1.0
Aim
This course is designed to develop an understanding of finance and
corporate financial analytical tools at a higher level. The course is a
continuation of Corporate Finance.
2.0
Objectives
By the end of the course, students should be able to:
2.1
Determine the value of Equity and Firms
Analyse Mergers and Acquisitions of Companies
2.2
2.3
Discuss Short term Financial strategies of firms
3.0
Method of instruction
3.1
Lectures
3.2
Demonstrations
3.3
Group discussions
3.4 Assignments
4.0
Assessment
4.1
Assignments
4.2
Intrasessional test
4.3
Final examination
15%
15%
70%
1
Total
5.0
100%
Course Content
5.1
5.2
5.3
Approaches To Valuation
5.3.1 Discounted cash flow valuation
5.3.2 Relative valuation
5.4
5.5
Valuation Of Companies
5.5.1 Valuation of Equity
Valuation in the stable growth model
Valuation in the two stage model
Valuation in the three stage model
5.5.2 Valuation of the Firm
5.5.3 Growth rate in FCFE and Growth rate in FCFF
5.6
Relative Valuation
5.6.1 Price Earnings Ratio
5.6.2 Price To Book Value Per Share
5.6.3 Price to sales
5.7
Share issues
Corporate
Financial
Strategy.3rd
Revised
Text
1. Brigham and Gapenski; Financial Theory, Policy, and
Practice
a. Financial Planning
b. Restructuring,Mergers,acquisitions
c. Financial Reporting
2.
3.
5.
6.
7.
Functional Strategy
a)
b)
c)
d)
Marketing Strategy
Human Resources Strategy
Production Strategy
Financial Strategy
Financial Strategy
Issues to consider in crafting this strategy:
a) Sources of funds
b) Uses of funds
c) Capital structure(Debt/Equity structure)
d) Risk return(measured by ke,P0,g,)
e) Dividend policy
Main Corporate Strategy issues: How financial strategy fits into it.
a) Market share and growth rate of the market
b) Product range(Product life cycle)At what stage of the PLC is each
product
c) Strategic Business Units (SBU)every SBU is strongly related to each
product in each product range. For e.g. Pioneer has Passenger transport,
trucking, courier (removals) as its SBUs.Each SBU will follow the PLC of
T.J Mabvure (Mr.)
its product or product range. The PLC of the product is the PLC of the
SBU.
Product Life Cycle (PLC)
Stage 1: Introduction
Profits are negative
Promotion of the product(Heavy expenditure on promotional activities
resulting in low profits)
Heavy expenditure on R&D
Cash flow are negative
Stage 2: Growth
Profits are positive and are increasing
Advertising expenditure because of new competitors
Developing of Brands e.g. Buddie, Mango.Cashflows will be negative
because of brand building. If positive they are still low.
Stage 3: Maturity
Market growth rate has started to decline
Rebranding activities/brand transfer; Buddie to Libertie; Mazoe orange
crush to raspberry, Granadilla.
Large companies who have survived
Large market share
Growth rate of market stabilized
Cash flows now positive, now exploiting the characteristic of your brand
T.J Mabvure (Mr.)
Stage 4: Decline
Cash flows now negative
Growth opportunities now small
Divesting from Subs e.g. Harvesting SBUs like gold mining where gold has
run out.Kamativi tin mine was divested long ago because of the increase
in plastic.
Boston Consultant Group
SBU
Star
SBU
Question Mark
High relative market share in a
Low relative market share in a
high growth market
high growth market
2.Growth
1.Introduction
Dividend payments low
Dividends nil
Listing or private placement
Equity financeventure capital
Option based borrowing
Gearing nil
PE ratio high
P/E ratio high
Operating risk high
Operating risk high, financial
Gearing low
risk
low
SBU
SBU
Dog
Cash Cow
High relative market share in a
Low relative market share in a
low growth market
low growth market
3.Maturity
4.Decline
Dividend high because of
positive
Cash flows
Net cash flows high
Rights issues
Operating risk now low
P/E ratio now low
Introductory stage
Net cash flows will be negative or very low because revenues are still
low and there are outflows in concept development
T.J Mabvure (Mr.)
Dividends are nil because profits still low and cash flows are negative.
Retention ratio is 100% in order to gain market share in the growing
market.
P/E ratio will be very high. Market perception that the company will do
well in the future are very high. Price per share relative to earnings per
share is high.
Total return(Dividend yield plus capital gain yield)
The investors are the promoters of the product concept and they are the
sponsors. The investors are venture capitalists using venture capital
(venture capitalists have different portfolios in different SBUs, i.e invest
in a controlling stake. They will be looking for capital gains and not
dividends. They sell their equity holdings as soon as the company grows
they pull out. Angel capitalists are an alternative to venture capitalists.
Financing structure will be all equity finance. Therefore the gearing
ratio will be Nill.The Company can not sustain loan obligations as they
come due.
Operating risk (business risk) will be very high so the required rate of
return by debt holders will be high and can not be sustained. Total
risk=Operating risk+Financail risk), so financial risk has to be maintained
at low levels.
Growth Stage
Still fighting competitors if the barriers to entry are very low. In the
telecoms industry POTRAZ and BAZ for broadcasting have artificially
raised the barriers.
Net cash flows are still low because of the heavy expenditures
incorporated in strengthening the brand, e.g netone, telecell, and
econet.
