Stock Valuation Methods And Techniques: Origin Energy Limited Case Study

1. Select a publicly-listed company on the ASX that has previously made dividend payments. The selected company should not be classified by the ASX as a ‘Financial’, ‘Metals and Mining’ or ‘Utilities’ company.

2. Using appropriate historical data calculate a beta for the company you have selected. Compare your beta to those published by research houses (ie Morningstar etc) for your chosen company. Are the values different? Why?

3. Using the CAPM model determine an appropriate discount rate for your company. Use a market risk premium of 6.5% p.a. in your calculations.

4. Using a constant growth rate of 4% pa. (commencing immediately) in the constant dividend growth model, determine a current stock price for your company.

5. Suppose that the previous dividend growth rate was only expected to apply for 5 years before reverting to a long-term growth rate consistent with the forecast inflation rate. Demonstrate the impact this would have upon your stock valuation.

6. Now disregard the previous growth forecasts. Using your own variables, determine a current stock price for the company that you think might represent something close to its fair value. Why do you believe the variables you have chosen give a more appropriate value than those used in questions 4 and 5? Discuss. 7. Compare the calculation that you obtained in question 6 with what you would have obtained for the value of the stock using the ‘method of comparables’ stock valuation approach.
 

Company Profile

Stock valuation is a technique which helps in taking important decisions in regard of trading. It is a method generally used for evaluating the value of company’s stock by applying various appropriate models. It helps the investors in their decision making process and provide insights about the undervaluation and overvaluation of the shares. It indicates the fair market value of the company’s stock for a particular time period. The reason for conducting stock valuation is to measure the performance and future price of the stock available for the potential investors for the purpose of purchasing and selling of investments (Hoover, 2006). 

The holders of the securities are known as stock holders to which the firm is liable to pay dividends out of its profit after tax. There are various methods used for evaluating a firm’s stock. These include dividend discount method, comparable method, discounted cash flow method, constant dividend growth rate model and many others. All these techniques provide different intrinsic value considering various factors. The report focuses on the stock valuation of ASX listed company named as Origin Energy Limited using the various models. It outlines the required rate of return by using the CAPM model and calculates the value of company’s stock using the constant growth rate model. In addition, assumptions in the variables have also been made to calculate the same and then the figures derived from different methods are compared and contrasted. Furthermore, the value of firm’s stock is also compared to its competitors Santos Limited and Beach Energy Limited and the conclusion has been made (Pástor & Pietro, 2003). 

1.The ASX listed company chosen for the valuation is Origin Energy Limited. It is a coordinated energy organization. The Company is occupied with exploration, generation, production and sale of energy products to households and organizations crosswise over Australia. Its fragments incorporate Energy Markets, Integrated Gas, Contact Energy and Corporate. The Company's exploration and generation portfolio incorporates the Bowen, Surat and Cooper/Eromanga bowls in Central Australia, the Otway and Bass bowls in Southern Australia, and in addition premiums in the Browse and Perth Basin in Western Australia, and the Bonaparte and Beetaloo Basin in the Northern Territory. It likewise has exploration projects situated in New Zealand in the Taranaki and Canterbury bowls, and also in Vietnam. It mutually owns and wholly operates gas-delivering offices in Australia and New Zealand, including the BassGas and Otway Gas Production plants in Victoria, coal crease gas (CSG) generation plants as a component of the Australia Pacific LNG Project in Queensland, and the Kupe Gas Project in New Zealand (Reuters. 2018). The company is currently traded at share price of AUD 7.09 and is listed on ASX with the symbol ORG: AX. Its market capitalization is worth AUD 12.47 billion with a 3 year monthly beta of 0.88.

Calculation of Beta

Being operating in energy sector of Australia, ORG has to face a lot of competition due to its existing competitors within the industry. Its core competitors include Santos Limited and Beach Energy Limited with whom its stock performance is measured. The board of directors of the company are focused on marinating a suitable balance between the cash returns given to the shareholders and investments made in business in order to maximize the shareholder value. In addition, its strategy includes taking the business towards clean energy and embracing a decentralized and digital future (Origin Energy. 2018). The company is focused on improving its performance year on year. However, due to the poor performance in 2017 and heavy losses, Origin Energy did not declare any dividends after 2016. During 2017, it has faced a setback in its financial performance and because of insufficient earnings the company did not paid any dividends to its shareholders. Further, its position improved in 2018 as it reported profits worth $218 million. However, due to such low earnings, it did not declare any dividends during 2018 also. On a whole, the company is focused on improving its strategies so as to increase and enhance its financial position and performance (Origin Energy. 2018).

