Valuation Models

Task: Based on the same company chosen for the group and first individual assignment, produce an individual professional report on the prospective analysis of the company. Forecast the future financial performance of your company for the next five years and beyond. Use four valuation models, i.e. Dividend Discount Model, Residual Income Model, Residual Operating Income Model and Free Cash Flow Model, to produce an estimate of the firm's share value. and compare to its current stock price. Perform sensitivity analysis on key forecasting assumptions using only Residual Operating Income Model and discuss the results. Based on sensitivity analysis and as a potential management consultant to your chosen firm, provide a discussion as to the possible opportunities for improvement, and potential challenges for the firm. Provide specific and reasonable remedies for these concerns. The report should cover: 
 
• Prepare your forecasts in an excel spreadsheet following a 10-step forecasting template. The forecasting table should include your specific forecasts for the next five years and should be included as an appendix in the report.

• Explain the reasons for your initial forecast assumptions, i.e. assumptions for sales growth, ATO, PM net dividend oavout ratio, cost of debt and cost of equity.

• Provide the calculation and results of four valuation models in a table and include it as an appendix in the report.

• Compare and discuss the estimates obtained from the four models. Compare the estimates with the actual share price to see whether the firm is currently overvalued or undervalued. 

• Adjust your initial forecast assumptions to reflect your optimistic and pessimistic outcomes for sales growth, ATO, PM, net dividend payout ratio, cost of debt and cost of equity and recalculate the estimated share value from the residual operating income model.

• Provide the sensitivity analysis results in a table.

• Provide explanations of how the optimistic and pessimistic outcomes for forecasting assumptions are chosen.

• Identify and discuss the key assumptions that the valuation is most sensitive to.

Valuation Models and Methods

Valuation Models

This is a method for valuing the stocks that a firm has in its portfolio probably from the shareholders contributions to the firm’s equity. It is calculated as the total forecasted future shareholders earnings Dividends discounted to present values. That is, the value of stock of a firm grounded on the net present value of the future shareholders earnings. Shareholders dividends are the distributed free cash flows in form of cash to shareholders of a company. corporations have the discretions to issue dividend to their shareholders or retain the cash in the business. Investors associate high dividend payment to the increase in the company’s stock prices while a decrease in dividends payout is associated with decreases in company’s stock price (Drake & Fabozzi, 2012).

Stock is part of ownership of a corporation give to the interested shareholders in exchange of equity. Shareholders hold stock for various reasons but the most featuring reason is to receive repetitive dividends pay-out in the future. Shareholders also hold stock to obtain capital gain when they sell their shares at high price. Common stocks of a company are estimated on the capacity as either a company's projected profitability or its projected dividend distributions to stockholders. The theoretical value of stocks can be based on the analysis of its dividends payments; therefore, shareholders can estimate the future cash-flow streams of dividend payments by applying an appropriate rate of discount. (Lin & Yao, 2012).

JB HiFi Ltd Share prices

Using a forecast of dividend payout for the next 5 years assuming a 65% payout, the following dividends payout pattern is expected to grow from 189,311.85 to 303,229.0 in the next five years.

The firm experience a steady increase in dividend payout for the forecasted 5 years.

Appraisal

Capital cost (WACC)            10%

Terminal value growth 2%

Shareholders earnings Forecast 8

Terminal Value 21

Intrinsic share value               $29

The above intrinsic share value had been significantly valued above the market value meaning that the shares of this firm has been undervalued. Therefore, the investors can buy the stock since the future earnings in predicted to increase.

Valuation plays an essential part in companies investing, financing and operating activities. Investment decisions by a firm as well as operating activities are decisions made by a firm and are applicable in determining the true value of a company (Perek & Perek, 2012). Residual income model is the most preferred valuation method. It is generally accepted as an hypothetical model for equity valuation founded on crucial evidence from financial reports. Residual Income Model is stated as a method of value- to- books ratio (Kim, et al., 2009). The model is seductive as it constantly provides assessments of performance at any given point in time.

JB HiFi Ltd Share Prices

There are major primary features that distinguish Residual Income Model from the more familiar discounted cash flow (DCF) method. Residual income model is a component of the accrual accounting principle that records transactions as they happen and not when cash is received rather than cash based accounting that records net cash flows. Cash flow estimates is a reliable method of accounting net income due to management’s inability to manipulate cash flows  (Longhofer, 2005)

The above intrinsic share value had been significantly valued below the market value meaning that the shares of this firm has been overvalued. Therefore, the investors is recommended to sell their shares since the future earnings in predicted to decrease.

This is a method that estimates the valuation of a firm in correspondence to the current value of the NOA added to the Current value of expected ROI.