Dividends payments are very low
P/E ratio still very high
Capital gains being sought for, other than dividends
Gearing lo because at this stage the business risk is still relatively high,
thats why there is need for reducing financial risk by reducing
borrowings
Equity financing but changed from venture because the company will be
listed to facilitate a new share issue (IPO) for expansion of the company.
Equity is now shareholders equity and the venture capitalists will pull
out. At listing there will be a price which will determine the price at
which the venture will sell their share. Private placements (approaching
institutional investors such as the MIPF, PTC, NSSA, OLD MUTUAL, etc)
would also be considered when the company does not want to list.
Option based financing; financing with imbedded options such as
convertible debentures, convertible bonds will be considered. This are
issued at a lower cost than plain vanilla bonds. These will be converted
after a period of time agreeable. The option to convert is not obligatory,
Decline
Divesting/harvesting
Zero opportunities
Total dividend, that is 100% payout
Not able to increase borrowings because the required rate of return will
be high. If the company increase borrowings and the company is wound
up the share of the debt holders will increase in the company. Therefore
the debt/equity ratio has to be decreased.
The company will grow(g) at the same rate as the growth of the
economy
APPROACHES TO VALUATION
The purpose is to arrive at the value of the company using its fundamentals,
which is the value of its assets. There are three approaches to valuation.
1. Discounted cash flow Valuation
1. Value of equityspecifically the price per share(P0)
2. Value of the firm
The value of an asset is the present value of the expected future
cashflows, discounted at the required rate or return that reflects
the risk ness of these expected cash flows.
n
Value=
t =1
CFt
(1 + ke)t
Value of equity=
t =1
CFEt
(i + ke)t
9
Value of firm=
t =1
CFFt
(1 + WACC )t
Applicability
10
11
a) Free cash flows for and unleveled firm: An unleveled firm has no
debt in its capital structure, therefore there are no interest and
principal Repayments, it finances all capital expenditures and
working capital needs with equity therefore the free cash flow to
equity will be as follows:
Gross Profit
Operating Expenses
EBITDA
Depreciation and Amortization
EBIT
Taxes
Net Income
Depreciation and Amortisation
Cash flow from operations
Capital Expenditure (CAPEX)
Changes in Working capital
Free cash flow to Equity (FCFE)
xxx
(xx)
xxx
(xx)
xxx
(xx)
xxx
xxx
xxx
(xx)
(xx)
xxx
12
The FCFE is the residual cash flow after meeting all the firms
financial needs; it can be negative in which case the firm must
raise new equity. If its positive it could but is not always paid out
as dividends to equity investors.
When we reach net income the amount w eventually deduct for
dividends has to take into consideration the CAPEX, and the
change in working capital.
Depreciation and amortization are treated as tax deductible
expenses in the income statement but they are noncash expenses
and therefore they should be added back.
Equity investors can not withdraw the entire cash flow from
operations from the firms since some or all of it will have to be
reinvested to maintain existing assets and to create new assets
to generate future growth.
Funds tied up in working capital cant be used elsewhere in the
firm therefore increases in working capital are cash outflows and
decreases are cash inflows(specifically noncash working capital)
Net Income
Depreciation
Funds from operations
CAPEX
WC
FCFE
2009($m)
100
40
140
(80)
(40)
20
2010($m)
20
45
65
(20)
(10)
35
The drop in the CAPEX and WC in 2005 resulted in increased FCFE through the
net income was much lower.
b) FCFE For a levered firm
In addition to making all of the outlays that an unleveled firm must
make the levered firm must also generate cash flows to cover
interest expenses plus principal repayments. It can also finance some
of its capital expenditures and working capital needs with debt
thereby reducing the equity investments needed.
Gross Profit
Operating Expenses
EBITDA
Depreciation and Amortisation
EBIT
Interest
T.J Mabvure (Mr.)
13
xxx
(xx)
xxx
(xx)
xxx
(xx)
EBT
Taxes
Net Income
Depreciation and Amortisation
Cash flow from operating Activities
CAPEX
WC
Principal Repayments (debt repayments)
Proceeds from new debt issues
FCFE
xxx
(xx)
xxx
xxx
xxx
(xx)
(xx)
(xx)
xxx
xxx
Net income
Depreciation
CAPEX
WC (2008=10)
Sales
2009(Reported)
$
250
50
150
25
1000
14
2010(Projected)
$
400
75
300
1500
25
* 100 = 2.5%
1000
WC (2010) =2.5%*1500=$37.5million
Net income
 (CAPEXDep)
FCFE
2009
250
(75)
(11.25)
163.75
2010(Projected)
400
(168.75)
(9.38)
221.87
The FCFE will increase as the amount of debt used by the firm increases,
that is the FCFE is an increasing function ofd.
Suppose we increase the debt ratio to 40%, the FCFE will be high.
d=40%
Net income
 (CapexDepn) (1d)
 (WC) (1d)
FCFE
2009
250
(60)
(9)
181.00
2010
400
(135)
(7.5)
257.50
ii) A levered firm with a debt ratio below the optimal level
A levered firm that is operating at a debt ratio below its desired level
can afford to use more debt in financing its capital expenditures and
working capital needs until it reaches the target debt ratio(optimal
level) and the FCFE for such a firm will be as follows.
Net Income
Depreciation and Amortisation
Cash flow from operations
T.J Mabvure (Mr.)