2.In terms of finance, beta of the investment is the factor which indicates the volatility of the investment and compares the same to the fluctuations in the market. It considered as the measure of risk that arises from the exposure to general market variations in contrast to eccentric factors. It measures the systematic risk of a portfolio and tells that whether the stock is more or less volatile than market. It is calculated on the basis of historical price data of the company which takes into account the changes happened in the stock prices over the year (Brealey, Myers, Allen & Mohanty, 2012).  

In case of Origin Energy, the calculated beta of the firm is 0.68 which is derived by applying a regression analysis on the past 19 year data of the company. In contrast to it, the beat highlighted by published resources such as Yahoo finance is 0.88 and Reuters reported the same at 1.29. The major reason for such difference is the time frame taken for the calculation. Yahoo Finance calculated company’s beta on the basis of past three years’ monthly stock price data whereas the regression analysis done is based on past 19 years’ stock data of the company on monthly basis. Due to such difference in time frame, the beta figures are totally different as there are lot of variations occurred over the period which brings the change in beta value of Origin Energy. Fluctuations in the prices have affected the beta value to a great extent. Therefore, it can be said that the time frame is the only main reason for having such variations in the figures reported by published sources and that derived by doing calculations.

Calculated beta	0.68
Yahoo finance (3Years)	0.88
Reuters	1.29

3.Capital Asset Pricing Model is a method of figuring out the expected return or required rate of return for the company. The model determines the relationship between expected return and systematic risk for the portfolio, specifically stocks. It is mostly used by every company or financial analyst for the purpose of pricing the risky securities, generating returns and calculating the cost of capital (Jaffe & Randolph Westerfield, 2004). The formula used for deriving expected return is:

Calculation of Required Rate of Return

E(r) = Rf + β*(Rm-Rf)

Where,

Rf = Risk free rate

Rm = Expected market return

Β = Beta of the security

By considering all these variables, CAPM figures out the expected return of the stock. The element risk free rate determines the time value of money, Beta shows the risk and the difference between market return and risk free rate indicate the risk premium earned on the security (Dempsey, 2013).

Risk free rate (10 year bond yield)	2.68%
Risk premium	6.50%
Beta (calculated one)	0.68
CAPM	7.10%

The appropriate discount rate for Origin Energy is 7.10% which is calculated using the CAPM Model. The risk free rate is taken as the 10 year Australian government bond yield which is 2.68% and the calculated beta for the company has been considered for the calculation. The market risk premium taken is 6.50%. The required return will be then compared to the expectations of the investor keeping in mind the company’s operations and its competency in future growth and success.

4.The constant growth rate model is a technique used to figure out the stock’s intrinsic value on the basis of future dividends growing at a constant rate. The Model takes into account the value of current dividend per share and then assumes that the same will grow at a steady rate in perpetuity. This is how it calculates the present value of future dividends which indicates the future value of company’s stock. The model is most suitable for the companies which declare dividends at stable growth rate (Henry, Robinson & Stowe, 2010). The formula applied by the model is: 

D / (k-g)

Where,

D= dividend per share

K= required rate of return

G= constant growth rate

Dividend per share (2016)	0.1
Required rate of return	7.10%
Constant growth rate	4%
Value of stock	$       3.23

The value of stock calculated using growth model is AUD 3.23 and current the share of Origin Energy is traded at AUD 7.09 per share. This indicates that the share price of the company will fall in future so it can be said that the investors have the opportunity to sell the company’s share toady and purchase the same in future.

However, the model is widely used by the companies but it also has some limitations like assumptions regarding the constant growth do not prove to be true every time. It does not always necessary that the dividends of the company will grow at the constant rate because of the business cycles and uncertainty prevails in the organization. The unknown financial difficulties and other factors do affect the company’s dividends and their growth rates. Thus, it can be inferred that despite being so useful, the growth model also has some limitations (Stowe, Robinson, Pinto & McLeavey, 2007). 

