Determining Firm’s Value One of the Financial Scenarios

Chapter 1

Determining firm's value is one of the vital financial scenarios in the current world. Investors are more aware of their investments and take basic precautions before investing in a company. It is said that, investing in an excessively over-valued companies that failed to earn the expected returns was one of the causes of economic recession during mid 2000s. This has created awareness among investors as well as analysts. Analysts use basic fundamentals, which generally based on publicly available information, such as accounting earnings, dividends, growth factors or leverage ratios, etc to infer the intrinsic value and compare whether it is over or under the firm's stock price (Lee, 1987).

Each company has its own characteristic features and it differs from industry to industry and country to country. It become important to understand the certain features of a company like investment methods, dividend policies, tax policies, liquidation regulations etc. The study tends to investigate large firms in various industries, which are problematic and not in line with the investment analysts who likely focus on one industry or one sector (Quirin et al., 2000). One of the main features an investor is worried about is future payoff which can be solved by firm's valuation.

Many valuation methods are used to estimate the firm's value. Fundamental models used for valuation are asset based valuation, discounted cash flow model and residual earnings model. These models help in estimating whether the firm's stock prices are overvalued or undervalued. Using the available information from the financial statements, analysts forecast the intrinsic value of the firm and evaluate its future stock returns.

According to the concept of efficient market hypothesis, the stock prices should reflect all the publicly available information which means that the share price of a company should be same as the intrinsic value of the company. But in reality, efficient market hypothesis does not hold valid. Thus, valuation models are employed to estimate the firm's value.

As we have known, for the past three years, economy around the world has seen drastic changes due to mortgage crisis. Many of the countries have recovered from this recession and many of them are yet to recover. The United Kingdom is one of those countries which are under recovery from the economic crisis. Telecommunication and digital satellite industry was also hit during the crisis. British sky broadcasting plc reported losses during that period and the same is reflected in the balance sheet of the company. The basic earnings per share of the company reported negative in 2008.

Keeping this in mind, we carry out further study on the valuation models. Two valuation models, Discounted cash flow and Residual earnings are chosen as the discussion topics in the dissertation. But due to deriving from the same assumption, the residual earnings model yields identical results as the discounted cash flow and dividend discount models (Ohlson, 1995, and Feltham and Ohlson, 1995). British sky broadcasting plc's historic financial data is used to estimate its intrinsic value based on discounted cash flow and residual earnings model.

Research question

Based on the discounted cash flow model and residual earnings model, which valuation model performs better for British sky broadcasting plc and why?

The main aim of the research question is to conduct the valuation analysis using discounted cash flow model and residual earnings model for British sky broadcasting plc. This process includes the estimation of equity values of the company, evaluating the performance of the model and discussing why the performance of models varies.

Delimitations

This dissertation work has been conducted under a limited time period. All the financial information used here are publicly available which is obtained from company websites and annual reports. No primary research has been undertaken or no primary source of information has been considered in this work.

The research work is based on British sky broadcasting plc. The company is listed in London stock exchange under FTSE 100 and follows IFRS (International financial reporting standards) to publish their financial statements. Annual reports from 2004 - 2009 are used for calculation of the model.

Disposition

Chapter 1: Introduction

Introductory chapter explains the background of the research, research question and aim of the research question

Chapter 2: Research methodology

This chapter explains about the methods used in research study, data collection and sources of data collection

Chapter 3: Literature review

This chapter explains about the theories related to the study of valuation models and brief study on British sky broadcasting.

Chapter 4: Analysis and results

Analysis of the valuation models and its results are explained in this chapter of the dissertation.

Chapter 5: Discussion and conclusion

This is the final chapter of the dissertation undertakes discussion and conclusions drawn from the above study, mentioning important research outcomes of analysts and future scope for the research on valuation models.

Chapter 2

Research methodology

This chapter describes about the choice of subject, approaches to the research study, methods used for research purpose and data collection.