15
xxx
xxx
xxx
CAPEX
WC
Principal Repayments
Proceeds from new debt issues
FCFE
(xx)
(xx)
(xx)
xxx
xxx
If the firm decides to increase its leverage towards its targeted levels
then the proceeds from new debt issues would be greater than the
principal repayments plus the CAPEX and WC needs.
Can not use the short cut method because debt levels not optimal
Proceeds from new debt>Principal repayments+d (CAPEX+ WC)
During the period when the firm is financing its investment needs
disproportionately with debt, the FCFE for such a firm would exceed
that of a firm which does not have such financing slack. A firm with
financial slack will have more FCFE than a firm with no financial
slack.
The principal repayments are still financed with new debt issues
therefore dont affect the FCFE.
Suppose the company has reported the following:
2009(Reported)
$
Net Income
900
CAPEX
400
Depreciation
80
WC
50
Debt(mkt value)
250
Principal repayments70
Equity(mkt value) 800
2010(Projected)
$
1500
600
100
55
70

d=
250
* 100 =24%
800 + 250
1500
16
Depreciation
Cash flow from operations
WC
Principal Repayments
Proceeds from new debt issues
Capex
FCFE
100
1600
(55)
(70)
463
(600)
1338
xxx
xxx
xxx
(xx)
(xx)
(xx)
xxx
xxx
17
2009(Reported)
400
120
20
50
55
450
1200
90
355
2010(Projected)
850
240
20
60
70
740
450
* 100 = 27.27%
450 + 1200
Calculate the current FCFE and the projected FCFE for 2010.
Proceeds from new debt issues=Principal repayments+d(CAPEX+ WC)
=20+0.4(240+60)
=140
Net income
Depreciation
Cash flow from operations
CAPEX
WC
Principal repayments
Proceeds from new debt issues
FCFE
18
2009
2010
400
55
455
(120)
(50)
(20)
90
355
850
70
920
(240)
(60)
(20)
140
740
2010
Net income
CAPEX
Depreciation
WC
Mkt value of debt
Mkt value of equity
Principal repayments
New Debt issues
18500
3600
2950
1850
7500

d=
14000
1750
1900
1400
40000
45000
5000
10000
40000
* 100 = 47.1%
45000 + 40000
The company plans to reduce its debt ratio from 47% to 25% by 2012,
to achieve this only the short term debt which is currently standing
at $10000 will be refinanced. All CAPEX and any increases in WC
needs would be financed primarily with equity that is 90% and 10%
debt. Long term debt outstanding would be repaid with cash flows
from equity.
Calculate the FCFE for 2009 and the projections for 2010.
Proceeds from new debt issues=New debt issues+0.10(3600+1800)=10540
For 2010 the 10000 which the company had in 2009 will be refinanced
and raise 10% in the proportion of CAPEX and WC.
Net income
Depreciation
Cash flow from operations
CAPEX
WC
Principal repayments
New debt issues
FCFE
2009
2010
14000
1900
15900
(1750)
(1400)
(5000)
10000
17750
18500
2950
21400
(3600)
(1800)
(7500)
10540
19090
19
Free cash flows to the Firm (FCFF)=FCFE+Interest expenses(1T)+Principal repayments+New debt issues+Preferred Dividends
Another approach will give the same result is where we start with
Operating earnings.
EBIT(1T)[Pretax EBIT]
+Depreciation
CAPEX
 WC
=FCFF
Suppose we have the following information.
EBIT
Depreciation
CAPEX
Tax rate
2009
2010
5000
200
3250
40%
10500
350
4500
40%
2009
2010
3000
200
(3250)
(1300)
6300
350
(4500)
(2500)
20
FCFF
1350
(350)
In the formula,P0=
21
average.
Year
EPS
$
0.66
0.90
0.91
1.27
1.13
1.27
2000
2001
2002
2003
2004
2005
%
36.36
1.11
39.56
11.02
12.39
Arithmetic mean=
g= 5
1.27
1 = 13.99%
0.66
1
1.27 5
or geometric mean=
1 = 13.99%
0.66
Estimating Issues
The first problem is that the EPS must grow at the same rate as the
DPS.
The growth rate is sensitive to the starting and ending period for the
estimation, for e.g. the growth rate in earnings over the past five
years will be different from the growth rate over the past 6 years but
the length of the estimation period is subject to the judgment of the
analyst for e.g. if 1999 had EPS of $0.65 then the arithmetic average
will be 13.32% and the geometric mean will be 11.81%.
2) Using the fundamentals reported in the current year: what are the
determinants of earnings growth?
The growth rate in earnings is determined by the decisions that
the firm makes with regards to product lines, profit
margins,leverage,and dividend policy.
The retention ratio and the Return on Equity(ROE)
NetIncome
The ROE=
BookValueofEquity
NI NI t 1
gt = t
NI t 1
NIt =Net income for this year
NIt1 =Net income for last year
gt =Growth rate in the net income
T.J Mabvure (Mr.)
22
ROE=
NetIncome
BookValueofEquity
Therefore
= $15600
= $4200
= 60%
ROE
=
=
Suppose
increase
T.J Mabvure (Mr.)
4200
* 100 = 27%
15600
60*0.27
16.15%
that in 2009 we had projected that the ROE will
to 30% from the current 27%. The retention ratio will
23
15600(0.30 0.27 )
+ 0.6 * 0.30 = 29%
4200
D/E=
EBIT (1 T )
BVA
BVD
BVE
InterestExpenses
i=
BVD
T=Tax rate
BVA=BVD+BVE
Interest expenses are those found in the income statement.
