11) An aggressive financial planner who claims to have a superior method for pic
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Question
11)
An aggressive financial planner who claims to have a superior method for picking undervalued stocks is courting one of your clients. The planner claims that the best way to find the value of a stock is to divide EBITDA by the risk-free bond rate. The planner is urging your client to invest in NewMarket, Inc. The planner says that NewMarket’s EBITDA of $1,580 million divided by the long-term government bond rate of 7 percent gives a total value of $22,571.4 million. With 318 million outstanding shares, NewMarket’s value per share found by using this method is $70.98. Shares of NewMarket currently trade for $36.50.
A) Provide your client with an alternative estimate of NewMarket’s value per share based on a two-stage FCFE valuation approach. Use the following assumptions:
Net income is currently $ 600 million. Net income will grow by 20 percent annually for the next three years.
The net investment in operating assets (capital expenditures less depreciation plus investment in working capital) will be $ 1,150 million next year and grow at 15 percent for the following two years.
Forty percent of the net investment in operating assets will be financed with net new debt financing.
NewMarket’s beta is 1.3; the risk-free bond rate is 7 percent; the equity risk premium is 4 percent.
After three years, the growth rate of net income will be 8 percent, and the net investment in operating assets (capital expenditures minus depreciation plus increase in working capital) each year will drop to 30 percent of net income.
Debt is, and will continue to be, 40 percent of total assets.
NewMarket has 318 million shares outstanding.
B) Criticize the valuation approach that the aggressive financial planner used.
Explanation / Answer
We will first calculate the FCFE using the following formulae:
FCFE = Net Income - Net Investment in operating assets (includes both capital expenditure as well as working capital) + New Debt - Debt Repayments
We will use two stage FCFE model where for the first 3 years we will project the components to calculate FCFE as given and for subsequent period we will arrive at terminal value basis long term stable growth rates. The discount factor shall be calculated using CAPM model - since we are using FCFE, we will discount by using the cost of equity for the company.
FCFE Calculation
Note the following:
a. As given the net income grows at 20% for first 3 years and subsequently at 8% to perpetuity
b. The Net Investments in Op. Assets grows at 15% for year 2 & 3; subequently it grows at 30% of net income to perpetuity
c. Debt is maintained at 40% of Net Investment in Op. Assets; after year 3, on a steady state basis, since the Net Investment will grow as a function of Net Income at 8%, the New Debt shall also grow at the same level.
Now we will calculate the cost of equity using CAPM:
risk free rate = Rf = 7%; Beta = 1.3; Equity Premium = 4%
Hence Cost of Equity shall be = 12.2%
Using this we will calculate the terminal value at the end of Year 4 = 908.78 /(12.2%-8%) = 13653.39
Now we can discount the value of the FCFE by 12.2%, and the NPV = 12,995.92 which translates into per share value of $ 40.87.
This value is significantly lower than what the aggressive financial planner is projecting simply because the planner has not considered the cost of equity for discounting the future cash flows but cost of long term debt. This is incorrect since the company growth rate, variability in earnings and higher risk compared to risk free rate warrant a higher discount rate.
Items Current Year 1 Year 2 Year 3 Post Year 3 Net Income 600 720 864 1036.80 1119.74 Net Inv. in Op Assets 1150 1322.50 1520.88 335.92 Debt 460 529 608.35 134.37 Debt Payments @ 7% 32.20 37.03 42.58 9.41 New Debt 460 69 79.35 134.37 FCFE -2.20 -426.53 -447.31 908.78Related Questions
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