Choice of subject

The topic for the master's dissertation was chosen on the basis of interest, academic knowledge and course perspective. I have chosen British sky broadcasting plc, a digital satellite and telecommunication company to proceed with my research. The company is sensitive to variable effects like market competition, price fluctuations, recession, inflation and customer preferences. Therefore, I try to invest my academic knowledge to understand the topic with reference to valuation models.

Research approach

Research philosophy depends on what the author want to develop the knowledge (Saunders et al.,2000). Understanding of the research philosophy is important to research methodology, according to the following reasons (Easterby-Smith et al., 1997; cited by Crossan, 2003):

- Help the author to clarify the research strategy and the research method.

- Help the author to avoid useless works with clarification of certain methods at the early stage.

- Help the author to select or adapt the methods, which previously are out of the experience.

Using theories of discounted cash flow model and Residual Earnings Model to observe which valuation model performs better on digital satellite and Telecommunication Company - British sky broadcasting plc.

Research method

Two types of research methods were used to study the dissertation subject. That is, both qualitative and quantitative methods were put into use during this period. Qualitative research was undertaken to understand the theoretical aspect of the subject, understanding of the industry and current market scenario. But mostly quantitative research was implied to understand the financial aspects of the company.

Data collection

Data collection is one of the vital aspects of research. Accuracy of the data and source to obtain it become important. Different sources were used to collect the data.

Subject related books and articles were obtained from Cardiff University's library, literature on the industry and journals were obtained from internet and company financials were obtained from university library's database.

Other financial information on the company was obtained from the annual reports of British sky broadcasting plc's website and university library from the year 2004 to 2009. Other financial data like current stock prices, market trend, analyst's opinions and customer preferences were studied and taken from several websites like Bloomberg, Reuters, Google finance, yahoo finance, LSE website etc. Statistical financial data, i.e. risk-free rate or market returns is obtained from DataStream database provided at the university library.

Chapter 3

Company overview

British sky broadcasting plc, a telecommunication and digital satellite broadcasting company listed on London stock exchange and one of the FTSE 100 companies. BskyB is one of the hugely subscribed broadcasters with annual revenue of £5,359 millions. During the economic recession in 2007-2008, company suffered financial difficulties which reflected in their balance sheets. But with their cost strategies, aggressive marketing techniques and investment strategies, they gained their market position back. Now, British sky broadcasting plc is one of the digital satellite broadcasting giants with their presence in several countries across the world.

Analysis of financial statement of the company

From study of historic data from 2005- 2009 of British sky broadcasting plc, we can observe the following trends in their revenues, investments and expenses.

Revenue and Net profit (2005-2009)

From the above chart, we can observe that the revenue of the company is increasing year by year but net profit has suffered a drawback in the year 2007-2008. It can be assumed that the cause for this decrease in net profit to be economic crisis during that period.

Earnings per share, dividend per share and book value per share

From the data obtained from balance sheet, it can be observed that in the past 5 years, 2006 has witnessed highest earnings per share whereas 2008 has reported least earning per share. But it can also be noticed that in the year 2009, the company has recovered itself from negative earnings per share by gaining 14.9 pence per share.

Cost operation of the company

To encounter the fierce competition in telecommunication and digital satellite broadcasting industry, company has adopted several strategies to retain the customer base of the company as well as to attract the new customers. Some of the strategies adopted by the company to increase the customer base are,

Reduction of cost of service without affecting the quality of the service

Acquisition of four new channels under Sky arts, one channel under Sky1 and three channels under Sky movies which includes HBO drama. This is said to increase the viewers by 1.5 million a month.

Signing a contract to telecast major sporting events of the country including Barclay's premier league football for three seasons will not only expected to increase the viewers for the channel but also increase the advertising revenue and customer subscriptions in the next two years.

Study of annual report of British sky broadcasting plc reports some of important financial developments in the year 2008-2009.

According to the report, the company has earned its first £5 billion group revenue.

Company's operational profit has increased by 4% compared to previous year and the free cash flow has increased by 25%.

The total customer base has increased by 15% from 2008.

Product sales of the company have reported its increase by three folds reaching 7 millions in 2009.

