Question

1. Assume that you are an equity analyst and you have been asked to generate a twelve month forward price target for ShopSmart Plc, a retail company. You decide to use the discounted Free Cash Flow to Firm (FCFF) valuation model. For the year just ended you have collected the following information on ShopSmart PLC:
? Net Income: £260 m
? Sales: £2,600 m
? Depreciation: £100 m
? Investment in fixed capital: £180 m
? Interest expense: £110 m
? The working capital has increased from £55m at the beginning of the year to £95m at the year-end
? Effective tax rate: 30%
? Current market value of the outstanding debt: £1,800 m
? Number of shares outstanding: 10 m
? Current P/E (price-to-earnings): 25
? The company’s target capital structure is 30% debt, and 70% equity.
? Before-tax cost of debt: 6%
? Risk free rate: 5%
? Market risk premium: 5%
? The stock’s beta: 1.3
You forecast that the FCFF and Net Income will grow at 7% per annum over the next three years. Due to uncertainty beyond this three-year forecast horizon, you decide to estimate the terminal value (at the forecast horizon) by using the sector’s historic-average EV/Sales (Enterprise Value-to-Sales) multiple of 4. You also forecast that future years’ net profit margin will remain constant, and will be equal to the margin of the year just ended.
Reminder of the FCFF formula:

FCFF = Net Income + Net Noncash Charges + Interest Expense x (1- tax rate) – Fixed Capital Investment – Working Capital Investment

Required:

Generate the twelve month forward price target for ShopSmart Plc using the FCFF valuation approach, and state and justify your investment recommendation for the stock. Please show your workings.

2. You are a buy-side analyst and your fund manager has asked you to estimate the value of EcoShop Plc, a listed retail company. You have collected the following data on EcoShop Plc, for the year just ended:
? Earnings per share (EPS): £26
? Number of shares outstanding: 10m
? Depreciation: £80m
? Investment in fixed capital: £110m
? Interest expense: £50m
? The working capital has increased from £30m at the beginning of the year to £40m at the year-end
? Effective tax rate: 20%
? Current market value of the outstanding debt: £1,400m
? The company’s target capital structure is 20% debt, and 80% equity
? Before-tax cost of debt: 4%
? The current yield on the 10 year UK Government bond is 2%
? Market risk premium: 5%
? The stock’s beta: 1.3

You estimate that the Free Cash Flow to the Firm (FCFF) will be growing at 6% per annum over the next three years. However, because it is too difficult to estimate the growth rate beyond this forecast horizon, you decide to determine the terminal value element of the valuation model by using the sector’s historic-average EV/FCFF (Enterprise Value-to-FCFF) multiple of 15. EcoShop’s current EV/FCFF multiple is 13.
Reminder of the FCFF formula:

FCFF = Net Income + Net Noncash Charges + Interest Expense x (1- tax rate) – Fixed Capital Investment – Working Capital Investment

Required:
Compute the fundamental value of EcoShop’s stock using the FCFF valuation model. State and justify your investment recommendation. Please show your workings.

3. A portfolio manager has recently taken a long position in XYZ Plc’s stocks, and wants to know whether this stock is still worth holding. She requests a sell-side analyst to provide an estimate of the stock’s twelve month forward price target. The analyst decides to use the Free Cash Flow to the Firm (FCFF) valuation model, and collects the following information for the year just ended:
? Earnings: £130m
? Sales: £1,300m
? Depreciation: £50m
? Investment in fixed capital: £90m
? Interest expense: £55m
? The working capital has increased from £35m at the beginning of the year to £55m at the year-end
? Effective tax rate: 20%
? Current market value of the outstanding debt: £900m
? Number of shares outstanding: 10m
? The company’s target capital structure is 35% debt and 65% equity.
? Before-tax cost of debt: 6%
? Risk free rate: 4.5%
? Market risk premium: 7%
? The stock’s beta: 1
? The stock’s current P/E (price-to-earnings) multiple is 18
The analyst forecasts that the FCFF and Sales will grow at 8% per annum over the next three years. Due to uncertainty beyond this three-year forecast horizon, the analyst decides to estimate the terminal value (at the forecast horizon) by using the sector’s historic-average EV/Sales (Enterprise Value-to-Sales) multiple of 2.

Reminder of the FCFF formula:
FCFF = Net Income + Net Noncash Charges + Interest Expense x (1- tax rate) – Fixed Capital Investment – Working Capital Investment

Required:
Estimate the one year forward target price for this stock using the FCFF valuation approach, calculate the return that the portfolio manager would realise by holding the stock over the next twelve months and then selling it at the projected target price, and explain whether this represents a worthwhile investment. Please show your workings.

Answer 1