Reference no: EM132832127

PART A Equity Valuation

This individual assignment is designed to apply the techniques that you learn in class on the equity valuation of companies in today's stock markets.

Step 1: Pick the companies and intrinsic valuation

Using Yahoo Finance or NZX Research for company search. Pick two companies, making sure at least you have:

• (Company 1, the main company that you analyse) One company which has growth potential. Look for companies whose earnings or revenues are growing in recent financial years.

• (Company 2) The other company should be the competitor of Company 1, which means that Company 2 has the similar capitalisation and business line to Company 1 or is in competition with the business of Company 1 for market share.

Provide a narrative regarding the purpose of this report and introduce/brief necessary details of Company 1 you choose (e.g. how your company was evolving; describing the product/service markets, industries, and the competition it faces; discussing the past three-year financial performance evident in some key financial ratios). Also, you must: 1) justify the validity of your companies' comparison; 2) tie your narrative to key numbers and conclusion in your valuation.

Step 2: Discounted Cashflow Valuation

Value the stock in Company 1 using a Free Cash Flows to Equity model (you need to decide the specifications of FCFE model that best fit your companies, e.g., 2-stage, 3-stage, or n-stage...etc) and provide your responses to the requirements as follow.

a) Justify the specifications of the FCFE model for your companies (i.e. what pattern (2-stage, 3-stage, or n-stage) will you assume the Company's growth to follow and why?).

b) Conduct firm valuation using the FCFE Model for Company 1 (besides descriptions, please provide all your calculations/workings in tables and graphs as possible). See the Steps below.

c) Identify at least two the assumptions used in your discounted cashflow valuation and describe their economic meanings.

d) Provide additional analyses and explain how the assumptions identified in (c) affect the results of your valuations.

e) Conduct Discounted Cashflow Valuation for Company 2 and compare the results in valuation for Company 1 with those for Company 2. (5%)

Page 3 of 4

Steps Using FCFE Valuation Model:

1. Estimate the discount rate r used in the equity valuation, that is, the cost of equity. Please follow the instructions of PART B to calculate it.

2. Estimate the current free cash flows to equity investors (FCFE) (see Week 3 Lecture slides)

• To calculate FCFE, you may access annual reports (Form 10-K) of the companies from SEC EDGAR Search https://www.sec.gov/edgar/searchedgar/companysearch.html

3. Estimate the future earnings and cash flows on the firm being valued, generally by estimating an expected growth rate in earnings ( 1) based on analysts' long-term growth forecasts (i.e. forecasted 5-year growth rate in EPS).

4. Estimate when the firm will reach "stable growth" and what characteristics (risk & cash flow) it will have when it does. In other words, determine the growth period(s), growth rate ( 2 3 ), and terminal value.

5. Use the DCF model you choose to estimate PV of future FCFEs.

6. Compare the value relative to the market capitalisation (= stock price x number of outstanding shares) to estimate whether the equity value of the company is currently overvalued or undervalued.

Calculating Free Cash flow to Equity (FCFE):

For the firm's leverage is stable (i.e. the net capital expenditure assumption),

Free Cash flow to Equity = Net Income - (1- DR) (Capital Expenditures - Depreciation) - (1- DR) Working Capital Needs; where DR = Debt/Capital Ratio

Step 3: Value relative to the comparable

a) Compute current PE Ratios for Company 1 and Company 2.

b) Consider value comparison using the PE Ratios of Companies 1 and 2.

Step 4: Final Value Estimate and Recommendation

Consider the results you have obtained from the discounted cash flow and the comparable.

a) Provide the economic implications of your comparisons from Step 2 and Step 3. How would you reconcile the inconsistent results (if existed)?

b) Make final recommendations on the stocks in your group (Strong Buy, Buy, Hold, Sell, or Strong Sell), justify your recommendations, and summarise all your analyses and the results with a conclusion.

PART B Cost of Equity

Required (please show all your workings of OLS regression analysis and simulations)

The Capital Asset Pricing Model (CAPM) is one of the most tested models in Finance. When beta is estimated in practice, a variation of CAPM called the market model is often used. To derive the market model, we start with the CAPM:

E( )= + [ ( )- ]

Since CAPM is an equation, we can subtract the risk-free rate from both sides, which gives us:

E( )- = [ ( )- ]

This equation is deterministic, that is, exact. In regression, we know that there is some indeterminate error. We need to formally recognise this in the equation by adding epsilon ( ), which represents this error: E( )- = [ ( )- ]+

Finally, think of the above equation in a regression. Since there is no intercept in the equation, the intercept is zero. However, when we estimate the regression equation, we can add an intercept term, which we will call alpha:

E( )- = + [ ( )- ]+

This equation, known as the market model, is generally the model used for estimating beta ( ). The intercept term is known as Jensen's alpha and represents the excess return. If CAPM holds exactly, this intercept should be zero. If you think of alpha in terms of the SML, if the alpha is positive, the stock plots above the SML and if alpha is negative, the stock plots below the SML.

You want to estimate the market model for the individual stock of a company you choose. First, go to finance.yahoo.com, or use Datastream (Eikon) database to download the adjusted prices for the last 61 months for the stock of the company and the S&P 500.1 You may access NZX Company Research from the AUT Library website for NZ companies. Next, go to the St. Louis Federal Reserve website at www.stlouisfed.org. You should find the FRED® database on this website (https://fred.stlouisfed.org/). Look for the 1-Month Treasury Constant Maturity Rate and download this data.2 This will be the proxy for the risk-free rate. This interest rate is the annual interest rate, while we are using monthly stock returns, so you will need to adjust the 1-month T-bill rate. For the stock that you select, estimate the beta and alpha of the stock using the market model. When you estimate the regression model, find the box that says Residuals and check this box when you do each regression. Because you are

1 You may use historical data of S&P/NZX 50 (or S&P/ASX 200) if the company you chose is listed in New Zealand (Australia) markets.

2 You may use the "Long-Term Government Bond Yields: 10-year: Main (Including Benchmark) for New Zealand" for New Zealand companies. (or "Long-Term Government Bond Yields: 10-year: Main (Including Benchmark) for Australia" for Australian companies).

Saving the residuals, you may want to keep the regression output in a new worksheet.

a) Draw characteristic lines for the companies and provide interpretation and implications based on the estimated beta and alpha.

b) Calculate the average cost of equity for the companies E( ) over the period by using the estimated equation.

c) Compare your group companies based on the estimates obtained from (a) and (b). Provide the corresponding implication.