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Step 1 of Coursework

Now that you have chosen your target company and completed Lecture 1, as well as the tutorial for the lecture, you can start your coursework.

The first method that we will use in the valuation of our target company is called Valuation Multiples (or method of comparables or “comps”). You may want to refer to the chapter in the recommended textbook on Valuing Stocks.

In line with the above and as advised during the tutorial class, you will now need to choose benchmark companies in the same industry as your target company. I do not need to approve your choice of benchmarks. While you may decide to use all firms in the industry, it is acceptable to restrict the number of benchmarks to three.

For all the companies (your target company and its benchmarks) you will need to calculate and discuss the following ratios:

• Price-earnings ratio (remember the example in the tutorial class)

• Enterprise Value to Sales ratio

• Enterprise Value go EBITDA ratio

• EBITDA to Sales ratio

Target company: HR Owen

http://uk.finance.yahoo.com/q?s=HRO.L

Benchmark companies:

1. Jardine Cycle & Carriage Ltd

http://www.reuters.com/finance/stocks/overview?symbol=JCYC.SI

2. Pendragon PLC

http://www.pendragonplc.com/investors/share_price/

3. Vertu Motors

http://shares.telegraph.co.uk/fundamentals/?epic=VTU

You will need to use the ratios calculated for the benchmarks to come up with your first (basic) valuation of your target company. You should refer to the chapter in the recommended textbook on Valuation and Financial Modelling: A Case Study.

Remember, while the coursework may be challenging, my emphasis when making your report will be on how reasonable your assumptions and figures are. Firm valuation is not a science. If it were the government of UK will get not the valuation of Royal Mail Plc seemingly wrong.

Note that this step accounts for 20% the marks attached to the coursework.

Step 2 of Coursework

Now that you have an idea of the value of your target company, by completing Step 1 of your coursework, our objective in Step 2 is to understand the company and its environment better. The purpose of this knowledge is to be able to improve and justify the valuation of the company.

Therefore, in Step 2, you will need to do a SWOT analysis (strength, weakness, opportunities and threats) of the company. Issues that you may want to cover include:

• The company’s market position (relative to its competitors)

• Business Model (how sound is it?)

• An assessment of the company’s sources of inputs and finance

• Risk management systems/corporate governance mechanisms in place (you may want to compare this with the requirements for listed companies on the London Stock Exchange, available on the Exchange’s website)

• Financial Performance (look at the liquidity/working capital position, profitability, gearing etc. What can you improve to generate synergy?

• Expansion potential

• Strong franchise value- this is the best source of growth. Does your target company have one it’s probably not maximising?

• Management team- poor management team is generally a motivation for takeover. There are ratios to calculate management efficiency, e.g. cost-to-income

NB: You do not need to cover all the listed issues in the report of the coursework. However, it is important to note that in practice your valuation should incorporate your judgement on these issues.

Other issues

Some of you have asked me if you need to show the formulas for your calculations. I need the figures used but not the formulas. You may want to send all formulas to the appendix (in which case I may not read them). Also, if you have used a spreadsheet to complete your coursework, you may want to include this when submitting.

In addition, students have raised the question regarding the interpretation of derived figures. You will need to read materials on ratio analysis, a topic I believe you should have taken. You may also consult the relevant chapters of BD textbook.

This step of your coursework is 20%

With the calculations (computations) going to the appendix, I expect that you limit the discussion of your results in the step to 800 words.

Step 3 of Coursework

This step of your coursework carries 50% of the total mark (i.e. 50% of the 30% allocated to the coursework).

In this step you are required to come up with a business plan for your target company as well as a valuation of the company. In coming up with a business plan you should look at the operations, investments and capital structure of your target company with the aim of assessing its potential for improvements and future growth. This plan must project the synergy post-acquisition. You will be coming up with a number of reasonable assumptions at this stage. These assumptions should be justified on the basis of past performance and position of the target company (strength and weaknesses of the income statements and the balance sheet).

In line with the BD text (Chapter 19- Valuation and Financial Modelling), please provide necessary calculations regarding operational improvements, capital expenditure and capital structure. You will then need to build a financial model of free cash flow. You need not forecast the balance sheet or the cash flow statement. You may also want to skip improvements in working capital management, as we have not treated this topic- the value of “increase in working capital” would be zero in this case.

It is important to note that your forecast of free cash flow should include two parts:

• Forecast over the short-term horizon ( Year 1-5, where Year 0 is assumed to be 2012 or 2013, the year for which the latest financial data is available)

• The terminal value – assume that free cash flow at the end of Year 5 will grow at a constant from Year 6 to infinity. You will need to justify the growth rate that you choose.

To be able to get the value of the company target company, discount the free cash flows at the company’s cost of capital. Therefore, I require you to calculate the weighted average cost of capital (10 marks). You should derive the cost of equity using CAPM. Please note for this, you do not need to follow BD in calculating unlevered beta (as we did not treat this in class). Simply use the beta value you have sourced (e.g. from Bloomberg or Financial Times). You will need to source the risk free rate (use yield on UK Treasury bill). However, assume that the market risk premium is 5%. Calculate the cost of debt as interest payment divided by long-term debt (i.e. do not include short-term capital in your calculation). You can get the corporate tax rates in the UK by following this link: http://www.hmrc.gov.uk/rates/corp.htm.

It is important that you pay attention to the terminal value as it accounts for a greater proportion of the value of the company. Very few of the best papers last year got this right. To recount what I said in class, to get the terminal value at the end of Year 5 (which is the beginning of Year 6) use the formulae for the present value of growing perpetuity. However, because we need the present value in Year 0, you will then need to discount back to Year 0, where “n” in your discounting formulae equals 5.

Therefore, the value of the target at Year 0 is the addition of the present value of cash flows (Year 1-5) and the present value of the terminal value. If you divide this by the number of shares in issue, you will get the intrinsic value per share (30 marks).

Remember the value you established in the Step 1? We need it in Step 3. To arrive at a value of the firm, we will need to find the weighted average of the value from Step 1 and the value from Step 3. In practice, we normally attach a greater weight to the value derived using the discounted cash flow method (Step 3).

You can now compare your final value of the firm with what the market says (i.e. market price per share). Is your company undervalued? That is market price per share is lower than your calculated value of the company- a good justification to recommend a takeover (10 marks)

Please allocate between 1000 words to the discussion of this part of your coursework. You may want to transfer all tables and calculations to the appendix section of your work.

Our final step would be the structure that I will require when presenting your report.

Please follow the guideline below in presenting your coursework report. (10marks)

Executive Summary

Review of UK and Global Economy (Re: Step 2 of Coursework)

Review of Target Company Sector (Re: Step 2 of Coursework)

Company Information (Re: Step 2 of Coursework)

Preliminary Valuation: Assumptions, Results, and Discussion (Re: Step 1 of Coursework)

Valuation: Assumptions, Results, and Discussion (Re: Step 3 of Coursework)

Sensitivity Analysis (Optional)

Recommendations and Conclusion

• Buy?

• At what price?

o e.g. average of results using the various valuation methods

o remember this is not an NPV coursework

• Any other issues

o e.g. limitations of your method

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