Further in the year 2009-2010, the company is expecting to earn revenues more than the previous year. Analysts have forecasted the growth in earnings per share of the company to increase by 120% in 2010 from the previous year.

Theoretical framework:

Discounted cash flow model

Discounted cash flow model is one of the essential valuation models in finance. It helps to estimate the value of an asset depending on the future worth rather than its past worth or the cost. It evaluates the future value of an asset in terms of time and risk.

Discounted cash flow models are one of the forms of financial pricing models that combine underwriting and investment returns and also incorporate risk considerations in establishing the target return on capital figure. Its approach is more robust than the Capital Asset Pricing Model, since it is not limited to valuing only systematic risk, and more intuitive, with the parameters more easily calculated, than the Option Pricing Model (Stephen R D'Arcy, FCAS).

Formula

The Present Value of a series of cash flows is:

PV = Σn t=1 CFt

(1+r)t

where CF = cash flow, t = time, r = discount rate

The Present Value is calculated on the cash inflows from an investment rather than cash outflows, neglecting the actual investments. But the Net Present Value considers both the inflows and outflows.

The Net Present Value calculation is:

NPV = Σn t=0 CFt

(1+r)t

Net present value helps the firms to decide their investments in a project. A project with positive net present value should be considered for investment rather than negative net present value projects.

Criticisms of DCF model

The main criticism of the net present value method of calculation is the uncertainty of the cash flows. But the probability to overcome this criticism is high by discounting the cash flow at the rate that reflects this uncertainty rather than at the risk-free rate.

Another disagreement to choose the appropriate interest rate for discounting may flourish but discounting is still in practise to value the projects.

The third criticism is based on the fact that the projects are really not independent. The cash flows included in the valuation of any one project should reflect the impact on other projects as well. However, this is a difficult task to accomplish (Stephen R D'Arcy, FCAS).

Gordon model

Gordon model was published in the year 1962 by Myron J Gordon. This model estimates the calculations for the perpetuity with constant growth henceforth is called as constant growth model. It is applicable only when the growth is considered to be constant and do not vary with time.

Definition: According to David SchrÄoder and Florian Esterer, Let g denote the constant growth rate of dividend payments to shareholders. Then the share price P0 is given by:

P0 =E0 [CF1]

k-g

The Gordon model assumes that future dividend payments to shareholders growth geometrically at a constant rate until infinity. In practice, this model does not capture the true dynamics of dividend payments declining usually over time, and is thus only a valid approximation for the share price of mature companies with stable dividend payments. Still, it can serve as a useful illustration of the implied equity duration (D. SchrÄoder and F. Esterer, 2008).

Advantages of Gordon model

Gordon growth model is simple and easy to calculate using readily available inputs from the balance sheet. Companies whose cash flows are strong and relatively stable can yield good result from the Gordon model.

Most of the mature industries use the model to obtain fair values. It is appropriate in the valuation of companies that pay high proportion of dividends from income.

Disadvantages

The model is purely quantitative in nature and neglects qualitative factors like market or industry trends.

The model assumes the constant future dividends growth rate to perpetuity and fails to consider slow growth rate period in future. Though the model is simple, it's not flexible enough to project changes of future dividend growth rate. This makes it less suitable for high growth industries like telecommunication and software technology.

Residual earning model

Residual earning model has been widely studied over a last decade since a paper by Ohlson (1995) on this valuation model was published. Utilising the values from the balance sheet, model calculates the intrinsic value of the firm. This model acts as a better valuation tool than previous models and is considered to be an alternative to discounted cash flow model.

A measure that captures the value added to book value is residual earnings. A model that measures the value added from forecasts of residual earnings is called residual earnings model. Sometimes it is also referred as residual income or abnormal earnings or excess profit model (Penman, 2007).

Derivations

Residual earnings for equity describe premiums over required return for book value of common equity at beginning of the period (Penman, 2007) as

REt = Earnt - (ρE - 1) Bt-1 (1)

Where REt is residual earnings of equity in the future, Earnt is comprehensive earnings at time t as REt, ρE - 1 is earning at the required return and Bt-1 is the book value of equity on the balance sheet.