The Net Operating Profit After Tax obtained through a growth percentage of 4.5% on the sales revenue of the estimated 5 year focus.

The net operating Asset calculated as the sales divided by the Asset turn-over is shown as follow

The growth in the operating capital is 7.0 which yield the following growth in operating income over the 5 years

The valuation of the company shows the following changes

The book value of shareholders, net income and equity Forecasts for the five years timeline assumes the firm to grow in stable state of economy. The presents forecasts of firm’s net income, shareholders equity book value, required income, and residual income for the five years are shown in the appendix. The sum of equity capital is $1252,750 with the outstanding shares of the firm yields share price of $26.

The valuation method of dividends- focuses on shareholders wealth distribution. Essentially, the value of shares is derived by calculating the current value of dividends the shareholders is expected to accrue in the future. FCF analyses forecasts and values the cash flows of investments of firms to generate and pay the dividends to the shareholders. This method measures the values the free cash flows available to a firm to be shared to stockholders as dividend payouts after the cash is utilized to pay lenders, debtors and even invest in necessary operating assets.

Most firms pay less dividends to its shareholders more than their total free cash flows to equity. This is necessary for firms to build a positive free cash flow which is desirable for a firm for expenditures and investments. (Muralidhar, et al., 2013).

Appraisal

JBH’s Free Cash Flows is positive, which is favorable good for the business. The positive Free cash flow is attributed to high returns on investments. Therefore, the firm FCF for 2018 through to 2022 should increase. Companies with high growth rate have negative Free Cash Flows due to the fact that they invest heavily in fixed assets. Therefore, it requires high working capital to support rapid growth which may then surpass cash flows from present operations. This is a desirable decision by management especially if the new investments are ultimately profitable and contribute to Free cash flow. Most analyst term this as the most important number that can be initiated in the accounting statements as compared to net income (Brigham & Houston, 2013).

From this analysis the total value of the firm is $7,888,248 which is more than all the other models of valuation. The debt value is $835 and the sum of equity is $7,887,413. This means that the share value of $69 is overvalued since it is greater than the market value. Therefore, investors can confidently invest in the shares of JBH due to higher returns on investments.

It is assumed under the model of this method that the firms share value is unevenly 22. Sensitivity analysis in the Appraisal assumes a long-term rate of growth of 3 percent while the capital equity cost is assumed at 10%. The sensitivity of factors affecting the business such as uncertainties, should be considered on sensitivity of the value of shares estimate for JBH since it has adversative changes in firm’s growth in the long-run together with the discount rates. A reduction of long-run growth assumption from 3.0 percent to 2.0 percent holding the discount rate constant at 10 percent, the share value will fall to $18.0, below the current market price. If the prediction and valuation are accurate, the reference point value estimate for this company at the end of the 5^th year should be overvalued in its shares. Their share price notwithstanding, the valuation estimates could support recommendation of buy option at the end of 2022 because the analysis reveals fractional shortcoming potential but substantial upside potential for the value of JBH shares.

Forecasted cash flows and dividends in the financial statement of this company is based on the following; Sales will grow each year at an average rate of 13% percent from 2017 to 2022. Sales in 2017 will grow at 15 % percent in 2017. Sales growth forecast relies on the past pattern of sales for the company, expected growth in industry sales, and the positioning of the company within the industry. The ratio of NOPAT to sales will be an average of 7 for the 5 years and is expected to remain constant. The initial level of assumed NOPAT reflects the company’s strategy and its past operating performance. The decline in NOPAT margins reflects the expected increase in competitive forces in this time period

Dividend-Based Valuation Method

The ratio of after-tax net interest expense to net debt is 5 percent. This is based on the expected interest rates given the company’s capital structure policy and forecasted tax rate. The ratio of net long-term assets to sales is 27 percent. This assumption reflects the pattern of asset turnover in the past, expected depreciation and amortization policies, expected capital expenditures, and expected increases in deferred tax liability; and Net debt is assumed to be 40 percent of net capital, based on the company’s business risk and financing strategy. Net debt includes any cash and marketable securities balances that are not required to support operations.

The valuations models used the cash flows and dividends in the company for the analysis, the cash flows analysis using free cash flow model found out the future value of the firms investments will be high and will influence JBH’s share price. Therefore, it is vibrant for JBH management to evaluate the long-term investments in the firm that will increase the firm value by generating a repetitive cashflows that are incremental in nature. It is evident also that, increase in investment improves the cash flows and thus improves company’s level of competition.

The company performance in the sector of gaming and music record performs a are the key market niche the company is branded. However, the other products such as computer and software and domestic appliance is also key to the organization.

