formula runs as followings).
Value of Operations (Enterprise Value )
+ Value of non-operating assets (one example would be marketable securities)
= Total Firm value
- Value of Debt [we use the book value of ST and LT debt; though theory suggests that the market value
- Value of Preferred Shares [if any]
= Value of Equity
÷ Number of Shares of Common Stock outstanding
Price per share
This price per share is your estimate of the fundamental value of the firm stock, which you would then use to argue that the firm is either currently over/under/fairly valued according to the market, i.e., by comparing your price/share to the current market price/share. Warren Buffet calls this estimate the “intrinsic value” of the firm. Remember that you may consider the efficient market hypothesis in relation to your price estimate.
2. Dividend Growth Model (Multi-stage growth model)
3. Comparables (Stock Price Multiples Model): This method is relatively easy and provides some useful valuations that often set the ranges for the stock price. The course packet lecture entitled “Using Stock Price Multiples to Estimate Stock Price” describes this method. You may use either a direct competitor or industry averages. For example, if you are analyzing Ford Motor Corp. it would be appropriate to use GM as a comparable firm (and/or the auto industry). Note that sector/industry ratios can be obtained on Yahoo.finance [look under profiles, then on the left hand side under Financial Links you should see competitors]. Many different financial ratios can be used, although the P/E and Price/CF ratios are common. Another alternative is to create your own “industry” averages from a diverse group of firms within the industry. You are limited only by your creativity; and a great deal of information is available on the Internet. The goal should be to calculate fundamental values by yourself.
The major focus of the project is to calculate and justify your estimate of the price/share of equity using the FCF Method. Many other elements of the project are necessary in order to complete a satisfactory project. Minimally, these include:
An example is given on CH12 (page 489- 495). Completing 5-year pro-formas for your firm. The pro formas serve as the central element of your project. Many steps lead up to the pro formas, and many important steps follow from the pro forma. All of your estimates should include appropriate justification/ support/ explanation. Many of the estimates of growth rates and ratios needed below should be calculated using regression analysis.
Growth. You will need to calculate the historical growth in dividends or in revenue for your firm (in order to obtain an estimate of future growth). The method for estimating growth is illustrated by an example of dividend growth for Firm XXX. – the related file is provided on Blackboard (BB) by the name of “Growth estimate sheet”.
Data Needed to Construct the Pro Formas
* Dividend data: You can attain the historical data from https://www.dividata.com/
*An Excel spreadsheet that you use to construct your pro formas. An excel file is provided on BB and here under the name: CH12 (Figure 1-3) . This file “automatically” completes the 5 years of pro formas for you; given that you have input the data and assumptions correctly.
* 2 years of the firm’s historical financial statements, including annual balance sheets, income and cash flow statements (these form the basis of your pro formas). You may also want to download 5-10 year historical data to do a better estimate. This data may be downloaded at Mergent-Online (available through the university library) or through the SEC official site: http://www.sec.gov/edgar/searchedgar/companysearch.html
NOTE: While you may want to read or skim the 10Ks for your company, you need not construct the 10 years of financial data from the 10Ks. Rather, using either SEC site or MergentOnline, you are able to download the 5-10 years of financial statements directly as a file which can be read by Excel. Should you have difficulty, please contact me.
* Estimates of the company’s current and future (long-term normal – gn ) sales growth (this should be completed in the same manner that you calculate dividend growth for a company) – you may use the Growth estimate sheet available on Blackboard as a guide. Use the 10 years of financial statements for the historical sales figures.
* A justification of your choice of constant or non-constant ratios when completing the pro-formas (the base case should usually be the constant ratio approach as discussed in the text).
* An estimate of the firm’s target capital structure (see the guideline below about Calculating a Firm’s WACC) – note that you need these weights both for the WACC.
* An estimate of the firm’s dividend payout policy.
* The firm’s tax rate.
