Question

CASE – 3: (Based on Ch-12: Company Analysis and Stock Valuation) –

You are planning to create a portfolio based on your learning of the ‘portfolio management and theory’ course. You are well aware of the risk and return aspects of various types of investible products such as stocks, bonds, commodities etc. Your objective is to maximize returns and wealth for the longer-term, therefore, you are interested in investing in stocks. Considering UAE as a growth-oriented economy, you decided to invest in UAE stock markets.

As you have gained some good understanding about the fundamental analysis of stocks and companies, you would like to do this fundamental analysis yourself. Spotting HypoReal as a real-estate company in the UAE, you gathered some relevant information in order to supplement your fundamental analysis.

Being a real estate company, HypoReal’s revenues and profits have shown a considerable growth in the past. The company’s free cash flows to equity (FCFE) at the end of the year 2019 was AED118 million, and it projected to grow in future at the rates given below. The number of shares outstanding remains 560 million.

Year Growth Rate

2020 6%

2021 10%

2022 16%

2023 20%

2024 16%

2025 12%

2026 9%

2027 7%

The company’s FCFE is expected to grow at a constant growth rate of 5% per annum from 2028 onwards. The company’s stock beta is 1.3. Supposing the end of 2019 market price of the stock AED4.00 per share, the equity risk premium of 6% while the risk-free rate is 3%.

Calculate (i) required rate of return on equity; (ii) the present value as of 2019 of FCFE during the period of increasing growth (that is for years 2020 to 2023); (iii) the present value as of 2019 of FCFE during the period of declining growth (that is for years 2024 to 2027); (iv) the present value as of 2019 of FCFE during the period of constant growth (that is for years 2028 onwards); and (v) the intrinsic value of the stock as of 2019. Suppose you were to make decision at the end of 2019 year, what would you have decided keeping in mind the so-calculated intrinsic price and the market price of end-2019? Critically evaluate your confidence in this type of fundamental valuation.

Answer 1

All financials are in AED million; number of shares are in million; share price is in AED

Let the year 2019 be year 0. Let Ci be the cash flows of year i.

Calculate (i) required rate of return on equity;

Ke = Rf + Beta x Rmp = 3% + 1.3 x 6% = 10.80%

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Let's work out all the cash flows, discount factor and the PV of cash flows. Please see the table below. Please be guided by the second row to understand the mathematics. The last column contains the PV of each year's cash flow.

Year	Period	Growth rate	FCFE	DF	PV
t	n = t - 2019	g	Ci	'=(1 + Ke)^(-n)	Ci x DF
2019	0		118.00
2020	1	6%	125.08	0.9025	112.89
2021	2	10%	137.59	0.8146	112.07
2022	3	16%	159.60	0.7352	117.33
2023	4	20%	191.52	0.6635	127.08
2024	5	16%	222.17	0.5988	133.04
2025	6	12%	248.83	0.5405	134.48
2026	7	9%	271.22	0.4878	132.30
2027	8	7%	290.21	0.4402	127.76

(ii) the present value as of 2019 of FCFE during the period of increasing growth (that is for years 2020 to 2023);

the present value as of 2019 of FCFE during the period of increasing growth (that is for years 2020 to 2023) = Sum of the PV from the last column for the first four years = 112.89 + 112.07 + 117.33 + 127.08 =  469.37

(iii) the present value as of 2019 of FCFE during the period of declining growth (that is for years 2024 to 2027);

the present value as of 2019 of FCFE during the period of declining growth (that is for years 2024 to 2027) = Sum of the PV from the last column for the last four years =  133.04 + 134.48 + 132.30 + 127.76 =  527.57

(iv) the present value as of 2019 of FCFE during the period of constant growth (that is for years 2028 onwards);

Terminal growth rate, g = 5%

FCFE of 2028, C9 = FCFE of 2027 x (1 + g) = 290.21 x (1 + 5%) =  304.72

TV of FCFE at the end of 2027 = TV = C9 / (Ke - g) = 304.27 / (10.8% - 5%) =  5,253.73

the present value as of 2019 of FCFE during the period of constant growth (that is for years 2028 onwards) = PV of TV = TV / (1 + Ke)n =  5,253.73 / (1 + 10.8%)8 =  2,312.86

and (v) the intrinsic value of the stock as of 2019.

Valye of equity, E = PV of cash flows in high growth + PV of cash flows in declining growth + PV of cash flows in constant growth =  469.37 + 527.57 + 2,312.86 = 3,309.80

Number of shares outstanding, N = 560

hence, the intrinsic value of the stock as of 2019 = E / N =  3,309.80 / 560 =  5.91

Suppose you were to make decision at the end of 2019 year, what would you have decided keeping in mind the so-calculated intrinsic price and the market price of end-2019? Critically evaluate your confidence in this type of fundamental valuation.

The stock is trading below its intrinsic value, hence I would have decided to buy the stock to realize the potential gain.

Fundametal valuation, like any other method of valuation has its own strength and weaknesses. In the absence of any thing better, industry does practise valuation using fundamental method. Hence, we all have confidence in this method. In the long run, fundamental analysis do yield precise and near correct results.