The firm has been doing well in the newly focused product line of home equipment’s with strategy to expand its market in other products of home consumption. However, the market is just 3% in its market segment in the native home appliance industry meaning no or lack of competition. Managers therefore, need to increase competition standards in this segment. Management can also advice the firm to maintain high standards for product value while maintaining an ecological clean environment.

JBH’s products could be harmfully affected by changes in customers taste and preferences or the technology applied in the production or the marketing techniques applied for sales and promotions of the products in the market.  Management must advice the firm in the cost cutting measures to improve the profit margins and enhance competitiveness of the company. Therefore, the management of JBH must find resourceful means to reduce those outflows. The company’s management ought to improve their online shopping platforms and services in the future, this move will tremediousl reduce the recurrent expenditures in the business. The firm can combat the high office expenses by investing in online business management and reduce the products prices.

Forecasted Cash Flows and Dividends

An Healthy cash flows is eminent for a business profitability and persistence in a foreseeable future, therefore, management need to apportion cash satisfactorily and effectively for preventing severe consequences such as insolvency. Therefore, managers need to re-evaluate the cash inflow and cash outflow activities. Management of this company must look at the overall cash flow of the firm to build positive cash flows.

References

Desai, M. A. & Gentry, W. M., 2004. The Character and Determinants of Corporate Capital Gains. Production Engineer, , 18(), pp. 1-36.

Drake, P. P. & Fabozzi, F. J., 2012. Dividend Discount Models. [Online]
Available at: https://onlinelibrary.wiley.com/doi/10.1002/9781118182635.efm0042/abstract
[Accessed 31 5 2018].

Frigo, M. L. & Ciecka, J. E., 1995. Analysis of divisional profitability using the residual income profile. Managerial and Decision Economics, , 16(1), pp. 33-36.

Kim, K.-J., Lee, C. & Tiras, S. L., 2009. Residual Income Valuation: A New Approach Based on the Value-to-Book Multiple*. [Online]
Available at: https://papers.ssrn.com/sol3/delivery.cfm/ssrn_id1465855_code16413.pdf?abstractid=1465855&mirid=1
[Accessed 31 5 2018].

Lin, H.-W. & Yao, J.-S., 2012. PRICING STOCKS BY USING FUZZY DIVIDEND DISCOUNT MODELS. Iranian Journal of Fuzzy Systems, , 9(3), pp. 61-78.

Longhofer, R. S., 2005. The Residual Income Method of Business Valuation. Business Valuation Review, , 24(2), pp. 65-70.

Muralidhar, K. S., Mungikar, V. & Nayak, R. P., 2013. Application of the Free Cash Flow to Equity Valuation Model to Infosys. Asia Pacific Journal of Management & Entrepreneurship Research, , 2(3), p. 132.

Perek, A. A. & Perek, S., 2012. Residual Income versus Discounted Cash Flow Valuation Models: An Empirical Study. Accounting and Taxation, , 4(2), pp. 57-64.

Desai, M. A. & Gentry, W. M., 2004. The Character and Determinants of Corporate Capital Gains. Production Engineer, , 18(), pp. 1-36.

Drake, P. P. & Fabozzi, F. J., 2012. Dividend Discount Models. [Online]
Available at: https://onlinelibrary.wiley.com/doi/10.1002/9781118182635.efm0042/abstract
[Accessed 31 5 2018].

Frigo, M. L. & Ciecka, J. E., 1995. Analysis of divisional profitability using the residual income profile. Managerial and Decision Economics, , 16(1), pp. 33-36.

Kim, K.-J., Lee, C. & Tiras, S. L., 2009. Residual Income Valuation: A New Approach Based on the Value-to-Book Multiple*. [Online]
Available at: https://papers.ssrn.com/sol3/delivery.cfm/ssrn_id1465855_code16413.pdf?abstractid=1465855&mirid=1
[Accessed 31 5 2018].

Lin, H.-W. & Yao, J.-S., 2012. PRICING STOCKS BY USING FUZZY DIVIDEND DISCOUNT MODELS. Iranian Journal of Fuzzy Systems, , 9(3), pp. 61-78.

Longhofer, R. S., 2005. The Residual Income Method of Business Valuation. Business Valuation Review, , 24(2), pp. 65-70.

Muralidhar, K. S., Mungikar, V. & Nayak, R. P., 2013. Application of the Free Cash Flow to Equity Valuation Model to Infosys. Asia Pacific Journal of Management & Entrepreneurship Research, , 2(3), p. 132.

Perek, A. A. & Perek, S., 2012. Residual Income versus Discounted Cash Flow Valuation Models: An Empirical Study. Accounting and Taxation, , 4(2), pp. 57-64.