Using this expanded version of the ROE the growth rate in earnings:
g=b*[ROA+D/E (ROAi)(1T)]
24
A firm with an ageing product line mix may look healthy in terms of
historical growth and current profitability, but it is not likely to sustain
this growth into the future. The analysis of growth for a firm can be
made more complete by looking at its individual products line and
examining where they stand in terms of the PLC.
The growth rate across product lines can then be estimated using the
following relationship:
gjt=b*[Mjt*TjtD/E(Mjti(1T)]
Where
Now to ke
Ke=Rf+(RmRf)
CAPM
Rf=Risk free rate which can be the Treasury bill rate as a proxy for the
risk free rate, normally its the money market rate.
Rm =Average return on the market index, ie Holdings Period Return
(HPR) on the index.
Rm=HPR=
M 2 M1
M1
25
The beta coefficient measures the risk of the asset in relation to the
market. The volatility of the return on the assets in relation to return on
the security.
if an asset has a =1.2,it means that if the return on the market increases
by 10% then the expected return on the security will increase by 10*1.2=12.
if the market is bullish you hold an offensive security. If the market
sentiments are bearish you hold a defensive security.
To estimate the we regress the excess returns on the security against the
excess returns on the market.
Diagram
Firm
Barclays
CBZ
NMB
Average
Beta
1.20
0.90
1.40
1.17
D/E
0.40
0.25
0.42
0.36
What is the beta for stanbic whose debt ratio is 30% and is not listed
The beta of a levered firm L:
L =U[1+(1t)(D/E)]
U= for an unlevered firm
L
U =
I + (1 T )(D / E )
Then calculate the unlevered betas of the firms; we want to remove the
leverage effect from the companys. Assuming that tax rate is 40%.
T.J Mabvure (Mr.)
26
U =
1.17
I + (1 0.40 )(0.36 )
L =0.96[1+(0.6)(0.30)]
=1.13
Therefore the for stanbic is 1.13
The formula has now taken into effect the 30% leverage of stanbic.
Valuation of companies
Valuation of Equity
i.Valuation using the stable growth model
ii.Two stage model
iii.Three stage model
We are canceling out the decline stage
In the stable phase the company is growing but the growth is stable
Opportunities for expansion are no longer there
The growth rate is now equivalent to that of the economy is identical to
normal growth rate
T.J Mabvure (Mr.)
27
FCFE1
Ke g n
Where gn=stable growth rate which is expected to be maintained in
perpetuity
This assumption is suitable for a firm that is large for a firm that is large
In size (because it has gained relative market share in that industry) but is
not likely to grow much faster than the economy in the long term because
there are no more growth opportunities in that industry.
It generates large cash flows, which means that it will pay out much less
dividends than its generating in FCFE, because of this the financial
leverage will be higher but stable.
Free cash flows large thats why its called a cash cow.
Free cash flows also used to pay dividends as well as support other SBUs.
P0=
EPS
CAPEX per share
Depreciation per share
WC
Debt ratio
28
EPS(CAPEXDepreciation)(1d)( WC)(1d)
FCFE =3.15(3.152.78)(10.25)0.50(10.25)
=2.4975
FCFE1
Ke g
FCFE (1 + g )
=
Ke g
2.4975(1.06 )
=
0.1245 0.06
=$41
P0=
FCFE n +1
Ken g n
FCFE 4
P3=
Ken g n
Pn =
PV of P3=
P3
(1 + Ke)3
29
15
40
5
1.50
The following estimates have been made for the high growth period:
Length of period
Return on Equity
Retention ratio
4 years
22%
95%
The company pays very low dividends because its shareholders are more
interested in capital gains.
g=b*ROE=0.95*22=20.9%
the following market parameters will apply during this period:
TB rate
Average return on the market
coefficient
15%
27%
1.8
Ke = Rf+(RmRf)
= 15+(2715)
= 36.6%
CAPEX, Depreciation and revenues are expected to grow at the same
rate as earnings
The WC is expected to be 20% of revenues. The debt ratio which is
considered to be optimum at this stage will be 5%.
30
Question
Estimate the value per share. The assumption is that the debt ratio is at its
optimal level
Three stage model
The company is still at the introduction stage and wants to move through other
stages,ie to grow and then mature.
31
P0=
n2
FCFEt
FCFEt
t n1
n1n2
n1
n1
n2
Pn2
(1+ Ke ) (1+ Ke )
n2 n1
n2
n1
n2
CAPEX VS Depreciation
Its reasonable to assume that as a firm goes from high growth to stable
growth the relationship between CAPEX and depreciation will change. In the
high growth stage CAPEX is likely to be much higher than depreciation.
In the high growth stage CAPEX is likely to be much higher than depreciation,
because we are buying new assets and depreciation, that is wearing and tear
is minimal.
In the transition stage the difference is likely to narrow down and in the
stable phase they are likely to be equal
32
30
40
10
100
20%
33
FCFF1
WACC g n
EBIT
Capex
Depreciation
Revenues
WC as a % of Revenues was
Tax rate
Tax rate
TB rate
Rm
34
The firm is approaching a high growth phase which will last for 4 years
after which earnings will stabilize.
Expected growth rate for operating earnings (EBIT) during the high growth
phase will be 20% p.a
will be 1.5
The other market parameters will remain the same.
