Question

You are a buy-side analyst and your fund manager has asked you to estimate the value...

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.

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Answer #1

Net income = EPS * No. of shares= 26*10 = 260 million

FCFF = 260+80+50*(1-0.2)-110-(40-30) = 260 million

FCFF for year 1 = 260*1.06 = 275.6

FCFF for year 2 = 275.6*1.06 = 292.14

FCFF for year 3 = 292.14*1.06 = 309.66

Terminal value = 15*EV/FCFF

EV = debt + Equity

= 1400+1400*4 = 7000 since debt is 20% and Equity is 40%

Terminal value = 15*7000/260 = 403.85

Cost of capital = 0.2*after tax cost of debt + 0.8*cost of equity

Cost of Equity = Rf + beta *(risk premium)

=2+1.3*5

= 8.5%

Coat of capital= 0.2*4*(1-0.2) + 0.8*8.5

= 7.44%

So, value of firm = 275.6/1.0744 + 292.14/(1.0744^2) + 309.66/(1.02^3) + 403.85/(1.0744^3)

= 1127.02 million

Value of stock = 1127.02/10 = 112.7

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