Steps to Take after Completing the Pro Formas
* As mentioned above, the goal is to calculate the firm’s value (in the end, your estimate of the stock price/share). This requires that you calculate the firm’s FCFs (free cash flows) as discussed in the relevant chapters in your text (CH2 and CH12). This should be a relatively easy procedure, and should be done on the same Excel spreadsheet as your pro-formas (see CH12 (Figure 1-3)).
* You also need to calculate the Continuing Value (or terminal or horizon values) as discussed in CH6 – see the related equation (it is analogous to the constant growth part of the supernormal growth model)! This is a crucial part of the project, because the continuing value of the firm will typically be the largest proportion of any firm’s current value.
* To discount the FCFs back to the “present” (to the date of your last historical financial statements) you need to have an estimate of the firm’s WACC(note that this includes the weights of debt and equity, the costs of debt and equity, the latter of which is calculated by using the CAPM, with your estimate of the firm’s beta). Again, see the guidelines of WACC Calculationabout Calculating a Firm’s WACC, and also review the “Four Mistakes to Avoid” (see the index to your text).
* Once you have completed these steps, you are then ready to follow the general steps described above to calculate your estimate of the stock price/share.
Improving the Quality of your Project(Optional)
Other elements are left up to you, in terms of how complete and/or creative you want your project to be. Some of these elements must be completed in order to earn a higher than average or satisfactory evaluation for the project. You may/should include these other elements if you believe that they will improve your “case” for your estimate of the price/share for your firm. For example, a SWOT analysis is often used in business. For this project, it may be useful, but only if you can connect the main conclusions of the SWOT analysis to your evaluation of the firm.
The most important extensions include:
* Using ratios that are not a constant percentage of sales when constructing the pro formas (the basic percent of sales method is described in the Financial Planning and Forecasting Financial Statements chapter of the text). The relevant procedures are either discussed in the text or are available on spreadsheets that come with the text and/or are on the text’s homepage (listed in the syllabus). The firm’s profit margin has a very important impact on firm value. If you use the most recent profit margin in the pro formas, you may not be providing an accurate longer-term picture of the firm’s operations. As a result, it may be useful or even crucial to analyze this ratio and/or others when constructing the pro formas.
* Sensitivity analysis. How does your estimate of the price/share change with changes in the firm’s WACC, the firm’s short or long-term growth rates, changes in the firm’s profit margin(s) and so on. The amount of work that could be done here is almost limitless, so good projects would demonstrate good judgment in which sensitivity analyses they conduct.
* Scenario analysis. This is similar to sensitivity analysis, but discrete scenarios (e.g., a recession or a boom) are analyzed instead.
* Ratio analysis. Ratios can be used as diagnostic tools in evaluating the “health” of a firm. Note that such analysis would typically include comparisons of your firm’s financial ratios to the industry standards (or averages). These averages are available on the Yahoo.finance site under: Profile/Competitors (Sector or Industry). Ratio analysis by itself is not very useful in terms of valuation. It provides a diagnostic view of the company which may be helpful in terms of analyzing the better and poorer practices of a company. In order to make ratio analysis relevant for this project, it must be tied directly to the firm’s valuation. For example, if a company’s current Inventory Turnover is very poor, the group can suggest that it should get better into the future, and then make the necessary adjustments (which may require changes in the formulas) in the pro forma sheets, to see how improving the inventory turnover would increase the firm’s value.
Advanced Elements of the Firm Valuation Project If you attempt any of the following, you should connect the additional analysis directly to the base case for your firm valuation project.
* Managerial/Strategy Analysis. You may view your job of this project as the managers of the firm. In completing the project, you may recognize that the company is either performing some function very well or very poorly. It is perfectly appropriate to make suggestions for improving or maintaining the operation of the firm.
* Marketing Analysis. Future sales typically depend upon marketing. Projects which focus on companies for which this may be particularly important may consider analyzing the marketing policies of the company in order to determine how those policies affect firm value.