For every earnings period t, residual earnings can be restated as

REt = [ROCEt - (ρE - 1)] Bt-1 (2)

Where ROCEt = Earnt / Bt-1 is the rate of return on common equity.

From the above equations, we can see that if rate of return on equity equals earnings at required return then residual earnings will be zero as well as the value creation of the firm.

It can also be noticed that, RE is affected by two variables namely ROCE and the book value of equity. These are called residual earnings drivers or value drivers. Increased ROCE and book value increases the RE and the value of the firm.

The value of equity can be calculated by adding the book value and the forecasted residual earnings,

VE0 = B0 + Present value of RE (3)

Where VE0 represents value of a firm and B0 is book value of equity.

To get intrinsic price-to-book (P/B) ratio divide both sides of the equation by current book value B0,

VE0 = 1 + Present value of RE (4)

B0 B0

It can be noticed that for the firms to earn income for the shareholders, the equity will be worth more than the book value and should sell at premium. P/B ratio defines the relationship of the firm's stock price and its net worth. An investor often pays for an earnings growth of a firm with higher price, but earning growth does not always mean value growth (Penman, 2007).

Equation for valuation model with indefinite time period is,

VE0 = B0 + RE1 + RE2 + RE3 + … (5)

ρE ρ2E ρ3E

The forecasting of future residual earnings is uncertain yet important for the firms in a long run. Therefore, forecasting is done for a definite period of time and adds Continuing value (CV) at time T.

VE0 = B0 + RE1 + RE2 + RE3 + … + RET + CVT (6)

ρE ρ2E ρ3E ρTE ρTE

There are three variations in the continuing value model, they are:

If residual earnings are zero then,

CVT = 0

If residual earnings are constant, but non-zero then,

CVT = RET+1

ρE -1

If residual earnings grow with constant rate then,

CVT = RET+1

ρE - g

Where g is the growth rate at time T.

Deriving residual earning model from dividend discount model

From dividend discount model, the price of the stock equals to future dividend streams (McCulloch, 2005), using this we can derive residual earnings model.

Where P0 is the price of the stock at time t, Dt is future dividend and r is the discount rate of return.

From the clean surplus relation expressed in the change of book value as:

Bt = B0 + dt - xt

Where Bt is net book value at time t, dt is net dividends paid at time t and xt is equal to the earnings at the time (t-1, t).

By placing the clean surplus relation to the dividend discount model, we will get the residual earnings model as follows,

Where aet is equal to the [earnings - rBt-1]

For the infinite forecast period, both residual earnings model and the dividend discount model yield the same results. But, the disadvantage of dividend discount model is that it cannot forecast results for the firm having zero payout for several years as the model cannot measure the value. According to Penman (2007) the dividends may not relate to the value creation because the firm can borrow money for dividend payment. Here, he considers the dividends as value distribution and not value creation.

Advantages of Residual earnings model

Residual earnings model is considerably better formulated valuation model. The advantages of the model is that it uses the properties of the accrual accounting helping to recognise the value added ahead of the cash flows and does not treat investment as a loss of value and considers as an asset. RE forecasts also recognise the value in the current book value on the balance sheet than free cash flow forecasts. Usage of readily available accounting data makes it easy for the user.

RI model is not affected by the distribution of dividends, share issues or the repurchases of the company. It also not affected by the assumptions regarding the growth. Hence this model holds valid for those companies that do not issue dividends or issue shares at a regular interval of time.

RI model has a built in safeguard against paying too much of earnings growth: value is added only if the investment earns over or above the required rate of return (Penman, 2007). This helps investors avoid paying for the earnings growth of the firm that invest more and do not add value or fail to earn the required rate of return. Thus protects from paying for the earnings created by the accounting.

Disadvantages of residual earnings model

RI model relies mainly on the accounting data from the balance sheet. Analysts using this model need to have strong accounting knowledge. On the other side, many question the accuracy of the financial statements published by the company as they are believed to be altered. According to the author, it would be an advantage if analysts' un-wrap misleading accounting numbers before the problems appear (Penman, 2007).