The WC as a % of revenue
25%
The pretax cost of debt
20%
The debt ratio(D/E)
50%
This high level of leverage is targeting the resulting of a leveraged buyout
in the last 2 years.
Its anticipated that this high debt ratio will be reduced gradually over the
next 4 years to acceptable levels.
Capex,revenues and depreciation will grow at 20%
Inputs for the stable growth phase
Expected growth rate in earnings
throughout the period
Pretax cost of debt
Debt ratio(D/E)
CAPEX will be offset by depreciation
WC as a % of revenue
Revenues will grow at
10%
0.9
8%
25%
30%
10%
400
550
300
10% of Revenues
40% for all periods
35
4 years
40%
30%
12%
WC
10% of Revenues
Transition Period
Length of Period
3 years
Growth rate of EBIT and Revenue will decline linearly from 40% in year 4 to 10%
in year 7
Capex will grow at
20%
Depreciation will grow at
15%
will drop from 1.8 in Y4 to 1.20 in Yr7 linearly
WC=10% of revenue
Debt ratio
10%
Pretax cost of debt
10%
Stable Period
Growth rate in EBIT and Revenues
Pretax cost of debt
Capex and Depreciation will cancel each other
=1.00, Debt ratio
WC=10% of Revenues
5%
15%
36
We know that P E =
Therefore P E =
P0
EPS 0
P0
(PayoutRatio )(1 + g )
=
EPS 0 (1 + g )
Ke gn
37
b) Risk ness of the firms cash flows as reflected by the beta of the
company in the cost of equity(Ke)
c) Dividend payout ratio.
E.g. A firm had EPS of $250 in 2009 and paid out a dividend of $120. The
growth rate in earnings and dividends in the long term (stable state) is
expected to be 10%. The market parameters are as follows: RF=20%, Rm=25%,
=1.2
Calculate the P/E today based on these fundamentals.
Ke=26%
120
= 0.48
250
P0
(PayoutRatio )(1 + g ) = 0.48(1.10) = 3.30Times
P/E =
=
EPS 0
Ke gn
0.26 0.10
Payout ratio=
If the actual P/E at the time of the analysis was say 10.5. the low P/E of 3.3
is an indication that the firm was not paying out what it could afford as
dividends.
If the firm is paying out significantly less dividends than it can afford we can
use FCFE in stead of DPS to calculate P/E.
E.g. A company has EPS of $400 and paid no dividends. The following market
parameters apply, RF=20%, Rm=20%, =0.9. The expected growth rate in
earnings was 10% and the FCFE per share was 350.
The P/E ratio based on these fundamentals will be:
Ke=24.5%
Payout =
FCFE 350
=
= 0.875
EPS
400
FCFE
is the free cash flow payout ratio, as an equivalent of the dividend
EPS
payout ratio.
P E=
0.88(1.10)
= 6068
0.245 0.10
The firm didnt payout dividends,ie we are saying what will be the P/E if we
use FCFlows rather than the dividends that are giving a 3.0 value.
T.J Mabvure (Mr.)
38
If the company was selling at a P/E of $10.5, then dividends alone cant be
blamed for the low valuation.
The low value of the firm is not sorely to do with dividends. The firm is over
valued by the market yet the fundamentals are lowly valuing the firm.
E.g. a company has EPS of $40 and paid out a dividend of $12.50/share. The
growth rate in earnings and dividends is expected to be 10%. The =0.9,
TB=15%, Rm=22%. Calculate the P/E ratio based on these fundamentals.
Ke=21.3%
Dividend payout ratio=
12.50
= 0.3125
40
g=10%
P E=
0.315(1.10)
= 3.05Times
0.213 0.10
E.g. A Company is currently selling at a P/E ratio of 6.00. The company had EPS
of $60 and paid out dividends of $22/share. The FCFE was $30 per share.
Expected growth rate in earnings is 10%. RF=15%, Rm=22%, =0.9. Comment on
the value of the company.
Ke=21.3%
Dividend payout=
22
= 0367
60
g=10%
P E=
0.367(1.10 )
= 3.57Times
0.213 0.10
FCF payout=
30
= 0 .5
60
g=10%
P E=
0.5(1.10 )
0.213 0.10
39
The company is paying out less dividends than what the market is expecting.
Comment
The market is overvaluing the company because the company is paying less
dividends than what the market is expecting and the market is anticipating
higher cash flows than what is being generated and at the same time the
market is understating the risk of the cash flows or the risk ness of the firm.
Comparing the P/E ratio with other P/Es
P/Es across countries(markets)
P/Es across time
P/Es across firms
SEE ASWATH DAMODARAN
P/E Ratio for a High Growth Firm
Valuation for high growth; two stage model
P0 =
t =1
Pn =
FCFE
+ PVofTer min alValue
(1 + Ke)
FCFE n +1
= Ter min alValue
Ken gn
The P/E ratio for a high growth firm can also be related to the fundamentals
in the case of the two stage model.
n
(
1+ g)
PayoutRatio(1 + g )1
(1 + Ke )n PayoutRation (1 + g )n (1 + gn )
P0
P E=
=
+
EPS 0
Ke g
(Ke gn )(1 + Ke)n
EPS0
g
Ke
gn
period)
Payout ratio
Payout ration
Ken
n
40
1) The payout ratio during the high growth phase and the stable period, the
P/E ratio increases as the payout ratio increases.
2) The riskiness of the firm through the discount rate Ke. The higher the risk
the lower the P/E.
