Question

Discuss the model that you believe best fits the reality of the firm you are analysing and why. Explain how you estimate the future growth of the firm.

Example model: FCFE model. DDM model and fundamental model. The firm is BASF (German chemical company and the largest chemical producer in the world).

Typed the answers please.

Answer 1

The valuation of BASF can be done via various methods. Let us see one by one why each of the models listed in the question are a valid or not for BASF-

DDM- this usually applies to steady growth and steady dividend paying companies. These businesses mature and exponential growth or decline are not expected. BASF operates in multiple segments within chemical industry and in multiple geographies. It is unlikely that the company will experience a steady growth in the future. The financials for the company are in the table 1 below. It can be seen that the dividend payout is not proportionately related to the net profit.

FCFE/ FCFF- Free cash flows to the firm or equity holders is a more suitable for BASF. This model measures the company’s profitability or ability to generate cash after all expenses and reinvestments. This model can accommodate multiple growth rates for the firm in the long term and can be modified to suit the expected state of the business in every year in the future. Hence, it can be used to value BASF. We can take growth estimates for the next 5-10-15 years and then a steady growth rate to arrive at the present value of the cash flows of the firm.

From the recent 5 year financials, it can be seen that the company has had a –ve growth rate in sales and profits. The assets have grown at an annualized rate of 6.1% over the period. A 2-year growth rate is 4.36% for sales 7.73% for PAT. However, this increase in last year was due to special items. The analysts or the management commentary during the analyst call do not expect the company to grow at this rate in near future. The consensus is that the next 2-3 years will be almost flat in terms of growth.

SOTP- the sum of the parts is also a suitable model for valuing a diversified business such as BASF. It is generally used for companies in different sectors and/ or markets as global conglomerates. It can be used for BASF as well since BASF operates in multiple geographies and in multiple product lines. The SOTP model is a derivation of the FCFF model. It allows us to consider different growth rates for different markets and segments of the company and value each ‘parts’ of the business separately. It then combines the value of each part to arrive at the value of the whole company. Since BASF operates in multiple geographies, it will be unwise to assume a constant growth rate for emerging markets as well developed markets. One argument against using the SOTP model is that the sum of the parts is often less than the total value of the company. SOTP ignores the synergies from scale and global integration for the business segments and hence, it arrives at a lower valuation. For a company such as BASF which operates in a single industry (Chemicals), the synergies from global integration are high. Hence, it is not the best choice for valuing BASF.

After considering the advantages and disadvantages for the above models, it is proposed that the DDM model is best suitable valuing BASF. The dividend yield has been at ~4% for the past 10 years. Hence, we can comment that the in spite of ups and downs, the company management has been able to keep the dividend yield stable. We can use the dividend yield of 4% for valuing the company by DDM. The proposed dividend for the next year by management is EUR 3.2.

Table 1

Year	Revenue	Net income	Total Assets	Dividend
	in bn. EUR€	in bn. EUR€	in bn. EUR€	in EUR€/ share
2013	73.973	4.842	64.382	2.7
2014	74.326	5.155	71.359	2.8
2015	70.449	3.987	70.836	2.9
2016	57.55	4.056	76.496	3.0
2017	64.475	6.078	78.768	3.1
2018	62.675	4.707	86.556	-
CAGR (5-year)	-3.26%	-0.56%	6.10%	2.80%
CAGR (2-year)	4.36%	7.73%	6.37%

Table 2

Year	2009	2010	2011	2012	2013	2014	2015	2016	2017	2018	Average
Dividend value EUR	1.7	2.2	2.5	2.6	2.7	2.8	2.9	3	3.1	3.2 (proposed)	-
Dividend yield	3.90%	3.70%	4.60%	3.70%	3.50%	4.00%	4.10%	3.40%	3.40%	5.30%	3.96%