Question

OZ Minerals (OZL) is an ASX listed copper and gold mining company. Two comparable firms for OZL are Regis Resources (RRL) and IGO Limited (IGO). Current information on the three stocks are:

	OZL	RRL	IGO
Price	$9.95	$5.05	$5.09
Net Income	$164 million	$163 million	$176 million
Historical Cash flow	510 million	$276 million	$372 million
Historical Dividends	$0.23 per share	$0.16 per share	$0.14 per share
Shares Outstanding	324 million	508 million	591 million
Total equity	$2980 million	$716 million	$1849 million

a) Use the dividend discount model to determine the fundamental value of OZL. You have a required rate of return of 5.5%.

b) Using the data above determine the relative valuation of OZL based on RRL and IGO and two financial ratios.

c) Based on your analysis above, do you think OZL is a good investment at its current price? Why or why not? Discuss any uncertainty that you have about your valuation.

Answer 1

a) Value of OZL

We are given,

Dividend per share(D0) = $0.23

reqd. rate of return = 5.5%

Net income = $164 million

No of shares outstanding = 324 million

Total dividends paid = Dividend per share(D0) * number of shares outstanding

Total dividends paid = 0.23 * 324 million = $74.52 million

Retained Earnings = Net Income - Total dividends paid

Retained Earnings = 164 - 74.52 = $89.48 million

Retention ratio (RR) = Retained Earnings/Net Income = 89.48 / 164 = 54.56%

Return on Equity = Net Income/Total Equity = 164 / 2980 = 5.5%

Retention ratio * return on equity = sustainable growth rate(SGR)

SGR(g) = 54.56%*5.5% = 3.00%

We can calculate the value of the stock by the Gordon growth model,

P = D0*(1 + g)/(r - g)

P = 0.23*(1 + 0.03) / (0.055 - 0.03) = 9.48

Price per share = $9.48

Hence the fundamental value of OZL is $9.48

b) Relative valuation of OZL based on RRL and IGO

To compare OZL with RRL and IGO, we will use ratios like P/E ratio and P/CF ratio

Earning per share(EPS) = Net income / Total no of shares outstanding

P/E ratio = Price per share / Earnings per share(EPS)

We will calculate the P/E ratio for every stock and compare,

Particulars	OZL	RRL	IGO
Net income	164	163	176
Shares outstanding	324	508	591
Earning per share	0.51	0.32	0.30
Value	9.95	5.05	5.09
PE ratio	19.66	15.74	17.09

Lower the P/E ratio, the better the stock is. Among the given stocks, OZL has the highest P/E ratio and hence can be considered overvalued.

Cash Flow per share = Cash flow/number of shares outstanding

P/CF = current market price per share / Cash Flow per share

We will calculate the P/CF ratio for every stock and compare,

Particulars	OZL	RRL	IGO
Cash flows	510	276	372
Shares outstanding	324	508	591
Cash flow per share	1.57	0.54	0.63
Value	9.95	5.05	5.09
P/CF ratio	6.32	9.29	8.09

The lower the P/CF ratio, the better the stock is. By comparing the P/CF ratio of these stocks, QZL stock is undervalued as compared to RRL and IGO as it has the lowest P/CF ratio.

c)

According to the Gordon growth model, we got the value of OZL's share as $9.48. The current market price is $9.95. As the current market price is more than the intrinsic value, the stock is overvalued. Hence it should be sold.

Using the P/E ratio, the stock appears to be overvalued.

Using the P/CF ratio, the stock is undervalued as compared to other stocks.

As OZL is overvalued by analyzing P/E ratio and intrinsic value(2 very important metrics), we conclude that OZL is overvalued.

There is uncertainty regarding estimates of growth and retention ratio in the Gordon growth model which have a significant impact in determining the intrinsic value of the share.

If you have any doubts please let me know in the comments. Please give a positive rating if the answer is helpful to you. Thanks.