3) The expected growth rate in earnings in both the high growth and stable
periods. The higher the growth rate, the higher the P/E. If the firm is not
paying dividends we use the ratio of the free cash flow to equity to EPS
instead of the dividend payout ratio.
E.g. A firm is expecting a five year period of high growth after which the
growth rate will normalize in line with the growth rate of the economy.
The following data pertains to the high growth period:
Expected ROE
20%
Expected payout ratio
25%
Therefore growth rate in the high growth period will be:
g=b*ROE=0.20(10.25) =0.15=15%
Rm
Rf
1.5
20%
15%
Ke=22.5%
Stable growth period
Expected growth rate
Expected ROE
Rf
Rm
5%
15%
1.1
15%
20%
g
0.05
= 1
= 0.667
ROE
0.15
Ke=20.5%
41
(1 + g )n
Payout (1 + g )1
(1 + Ke)n Payout n (1 + g )n (1 + g n )
P E=
+
Ke gn
(Ke gn )(1 + Ke )n
5
1.15)
(
(0.25)(1.15)1
=
+
=
+
= 4.35
5
0.225 .15
(0.205 0.05)(1.225) 0.225 0.15 0.44
E.g. A firm is expected to have five years of high growth after which it will be
in a steady state. Inputs for the high growth period
Expected ROE
Expected payout ratio
Rm
Rf
22%
25%
1.8
22%
15%
Stable period
Expected growth rate
Rf
Rm
Expected ROE
6%
0.75
15%
22%
15%
42
2. Price to book value ratios can be compared across similar firms for
signs of under or overvaluation, even firms with negative earnings
which cant be overvalued using the PBV ratios.
Disadvantages of using PBV ratios
Book values like earnings are affected by accounting decisions on
depreciation and other variables (accounting can manipulate the book
by either increasing or decreasing depreciation).
When accounting standards vary widely across firms(some companies
may not be consolidating the earnings of their subsidiaries; stock
valuation methods such as FIFO, LIFO, AVCO, straight line, and reduced
balance method may be in use in different companies).
Book values may not carry much meaning for service firms that dont
have significant fixed assets (e.g. insurance companies; most of the
assets are in investments a.w.a real estate).
PBV for a stable firm
DPS1
P0 =
Ken g n
Substituting EPS0 (Payout) (1+g) for DPS1
EPS 0 (Payout )(1 + g )
Ken gn
EPS 0
ROE =
BVE
EPS 0 = ROE * BVE
P0 =
43
P0
ROE * Payout
=
BVE1
Ken g n
This indicates that the PBV ratio is on increasing function of the ROE, the
payout ratio and the growth rate of earnings. It is an increasing function of
the risk ness of the firm as indicated by in Ke.
P0
ROE * Payout
= PBV1 =
BVE1
Ken g n
g=b*ROE
=ROE (1Payout)
Relating g to the ROE.
g = ROE*b
=ROE (1Payout)
=ROEROE (Payout)
g+ROEPay=ROE
ROE*Payout=ROEg
ROE*Pay is identical to ROEg
P0
ROE g
=
BVE Ken gn
A firm had EPS of $600 in 2009 and paid 40% of its earnings as dividends that
year, the growing rate of earnings and dividends in the long term is expected
to be 10%. The ROE for the firm is 20%. The following parameters apply:
=0.9,
Rm =20%,
Rf =15%
Therefore Ke =19.5%
Qn. what is the PBV a) Today
not paying dividends
44
PBV 1 =
P0
ROE g
=
BVE1
Ke g
P0
ROE * Payout (1 + g )
= PBV0 =
= PBVToday
BVE0
Ke g
P0
ROE * Payout
= PBV1 =
PBV based on expected earning next year
BVE1
Ke g
P0
ROE g
=
BVE1
Ke g
ROE * Payout
(0.20 )(0.4) = 0.84
=
Ke g
0.195 0.10
P0
ROE g
0.20 0.10
=
=
= 1.05
BVE1
Ke g
0.195 0.10
45
Overvalued
Correctly valued
undervalued
Correctly valued
Therefore P0 =
NetIncome
Sales
PM =
EPS 0
SalesPerShare
46
Substituting:
P0 =
If the profit margin is based on expected earnings next year we can rewrite
P0
PM (Payout )
this as follows:
=
Sales (1 + g )
Ke g
P0
PM (Payout )
=
Sales1
Ken g n
The price to sales ratio is an increasing function of the profit margin, the
payout ratio and the growth rate in earnings and dividends. It is a decreasing
function of the risk ness of the firm as reflected in the Ke(Required rate of
return).
After calculation you have to relate your answer to these fundamentals as
said above.
QN. A Company has revenues/share of $100 in 2009 and EPS of $5. It paid out
60% of its earnings as dividends. The growth rate in earnings and dividends in
the longterm is expected to be 5%, =0.9, Rf=15%, Rm=20%. Calculate the
current price to sales ratio based on these fundamentals and also the Price to
sales ratio based on expected earnings next year.
These must be compared to the market price to sales multiples.
Suppose the company was trading on a price to sales of 0.3 then we would
conclude that its overvalued according to the fundamentals.
47
Firms involved in businesses that have high margins can expect to sale for
much higher PS multiples (they will be trading on higher PS than the market).
A decline in PM has two effects.