In a long run, it is difficult to forecast the value of the firm using RI model because the estimation of a growth rate becomes tough with uncertainty.

Clean surplus relation

Residual earnings model is based on the assumption of clean surplus relation. The clean surplus relation states the change in equity from one year to another is equal to the net income minus dividends. But this does not happen in reality. In general, income items are reported as a part of equity rather than in an income statement. This is known as dirty surplus accounting. This violates the clean surplus relation affecting the affecting the book value of equity.

Clean surplus relation can be expressed in the change of book value as

yt-1 = yt + dt - xt

Where yt is net book value at time t, dt is dividends paid and xt is earnings at the time (t-1, t).

Chapter 4

Analysis of Discounted cash flow model

This section of the study explains about the assumption and calculations related to discounted cash flow model. Financial data used in the study of the model is obtained from company website and annual reports from 2004-2009 of British sky broadcasting plc.

Many analysts have implemented DCF model in valuation process in the past. Earlier studies have however concluded that practitioners often use a shorter forecasting period, often no longer than five years (Levin and Olsson 1995 and Barker 1999). Through forecasting entire income statements and balance sheets an analysis using financial ratios is possible. This analysis can be used to determine the fairness of the assumptions regarding the future (Levin 1998b).

The key estimations of DCF model

Cost of capital: Companies obtain their capital from many sources like issuing shares, debts, government etc. Every company expects to earn a minimum rate of return to pay back the debtors, shareholders or even to invest in assets. Cost of capital helps in assessing the worth of investments. This allows the companies to decide whether to invest or not in such projects. Cost of capital is found using WACC (weighted average cost of capital) method. WACC is calculated using the formula,

WACC = ND rnd (1-Tc) + E re

ND+E ND+E

Where, ND is total debt, E is total equity, re is expected return on equity, rnd is expected return on debt and Tc is tax rate.

Continuing value: The forecasting of a firm's financial performance is divided into two periods: the explicit forecast period and the post-horizon period. During the explicit forecast period the firm is expected to transform into a steady state. When the firm has reached the steady state the terminal value is calculated by a continuing value formula (Martin Edsinger, Christian Stenberg, 2008).

Continuing value of the firm can be calculated using the Gordon growth model. Gordon model is used on the assumption that growth is steady and does not vary with time. The formula used to calculate Gordon model is,

P0 =E0 [CF1]

k-g

Where P0 is the share price and g is constant growth rate.

Capital asset pricing model: This model is used to calculate the cost of equity. The formula used to calculate the CAPM is,

CAPM = RF + β (Rm - RF)

Where, RF is the risk free rate and Rm is the market rate.

Risk free rate: Risk free rate is assumed from 10 years UK government bond rate. RF is 4.25% and obtained from DataStream.

Market rate: As it was difficult to find information on past market rate values for the company, average industry market rate for telecommunication industry was taken from DataStream database. The market rate of return obtained is 11%.

Beta: Beta was obtained from OSIRIS database under 1 year beta estimation for the company. The mean beta is 0.6200.

Market risk premium: Based on evidence from the different used models suggests a market risk premium around 5 percent (Koller et al 2005). Risk premium can be calculated using the below formula,

Market premium = Rm - RF

Where, R­m is expected market return and RF risk free rate.

Free cash flow analysis: One of the main features of discounted cash flow model is estimation of free cash flow. The constructed free cash flow for the valuation purposes should be identical to the financial cash flow of the company.

Key estimations of discounted cash flow model

Growth rate

4%

Reinvestment rate

0.4891

Return on capital employed

0.0818

Weighted average cost of capital

8.18

Beta

0.62

Cost of debt

5.64

Cost of equity

8.63

Tax rate

28%

Valuation analysis

From the above calculation of discounted cash flow model, we can observe that,

The firm chosen is not a pure equity firm as there is net debt amount considered.

It is said that treating the investments in the cash flows as negative may reduce the accuracy of the model. But the estimates obtained from the free cash flow analysis are positive in nature.