Constant Growth Rate Model

5.Another method used for calculating the stock value is two-stage growth model which takes into account the two stages of growth. It is a method of equity valuation under which the first stage have higher growth rates while in the second stage it is usually assumed that the rate will be stable. Generally, it is assumed that the first phase will have a fluctuating rate while in the second phase the rate will be stable which lasts forever (Damodaran, 2012). 

Valuation of stock using two stage dividend model
Current dividend	0.10
1st year dividend	0.104
2nd year dividend	0.108
3rd year dividend	0.112
4th year dividend	0.117
5th year dividend	0.122
Inflation rate	2.10%
It has been assumed that this will be the constant grwoth rate for company's dividends
Expected dividend	0.12
Required rate of return	7.10%
Constant growth rate	2.10%
Present value at the end of 5th year	$       2.44

Calculation of terminal value
Years	Cash flow	[email protected]%	Present values
1	0.104	0.93371	0.09711
2	0.108	0.87181	0.09429
3	0.112	0.81401	0.09157
4	0.117	0.76005	0.08892
5	0.122	0.70966	0.08634
5	2.436	0.70966	1.72856
Value of stock			$                                                                                                                            2.19

In case of Origin Energy, the dividends grow at a rate of 4% for the next five years and after that Australian inflation rate is taken as a consistent growth rate of dividends. The current inflation rate in Australia is 2.1% which is lower than the rate of 4%. By applying this model, the value of ORG’s stock appears to be AUD 2.19 per share. It is less than the value derived from constant growth rate model in the above requirement. The reason for such variation is the use of two different growth rates in the presupposed high growth period and stable period. Also the value derived is lower because it has been assumed that the growth rate in future will be lower and dividends will grow on that rate only. The fluctuations in the rate have affected the stock valuation of Origin Energy Limited. However, there is no such difference in the interpretation of the value as it clearly indicates that the stock of Origin Energy is overvalued and the market expects the company to grow faster than the estimates. Reason being, the calculated value is way lower than the market price of ORG’s shares.

Apart from this, like every model, this method or model also have some limitations. One of the biggest disadvantages of using this technique that it is based on estimation which can prove to be wrong. It includes estimating the length of first period and error on that part can lead to undervaluation and overvaluation of shares. Secondly, it is also very difficult to predict the growth rates in both the stages while evaluating the stocks of the company (Damodaran, 2010).  

6.Apart from the models used above, the value of a company’s stock can also be considered by interpreting the growth in ORG‘s historical dividends. As the company has not paid nay dividends in 2017 and 2018 so the historical data from 2013- 2016 has been taken. Below table shows the calculation of stock valuation by using assumptions and making changes in the variables. The history of dividends has been derived from the company’s website and are properly analysed in order to figure out the growth rate over the years. It has been observed that from 2013-2015 the company’s dividend remain same at 0.5 cents and does not showed any kind of growth (Origin Energy. 2018). However, in 2016 the same fall by 80% to 0.1 cents due to the deteriorating performance of the company. The average growth rate over such past years accounted at -26.7% and the same have been utilized for the stock valuation. The negative growth rate indicates that the company is not able to pay sufficient dividends to its shareholders. Also, it is focused on reinvesting the retained profits in the business instead of paying them out in form of dividends, so as to improve its overall performance and financial situation. It has been assumed that the dividends of the company will grow at the same rate in future and the value of stock is calculated using constant growth method (Origin Energy. 2018).

Dividend declared by ORG in past three years	Amount	Growth rate
2013	0.5
2014	0.5	0.0%
2015	0.5	0.0%
2016	0.1	-80.0%
Average growth rate		-26.7%

Dividend per share	0.1
Required rate of return	7.10%
Constant growth rate	0%
Value of stock	$       1.41

Two-stage Growth Model

By this method, the value of stock appears to be $1.41 per share which is way much lower than the fair market value of ORG’s stock. Current, the share is trading at $7.09 and its future value is accounted at $1.41. This indicates that the company’s stock will fall in future and investors should sell their shares today in order to book high profits and then purchase later on. The reduction in the value is because of the fact that no growth has been considered in the dividends of the company for the rest of the years. This method is much reliable than above two because the growth rate taken is based on the real facts and figures of Origin Energy. It is not assumed like the one done in above methods. The rate has been calculated by properly interpreting historical dividends of ORG. This increases the relevancy and reliability of the method and also the value provided is much more appropriate. Also the rate reflects the past movements or trends in firm’s dividends which help the investors to properly study the stock performance of the company before making any sort of investment decisions.

