Question

Assume that you are an equity analyst and you have been asked to generate a twelve month forward price target for ShopSmart Plc, a retail company. You decide to use the discounted Free Cash Flow to Firm (FCFF) valuation model. For the year just ended you have collected the following information on ShopSmart PLC:

Net Income: £260 m

Sales: £2,600 m

Depreciation: £100 m

Investment in fixed capital: £180 m

Interest expense: £110 m

The working capital has increased from £55m at the beginning of the year to £95m at the yearend

Effective tax rate: 30%

Current market value of the outstanding debt: £1,800 m

Number of shares outstanding: 10 m

Current P/E (price-to-earnings): 25

The company’s target capital structure is 30% debt, and 70% equity.

Before-tax cost of debt: 6%

Risk free rate: 5%

Market risk premium: 5%

The stock’s beta: 1.3

You forecast that the FCFF and Net Income will grow at 7% per annum over the next three years. Due to uncertainty beyond this three-year forecast horizon, you decide to estimate the terminal value (at the forecast horizon) by using the sector’s historic-average EV/Sales (Enterprise Value-to-Sales) multiple of 4. You also forecast that future years’ net profit margin will remain constant, and will be equal to the margin of the year just ended.

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

Required: Generate the twelve month forward price target for ShopSmart Plc using the FCFF valuation approach, and state and justify your investment recommendation for the stock. Please show your workings.

Answer 1

NOTE: We have enough information to calculate the FCFF for the year just ended which is assumed to be the end of Year 0. In order to determine the one-year forward stock price, we need to determine the firm's intrinsic value at the end of Year 1. The firm's debt value needs to be subtracted from the intrinsic firm value to arrive at the firm's market value of equity. The market value of equity divided by the number of shares outstanding would give the one-year forward intrinsic stock price.

FCFF0 (at the end of Year 0) = 260 + 100 + 110 x (1-0.3) - 180 - (95-55) = 217 m Pound

Growth Rate of FCFF = 7% per annum

Therefore, FCFF1 = 217 x 1.07 = 232.19 m Pound. FCFF2 = 232.19 x 1.07 = 248.4433 m Pound, FCFF3 = 265.834331 m Pound

As the Net Profit Grows at 7% per annum and Net Profit Margin stays fixed at 10% per annum, the annual sales should also grow at a constant rate of 7% per annum for the next three years.

Sales 3 (at the end of Year 3) = 2600 x (1.07)^(3) = 3185.1118 m Pound

Terminal EV/Sales Ratio = 4

Therefore, Terminal Value = TV = 4 x 3185.1118 = 12740.4472 m Pound

Cost of Equity = ke = Risk-Free Rate + Beta x Market Risk Premium = 5 + 1,3 x 5 = 11.5 %

Cost of Debt = kd = (1-tax rate) x Before Tax Cost of Debt = (1-0.3) x 6 = 0.7 x 6 = 4,2 %

Debt Proportion = D = 0,3 and Equity Proportion = E = 0.7

WACC = 0.3 x 4,2 + 0.7 x 11.5 = 9.31 %

PV of TV at the end if Year 1 = 12740.4472 / (1.0931)^(2) = P1 = 10662.64337 m Pound

PV of FCFF2 and FCFF3 at the end of Year1 = P2 = 248.4433 / (1.0931) + 265.834331/(1.0931)^(2) = 449.7633861 m Pound

Total Intrinsic Firm Value = P1 + P2 = 10662.64337 + 449.7633861 = 11112.40676

Total Intrinsic Equity Value = 0.7 x 11112.40676 = 7778.684732 m Pound

Price per Share at end of Year 1 = P(T) = 7778.68732 / 10 = 777.87 Pound

Current PE Ratio = 25

EPS0 (Current year) = 260 / 10 = 26 Pound

EPS1 = (260 x 1.07) / 10 = 27.82 Pound

Assuming a constant PE Ratio of 25, Price per Share at the end of Year 1 = 25 x 27.82 = P(P) = 695.5 Pound

As the predicted price through PE multiples is lesser than the intrinic stock price( P(P) < P(T)) , the stock is fundamentally undervalued. Hence, the analyst should put a buy rating on the stock.