Vodafone, the wireless telephone company, has annual reports that are
detailed and a model for investor disclosure. They include top-level
numbers in both U.S. and U.K. GAAP, as the company has important U.S.
operations and is traded on both the London Stock Exchange and on the
NYSE in American Depository Receipts (ADRs). I will use the U.K. GAAP
numbers ? and everything will be in pounds.
The problem with Vodafone is that it?s financial numbers are TOO
detailed for those new to reports of this kind. The 2004 annual
report is 142 pages.
I will cite sources for the figures below from the pages of the annual
reports, at least where it?s not too cumbersome.
FREE CASH FLOW
Vodafone is interesting because it has shown an accounting loss since
2000, but has been generating a positive cash flow. The losses are
due to acquisitions and increases in goodwill amortization ? which
generate paper losses but don?t use cash. Indeed, cash flow has been
strong enough that dividends were INCREASED last year, a rarity in a
Below is cash from continuing operations, taken from the ?Liquidity &
Capital Resources? of the 2004 report (p. 73 in the PDF document).
The 2002 and earlier numbers all come from the 2002 Annual Report (p.
VODAFONE: CASH FROM CONTINUING OPERATIONS
2004: 12,317 million ?
A variety of things either increase or reduce Vodafone?s free cash
flow. In 2004 the purchases of fixed assets reduced free cash flow by
4.371 million ? (p. 42). Taxes reduced free cash flow by another 1.1
million ? ? while dividends from joint ventures increased cash flow by
1.8 million ?.
VODAFONE?S FREE CASH FLOW
2004: 8,520 million ?
Note: you?ve asked for a valuation ? so we?ll put a valuation on the
company, based on its cash flows. This is NOT a per-share valuation.
Vodafone?s number of shares outstanding has gone from 15.4 million in
1998 to 68 million shares in 2004.
With yesterday?s market close of 139.5 pence and 68 million shares,
the market is valuing this company?s future cash flows at 94.9 million
FORECASTING CASH FLOW
This is where the science of finance turns back into an art.
You can see the variation in the 7 years of data above ? and should
feel free to use any of the growth rates that you?d like.
But the 10-year cash flow growth for Vodafone is 24.5% growth,
according to Value Line. Will it continue? Value Line (and other
analysts) doesn?t think so because of the competitive nature of the
wireless business worldwide. They are forecasting a growth of cash
flow in the next 5 to 7 years to be only 11%. As Value Line
observes, ?the natural course of events in a maturing industry should
make it difficult for the mobile operator to increase market share and
maintain average revenues per unit.?
Here?s a forecast at 11% growth:
FORECAST FREE CASH FLOW (2005-2008)
2004: 8,520 million ?
This growth of almost 37 percent in cash flow should make the
company?s value 129.8 million ? in 2007 ? if interest rates or other
facors don?t change.
The weighted-average cost-of-capital (WACC) mixes the impact of debt
and equity -- and provides larger equity returns in percentages, at
of increasing risk by diverting cash flow to the bondholders. WACC is
WACC = rE (E/VL) + rD(1-t)(D/VL)
rE: return on equity
E/VL: proportion of equity in total firm value
rD: bond returns (which are slightly different for the two divisions)
t: tax rate (expressed as a decimal; 40% = 0.40)
D/VL: proportion of debt in total firm value
D = debt = 19.7 million ? (p. 45)
rD = return on debt = 572 million (p. 33) or 2.9%. (Note that this
may be low, as longer-term bonds start to raise the numbers ? but it
E = equity = 94.9 million ? (figured above)
VL = 19.7 + 94.9 = 114.6 million ?
t = 0 = because the company is reporting losses
The hard one is rE ? what?s the right return on equity? For that, we
have to apply the capital asset pricing model (CAPM).
The CAPM model says that the return to investors (and to the
corporation, rE) has to be equal to:
? the risk-free rate
? PLUS a premium for stocks as a whole that is higher than the
risk-free rate. This market return premium is (rM ? rf)
? And the market return should be multiplied by the risk factor for
the individual company, termed the ?beta of the corporation? (ßc)
Expressed as a formula, it?s:
rE = rf + ßc(rM - rf)
rE is the company's expected return on capital
rf is the risk-free return rate, the rate for gilts in the U.K.
rM is the expected return on the entire market of all investments.
Most measures in the U.K. use the FTSE 100 ? the 100 largest companies
on the London Stock Exchange
ßc is the company's Beta, based on its covariance with the market.
rf in the U.K. is about 4.55% according to the Wall Street Journal
quotes (http://www.wsj.com -- in the credit markets section) --
Sept. 2006 maturity, 4.55%
Dec. 2009: 4.55%
Sept. 2015: 4.57%
Mar. 2036: 4.47%
rm in the U.K. has historically been 5.6%, according to Motley Fool
U.K., a well-known investment site:
Motley Fool U.K.
According to Value Line, the beta (ßc) for Vodafone is 0.95 ?
providing the following rE:
rE = 4.55% + (0.95) * 1.05% = 5.55%
BACK TO WACC
WACC = rE (E/VL) + rD(1-t)(D/VL)
Vodafone?s WACC is:
5.55% (94.9/114.6) + 2.9% (19.7/114.6) = 4.60% + 0.50% = 5.10%
You can see why Vodafone?s borrowing as competition increases: it?s
lowering it?s cost-of-capital, even as it increases its leverage and
financial risk. But with a low beta and good, stable business, it?s
an economical move.
BACKGROUND ON FINANCIAL REPORTS
Though it?s not really necessary to answer this question ?
particularly because Vodafone is so good a breaking out it?s cash flow
numbers ? if you?re going to continue with finance work I?d recommend
strongly that you print a copy of the Merrill Lynch publication ?How
to Read a Financial Report? as a reference document.
?How to Read a Financial Report?
A newer publication (also linked on the Merrill Lynch page) is the
?Guide to Understanding Financial Reports,? which includes some
updated information on definitions of financial terms. Accounting
standards are continually changing on definitions of terms (even of
?sales?) and this newer guide updates that information.
Google search strategy:
Vodafone ?investor relations?
If you have any questions on these calculations, please don?t hesitate
to ask with a Clarification Request.