7.Method of comparables is another technique of equity valuation which is based on the premise that the equity’s value should resemble to the other equities of same class. The method deals with the comparison of the company with its core competitors or other firms working in the same industry. The difference between the values of similar firms creates opportunities for the investors. Generally, there are two approaches of comparables; one deal with the comparison of common market multiples such as P/E ratio, price to book ratio, enterprise value and others. The second approach takes into account the market transactions of similar companies like acquisitions made (Shapiro, Davies & Mackmin, 2012). 

In case of Origin Energy, the first approach has been applied where the price to earnings ratio of its competitors is considered. Santos Limited and Beach Energy Limited are also Australian ASX listed companies that operates in energy sector of the country. Being operating in the same industry, they are the key competitors of Origin Energy.

P/E ratio of Santos Limited	55.42
P/E ratio of Beach energy Limited	16.92
Average P/E	36.17
EPS of Origin Energy	0.12
Value of stock	$       4.34

The P/E ratio of Santos reported at $55.42 and that of Beach Energy is $16.92. The average of both companies’ P/E ratio derived at $36.17. The average is used to calculate the value of company’s stock by multiplying it with EPS of Origin Energy. From the comparables method, the stock value is $4.34 which is also less than its current trading price. As compare to the figure obtained in above method, the comparable approach give high value of stock which is almost close to the fair market value of Origin’s stock. Also the P/E ratio of ORG is accounted at 57.18 which are more than the ratio of its competitors. This means investors are expecting high growth in future.

Conclusion 

From the above report, it can be concluded that the performance of ORG was not good and promising in 2017 and 2018 and due to this, the company did not declared any dividend in these two years. Also, by all the valuation models, the figure derived is less than the company’s market value of stock. This indicates that the stock of Origin will fall in future and therefore investors should sell their shares in present. Also, the company must focus on improving its financial position and performance. 

References  

Brealey, R. A., Myers, S. C., Allen, F., & Mohanty, P. (2012). Principles of corporate finance. Tata McGraw-Hill Education.

Damodaran, A. (2010). Applied corporate finance. USA: John Wiley & Sons.

Damodaran, A. (2012). Investment valuation: Tools and techniques for determining the value of any asset (Vol. 666). USA: John Wiley & Sons.

Dempsey, M. (2013). The capital asset pricing model (CAPM): the history of a failed revolutionary idea in finance?. Abacus, 49, 7-23.

Henry, E., Robinson, T. R., & Stowe, J. D. (2010). Equity asset valuation (Vol. 27). USA: John Wiley & Sons.

Hoover, S. (2006). Stock valuation: an essential guide to Wall Street's most popular valuation models. USA: McGraw Hill Professional.

Jaffe, J., & Randolph Westerfield, R. (2004). Corporate finance. Tata McGraw-Hill Education.

Origin Energy (2018). Five year financial history. Retrieved from https://www.originenergy.com.au/about/investors-media/reports-and-results/financial-history.html 

Origin Energy (2018). Our strategy. Retrieved from https://www.originenergy.com.au/about/who-we-are/our-story.html 

Pástor, ?., & Pietro, V. (2003). Stock valuation and learning about profitability. The Journal of Finance, 58(5), 1749-1789.

Reuters (2018). Origin Energy Ltd (ORG.AX). Retrieved from https://www.reuters.com/finance/stocks/company-profile/ORG.AX 

Shapiro, E., Davies, K., & Mackmin, D. (2012). Modern methods of valuation. New York: Routledge.

Stowe, J. D., Robinson, T. R., Pinto, J. E., & McLeavey, D. W. (2007). Equity asset valuation (Vol. 4). USA: John Wiley & Sons.