1. reduction in PS Margin
2. reduction in the growth rate of earnings
We can use the ratio between the sales per share to book value of equity to
link the profit margin to the expected growth rate.
g=b*ROE
Since ROE=
NI
Sales
*
Sales BVE
NI
Sales
*
Sales BVE
g = b * PM *
Sales
BVE
=
t =1
Dt
Pn
+
t
(1 + Ke ) (1 + Ke )n
Where Pn =
Dn +1
Ken g n
48
(
1+ g)
EPS 0 * Payout (1 + g )1
(1 + Ke )n EPS 0 * Payout n (1 + g )n (1 + g n )
P0 =
+
Ke g
(Ken g n )(1 + Ke )n
But EPS0=Sales*PM
Therefore PM =
EPS 0
Sales
(1 + g )n
(
)
Payout
1
g
1
+
n
(1 + Ke) Payout n (1 + g )n (1 + g n )
P0
PS=
= PM
+
Sales
Ke g
(Ken gn )(1 + Ke )n
Rm
Rf
5 years
25%
10%
5%
1.2
30%
25%
49
Stable period
During the stable period the profit margins will be maintained at
Expected growth rate in earnings
Payout ratio
Rm
Rf
10%
5%
60%
1.0
30%
25%
= 31%
=5%
=60%
=30%
(1 + g )n
Payout (1 + g )1
n
n
(1 + Ke ) Payout n (1 + g ) (1 + g n )
PS = PM
+
Ke g
(Ken g n )(1 + Ke)n
(1.25)5
0.05(1.25)1
= 0.10
+
= 0.10[0.21768 + 1.99339] = 0.2211
5
0.31 0.25
(
0.3 0.05)(1.31)
Growth rate
We can use the following relationship to compare difference competitive
strategies which are:
High margin (product differentiation), low margin high volume (cost
leadership).
50
Sales
BVE
A firm is considering these two strategies:
g=b*PM*
PM
Sales/BE
The firm is expected to payout 20% of its earnings as dividends after that.
The growth rate in earnings after two years is expected to be 10% p.a in
perpetuity.
The book value of equity per share is currently $10,=1.5, Rm=30%,Rf=25%.
Ke=32.5%.
In the stable period the will decrease to 1.0, and other parameters will remain
the same. Ke=30%.
To compare these strategies we have to look at PS multiple in each case.
Typical Examination
A company has sales per share of $6.50 with earnings of $125 per share. The
book value of equity was $420 per share. The company paid 20% of its earnings as
dividends. Based on these results calculate the profit margin. The sales to book
value, the retention ratio and the growth rate in earnings. Its envisaged that the
current period is a high growth period which will last for 2 years. During this
period =1.2, Rf=25%, Rm=30%.
After the high growth period the growth rate will stabilize to 10% p.a and the
dividend payout ratio will be increased to 60%. The will drop to 1.0 and the
other parameters will remain in the same.
51
Ken=30%
n=2
g=23.80
gn=10%
Ke=31%
Ken=30
Payout=20%
Payoutn=60%
(1.2380 )2
0.20 * (1.2380 )1
PS = 0.192
+
= 0.192
= 0.647
2
0.31 0.2380
2.947
(
0.30 0.1)(1.31)
Second scenario
Suppose that the company cuts the profit margin to 10% all other things being
equal. Calculate the PS multiple. Will this be a wise move?
SHORT TERM FINANCIAL STRATEGY
This is all about planning. Planning looks at forecast (prediction of whats
going to happen).
Forecast about sales levels in the future, WC requirements, profit, financing
mix (debt to equity); short term to long term.
Forecasting
Income statementprojected income statement and balance sheet. We would
be basing on the income statement this year and then predict for the next 5
years.
The starting point for an income statement is the sales projections e.g. by
10%.
The projected increase in sales has to be financed. The firm needs extra WC
and Fixed assets.
The increase in WC and fixed assets must be financed
Projected assets to support the increase in sales.
The Fixed assets and WC also depends on whether we are operating at full
capacity of below capacity. The former means there is need for increase in
financing and the latter means there is no need.
52
Sales
Operating expenses
Operating earnings (EBIT)
Interest
EBT (NI)
Tax (40%)
Net income
Preferred dividends
Net income to ordinary
Dividend to ordinary
Retained earnings
Actual
$
3000
(2716)
284
(88)
196
(78)
118
(4)
114
(58)
56
Forecast
$
3300
(2988)
312
(88)
224
(90)
134
(4)
130
(63)
67
The constant ratio method assumes that all expenses will increase at the
same rate as sales.
53
Balance Sheet
Cash
Accounts receivables
Inventory
Current assets
Plant and equipment
Accounts payables
Notes payable
Accruals
Long term loan
Preferred equity
Ordinary share capital
Retained earnings
Equity and liabilities
Actual
$
10
375
615
1000
1000
2000
60
110
140
754
1064
40
130
766
2000
Projected
$
11
412
677
1100
1100
2200
66
110
154
754
1084
40
130
833(766+67)
2088
Debt obligations that have nothing to do with sales will not increase when
sales increase.
After calculating the projected balance sheet we would have spontaneous
increase in terms of accounts payable and accruals.
Additional funds needed (AFN) =22002088=112.
This is the financing gap which needs to be covered by external sources.
The company requires 200m of new assets to support the projected sales
level which is 3300. if the existing capital structure is regarded to be optimal
then the additional funds of $112 must be raised by borrowing from the bank
as notes payable, issuing long term loans(bonds) and selling new ordinary
shares.
