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

FCFF0 (at current time or end of Year 0) = Net Income + Depreciation + Interest Expenses x (1-tax rate) - Fixed Capital Investments - Working Capital Investment = 130 + 50 + 55 x (1-0.2) -90 - 20 = 114m pounds

FCFF and Sales are expected to grow at an annual rate of 8% per annum for the next three years.

Therefore, FCFF1 = 114 x 1.08 = 123.12 pounds

FCFF2 = 114 x (1.08)^(2) = 132.9696 pounds

FCFF3 = 114 x (1.08)^(3) = 143.607168 pounds

Sales 3 (at the end of Year 3) = Sales 0 (Current Sales) x (1.08)^(3) = 1300 x (1.08)^(3) = 1637.6256 m pounds

EV/Sales Multiple = 2

Therefore, EV at end of Year 3 = EV3 = EV/Sales Multiple x Sales 3 = 2 x 1637.6256 = 3275.2512 m pounds

Risk Free Rate = Rf =4.5%, Market Risk Premium = RP = 7% and Beta = 1

Cost of Equity = ke = Rf + Beta x RP = 4.5 + 1 x 7 = 11.5%

Cost of Debt = kd =6 %

Target Capital Structure = 35% debt and 65% equity

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

Firm Value at end of Year 1 = FV1 = FCFF2 / (1+WACC)^(1) + FCFF3 / (1+WACC)^(2) + EV3 / (1+WACC)^(2) = 132.9696 / (1.09155)^(1) + 143.607168 / (1.09155)^(2) + 3275.2512 / (1.09155)^(2) = 2991.235388 m pounds

Equity Value at end of Year 1 = EV1 = 0.65 x FV1 = 0.65 x 2991.235388 = 1944.303002 m pounds  

Number of Shares Oustanding = N = 10 million

Therefore, target one year forward stock price = EV1 / N = 1944.303002 / 10 = 194.43 pounds per share