At 4% growth rate, reinvestment rate of 0.489 and return on capital employed at 0.082, price of the share is £2.84. The actual share price is £7.08 with 1,807,918 shares outstanding.

Long term growth rate is assumed to 4% based on historical data and market research. At 4%, share price is estimated at £2.84. Change in growth rate by 1% changes the estimated share price to £2.86.

According to calculations, the estimated re-investment rate for the company is 0.489. If the re-investment rate is increased to 0.589 then price of the share decreases to £2.28 and if the re-investment rate is decreased to 0.389 then price of the share increases to £3.38. There is inverse relation between the re-investment rate and the share price estimated.

Analysis: Residual earnings valuation

This section contains the key assumptions and analysis for British sky broadcasting plc on the basis of residual earnings model.

Using the historical financial data from 2004-2009 obtained from company annual reports, website and library database, the valuation model has been forecasted from the year 2010 to 2014. The key assumptions are as follows:

Earnings per share

Earnings per share growth rate is estimated based on the analysts forecast EPS from 2010 - 2013 obtained from OSIRIS database and it is assumed to increase accordingly. From the year 2014, the growth is assumed to be constant at 11%.

Dividend per share

Dividend per share is forecasted based on the study of historic DPS trend from 2005-2009 and assumed it to increase by 7.6% on an average for 5 years and to be constant from 2014 onwards.

Long term growth rate

Long term growth rate is assumed to be 4% based on the historical growth rate, market trends and future competition.

Risk free rate

The estimated risk-free rate is 4.75% based on the average rate of 10 years UK government bond for BskyB. It is obtained from DataStream database. UK government bond is used to assume the risk free rate as British sky broadcasting is listed in London stock exchange, UK.

Market return

The market return estimated for British sky broadcasting is 11% on FTSE 100 obtained from DataStream and is assumed to be the same for all the forecasting years.

Common equity Beta

The beta for the company is obtained from OSIRIS database. Beta for one year is expected to be 0.62 on FTSE 100 and is assumed to be the same for rest of the forecasting.

Cost of equity

Cost of equity was calculated using capital asset pricing model method. The formula used was,

CAPM = RF + β (market premium)

= 0.0475 + 0.6200 (0.0625)

= 0.0863

Where, RF is risk free rate and β is risk factor.

Share price

Share price is taken on 27th of august 2010 for calculation purpose. On the mentioned date, share price was 708.00 p. It was obtained from the website of London stock exchange plc.

Key assumptions of British sky broadcasting plc

Dividend per share

7.6%

Long term growth rate

4%

Risk free rate

4.75%

Market return

11%

Beta

0.6200

Cost of equity

0.0863

Discount factor

8%

Valuation analysis

From the above calculation, we can see that the estimated share price at the beginning of the year 2010 is £8.7454; actual share price is £ 7.0800 and the estimated share price obtained after residual earnings valuation is under-valued by £ 1.6654.

However, the earnings per share has increased by 120% from the year 2009 to 2010 but the study of historic data does not support the EPS growth rate forecasted by analysts. The basic earnings per share distributed from 2005 - 2009 does not follow specific trend. EPS shows growth of average of 34.88% in the year 2005 and 2006 and fall in growth in the year 2007 and 2008. In the year 2009, EPS has increased from -7.3 pence to 14.9 pence per share, which is 104% and expected to increase in future based on the following assumptions from the annual report:

The total customer base of the company has increased by 15% and product sales by 3 folds to 7 millions in 2009 and is expected to increase at the same rate in 2010.

BskyB is expected to increase its viewer's base by 1.5 million a month with acquisition of 4 new channels for Sky arts, 1 new channel for Sky1 and 3 new channels for Sky movies which includes HBO drama.

Signing a contract to telecast most of the major sporting events which includes ruder cup, ICC 20-20 world cup and also BPL football for 3 years till 2012/2013 is expected to earn very good revenues from sales and subscriptions for the company.

The company has witnessed its first 5 billion revenue is the year 2009 with increase in operating profit by 4% and increase in free cash flow by 25%. The company is expecting increased revenues in the 2010 and assumes it to grow further for next 4 years.

Cite this page