Raising additional funds needed.
The financing mix will be determined by the target capital structure,
conditions in the debt and equity markets as well as restrictions imposed by
T.J Mabvure (Mr.)
54
existing debt agreements (the company may have borrowed too much
already).
Assuming that the following financial mix is adopted.
Type of financing
Notes payable
Long term loans
Ordinary share
%
25
25
50
Amount
28
28
56
Cost(%)
8 interest
10 interest
On the notes payable we are paying 8% and on the long term 10% interest.
What this means is that there is going to be financing feedbacks which
require that we draw a new forecast, i.e. draft a new one.
The external funds raised to pay for the new assets create additional
expenses which must be reflected in the income statements.
This reduces the initially forecasted additions to retained earnings.
Financing feedbacks
a) Additional interest.
i) Short term debts(notes),i.e. 0.08*$28=$2.24
ii) Longterm debt
0.10*$28=2.80
$5.07m
b) Additional dividend.
Assuming that current share price is $23 and new share can be issued at
$56m
this price, therefore:
= 2.4millionShares
$23m
The dividend payout is projected to be $1.25 per share, therefore the
additional dividend payments will be: 2.4*1.25=$3m.
This means that the dividends to ordinary shareholders will now increase
to $66m(63+3).
The net effect of these financing feedbacks income by $7 million from
$68m to $61 million.
This reduces the projected retained income to $827m (766+61). This
results in a reduced financed gap of $7m that should be financed using the
mix of 25%,short term debt,25% long term debt,50% equity. It becomes a
vicious cycle.
After doing the feedbacks we have to now consider the restated income
statement and balance sheet.
Restated income statement
Sales
Costs
EBIT
Less interest (88+5)
EBT
T.J Mabvure (Mr.)
3300
2988(opp cost 2878 +dep 110)
312
(93)
219
55
Tax (40%)
Earnings to shareholders
Preferred dividends
Net income
Dividends
Retained income
(88)
131
(4)
127
(66)
61
( A * S ) (L * S ) MS1(1 div)
S
S
S=Actual changes in sales
A * S = These are assets that must increase is sales are to increase expressed
as a % of sales, i.e. the required dollar increase in assets per dollar
increase in sales.
= 2000 3000 = 0.667
T.J Mabvure (Mr.)
56
This means that for every $1 increase in sales, assets must increase by 67
cents.
Where A=Total assets
A*=assets that must increase
=A if the company is operating at full capacity.
L * S = Liabilities that increase spontaneously with sales as a % of sales,
i.e. the
Spontaneously generated financing per $1 in sales.
= (60+140)/3000=0.0667
This means that every $1 increase in sales generated $7 cents in
spontaneously financing.
L*=the liabilities that increase spontaneously
L=Total liabilities
L will always be greater than L* because other liabilities like long term
liabilities does not increase spontaneously.
S1= Sales (Total) projected for next year
=3300
Where S0=current sales=Current sales=3000
M=Profit margin (net profit margin)
NI
114
=
=
= 0.038
Sales 3000
58
d= dividendPayoutRatio =
= 0.5088
114
AFN = ( A * S )S (L * S )S MS1 (1 d )
= 200 20 62
= 118Million
=
=
112
7
119
57
iii) Profit margins and dividends payout ratios are constant; we may not be
necessarily true.
What is the relationship between growth and financial requirements?
The faster the growths rate in sales the greater the need for additional
financing.
If we apply the formula to differential growth rates.
Growth
sales
(10%)
O
3.21
10
20
rate
in in Sales
(300)
0
96
300
600
Forecasted Sales
AFN
2700
3000
3096
3300
3600
(230)
(56)
0
118
293
58
Internal expansion: The acquisition of long term assets over the years
gradually.
External expansion: Can be achieved through a takeover, which is acquiring
control of the shares and assets in another company. This is more complex
because it involves legal, tax, accounting and management issues.
Types of mergers
Horizontal, conglomerate, vertical:
When two firms in the same industry merge, its called a horizontal merger,
like two banks, WMMI, and Nissan and Clover Leaf motors.
A vertical merger is where either a firm expands towards a customer or
backwards towards the supplier. The former is the supply chain and the
latter is the distribution chain.
Conglomerate is where you expand along unrelated lines of business. The
purpose of this is to diversify away operating risk, like ZSR who now
concentrates away from sugar to Trador, Advance, Redstar.
Reasons sighted for merger
a.
The most sighted reasons are the possibilities of synergistic benefits arising
from the merger. Always expressed as
1+1=3 effect. That is Vxy>Vx+Vy,ie
the value of xy is greater than the value of x and y stand alone.
Reasons or other benefits are:
Economies of scale; as we increase the production the cost per unit
decreases.
Operating economies; as we increase the size of operations the benefits are
bound ti increase.
Managerial skills which are endowed with a certain company especially in
the highly technological engineering firms.
T.J Mabvure (Mr.)
59
Tax considerations; where a company has some tax assessed losses carried
over the years. The idea is to reduce the tax burden. In most of the cases
the company has to convince ZIMRA that the transaction was not for that
purpose.
Excess liquidity; the targeted company may have a strong liquidity position
e.g. retail organizations.
Diversification; new products and new markets
Reduced financial costs. The merger may result in reduced cost if the
company which is being targeted has a financial slack (excess borrowing
capacity).
Technology, acquisition that takes place in order to take/acquire the
technological expertise of the targeted company.
60