Question

A portfolio manager has recently taken a long position in XYZ Plc’s stocks, and wants to know whether this stock is still worth holding. She requests a sell-side analyst to provide an estimate of the stock’s twelve month forward price target. The analyst decides to use the Free Cash Flow to the Firm (FCFF) valuation model, and collects the following information for the year just ended:

Earnings: £130m

Sales: £1,300m

Depreciation: £50m

Investment in fixed capital: £90m

Interest expense: £55m

The working capital has increased from £35m at the beginning of the year to £55m at the year-end

Effective tax rate: 20%

Current market value of the outstanding debt: £900m

Number of shares outstanding: 10m

The company’s target capital structure is 35% debt and 65% equity.

Before-tax cost of debt: 6%

Risk free rate: 4.5%

Market risk premium: 7%

The stock’s beta: 1

The stock’s current P/E (price-to-earnings) multiple is 18

The analyst forecasts that the FCFF and Sales will grow at 8% per annum over the next three years. Due to uncertainty beyond this three-year forecast horizon, the analyst decides to estimate the terminal value (at the forecast horizon) by using the sector’s historic-average EV/Sales (Enterprise Value-to-Sales) multiple of 2.

Reminder of the FCFF formula: FCFF = Net Income + Net Noncash Charges + Interest Expense x (1- tax rate) – Fixed Capital Investment – Working Capital Investment

Required: Estimate the one year forward target price for this stock using the FCFF valuation approach, calculate the return that the portfolio manager would realise by holding the stock over the next twelve months and then selling it at the projected target price, and explain whether this represents a worthwhile investment. Please show your workings.

Answer 1

Tax Rate = 20%, Net Income = 130 m Pound, Depreciation, 50 m Pound, Interest Expense = 55 m Pound, Capital Expenditure = 90 m Pound, Increase in NWC = 20 m Pound

FCFF0 (FCFF at the end of Year 0 or current time) = 130 + 50 + 55 x (1-0.2) - 90 - (55-35) = 114 m Pound

FCFFs and Sales grow for three years at 8% per annum.

FCFF1 = 114 x 1.08 = 123.12 m Pound, FCFF2 = 123.12 x 1.08 = 132.9696 m Pound, FCFF3 = 132.9696 x 1.08 = 143.607168 m Pound

Target Capital Structure: Equity = 65% and Debt = 35 %

Cost of Equity = Risk-Free Rate + Beta x Market Risk Premium = 4.5 + 1 x 7 = 11.5 %

Cost of Debt = 6%

Target WACC = 6 x (1-0.2) x 0.35 + 11.5 x 0.65 = 9.155 %

Sales3 (Sales at the end of Year 3) = 1300 x (1.08)^(3) = 1637.6256 m Pound

Historic EV/Sales Ratio = 2

Therefore, Terminal Value (TV) at the end of Year 3 = 2 x 1637.6256 = 3275.2512 m Pound

Therefore, Intrinsic Firm Value = FCFF2 / 1.09155 + FCFF3 / (1.09155)^(2) + TV / (1.09155)^(2) = 132.9696 /(1.09155) + 143.607168/(1.09155)^(2) + 3275.2512/(1.09155)^(2) = 2991.23538 m Pound

As this is the expected future cash flows based intrinsic value which has been discounted at the target capital structure's WACC, one needs to assume that the intrinsic balance sheet (not market value balance sheet) is at the target capital structure.

Therefore, Equity Value = 65 % of Intrinsic Firm Value = 0.65 x 2991.23538 = 1944.303 m Pound

Number of Outstanding Shares = N = 10m

Intrinsic Stock Price = 1944.303 / 10 = 194.43 Pound

Current PE Ratio = 18, EPS0 (Current earnings per share) = 130 / 10 = 13 Pound

Current Stock Price = 18 x 13 = 234 Pounds

One-Year Forward Target Price = Intrinsic Stock Price (at t=1) = P(T) = 194.43 Pound

Return Generated = [(194.43 - 234) / 234] x 100 = - 16.91 %

As the investment generates a negative return over one year it is not worthwhile to go ahead with this investment.

NOTE: Having solved two other questions of similar type, I would like to present my views on the solution. Even though multiplying intrinsic firm value with the target capital structure to arrive at equity value is not the usual way of calculating equity value, the same is valid in this context because we are interested in calculating the firm's INTRINSIC Equity Value and NOT MARKET Equity Value. The intrinsic equity value is the value that the company's stock should possess as per the company's expected future cash flows. However, the stock's market value might be different from this value as not all stocks are fairly priced by the market (and intrinsic value is the fair value). Further, the usual method of subtracting Debt Market Value from Intrinsic Firm Value to arrive at Equity Value is valid only when it is assumed that the stock's market and intrinsic values are same, which is clearly not the case here. This is evident from the fact that the capital structure at t=0 or current time is different from that targeted. As capital structure changes and moves toward the target capital structure, the market value of debt too should change from its existing value of 900 m Pound. Hence, the same cannot be subtracted from the firm's intrinsic value at t=1 to arrive at the firm's then equity value. Instead it is assumed that the firm has already reached its target capital structure at t=1 year and the same can be used to determine its intrinsic equity value(not market equity value) .