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Q: Valuation in FTSE 100 index company ( Answered 5 out of 5 stars,   0 Comments )
Question  
Subject: Valuation in FTSE 100 index company
Category: Business and Money > Accounting
Asked by: beringela-ga
List Price: $70.00
Posted: 05 May 2005 14:52 PDT
Expires: 04 Jun 2005 14:52 PDT
Question ID: 518241
I woul like a forecast of free cash flow, weighted average cost of
capital and valuation, for vodafone group (FTSE 100) or for Sage Group
Plc (FTSE 100). Calculations should be done according to UK
accountancy standards. Could anyone help me please.
Answer  
Subject: Re: Valuation in FTSE 100 index company
Answered By: omnivorous-ga on 07 May 2005 14:29 PDT
Rated:5 out of 5 stars
 
Beringela --

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.

Vodafone
?Annual Reports?
http://www.vodafone.com/section_article/0,3035,CATEGORY_ID%253D404%2526LANGUAGE_ID%253D0%2526CONTENT_ID%253D230862,00.html


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
?money-losing? company.

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.
28):


VODAFONE: CASH FROM CONTINUING OPERATIONS

2004: 12,317 million ?
2003: 11,142
2002:   8,102
2001:   4,587
2000:   2,510
1999:   1,045
1998:      886

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 ?
2003: 5,171 
2002: 2,365
2001: (13,278)
2000:     276
1999:       22
1998      173


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 ?
2005E:   9,457
2006E: 10,497
2007E: 11,652

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.


WACC
=======

The weighted-average cost-of-capital (WACC)  mixes the impact of debt
and equity -- and provides larger equity returns in percentages, at
the expense
of increasing risk by diverting cash flow to the bondholders.  WACC is
calculated with:

WACC = rE (E/VL) + rD(1-t)(D/VL)

where,
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

WACC ELEMENTS: 

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
reflects 2004.)
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).


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? (c)


Expressed as a formula, it?s:

rE = rf + c(rM - rf)

Where,  

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
c 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.
Glossary
http://www.fool.co.uk/school/glossary/glossary9.htm#risk-free_rate_of_return

According to Value Line, the beta (c) 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.

Merrill Lynch
?How to Read a Financial Report? 
http://philanthropy.ml.com/ipo/resources/

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.

Best regards,


Omnivorous-GA

Request for Answer Clarification by beringela-ga on 08 May 2005 09:16 PDT
Omnivorous ?

Thanks for answering my question I have found it very helpful. Please
could you clarify the following calculations:

1-	For the WACC elements you quote these figures: rD=572 million (p.
33) or 2.9%. How do I calculate rD using figures from the annual
report? I cannot see this on page 33.
2-	For the CAPM model you quote these figures: 
            rf = 4.55% 
           rM = 5.6%.
	Should it not be the other way around, rf = 5.6% and rM = 4.55%?
Many thanks
Beringela

Clarification of Answer by omnivorous-ga on 08 May 2005 10:20 PDT
Beringela --

Let me take the easy one first:  The rF or risk-free rate is the
British gilt rate -- and the numbers are correct at 4.55%.  (As you
probably know, the risk-free rate in the U.S. is the U.S. T-bill rate,
usually a 10-year or 20-year rate.)  rM -- returns from investments in
"risky" stocks -- should ALWAYS be higher than the rF, according to
finance theory.

I've used the rM from Motley Fool's long-term numbers; the past 5
years have been so variable FTSE that they're a little harder to use. 
I calculated them in this Answer:
http://answers.google.com/answers/threadview?id=514424

Quite frankly, the only number that presents a problem for me is the
rD.  Vodafone has floated a number of bonds that range in term from
short-term to 10+ years.  We don't know what debt payments will be
next year -- but we do know that they paid 572M pounds (see the
section, "Net Interest Payable") from p. 33 (it's page 31 of the
annual report).

Best regards,

Omnivorous-GA

Request for Answer Clarification by beringela-ga on 15 May 2005 12:15 PDT
Hi Omnivorous,

One other small clarification please - I have a query about the "no of
shares outstanding" figure of 68 million you quote just before the
section heading "Forecasting Cash Flow".

How does this "number of shares outstanding" figure if 68 million
relate to the total number of shares available, which is around 64
BILLION today.

So I guess my question is how do you get that "number of shares
outstanding" figure of the free cash flow calculation? Should it
really be 68 million, and not somewhere in the billions?

Many thanks in advance, 
beringela.

Clarification of Answer by omnivorous-ga on 16 May 2005 05:05 PDT
Beringela --

Indeed you are correct: the number of shares has been relatively
steady over the past 3 years for Vodafone at 68.1 BILLION.  This
increases the total valuation by 1,000 (1 billion = 1,000 million) and
reduces the per share numbers based on the mistaken calculation by
1,000.

Since we've valued the company's equity at 139.5 pence x 68 million --
we're obviously low and the total valuation should be 94.9 billion ?
(though you may wish to adjust it for this week's price for Vodafone).

The total shares outstanding can be found on p. 85 of the PDF (p. 83
of the printed report).

Best regards,

Omnivorous-GA




The number of outstanding shares in found on p. 85

Request for Answer Clarification by beringela-ga on 18 May 2005 05:17 PDT
Dear Omnivorous
Thank you ever so much. Everything we have discussed has been very helpful. 
I have posted up another question 'Accounting theory - Modigliani and
Miller' (ID 522789)and it would be lovely if you could answer it
please.
Thanks.
Beringela-ga

Clarification of Answer by omnivorous-ga on 19 May 2005 04:16 PDT
Beringela --

I had seen the Modigliani & Miller question yesterday but am
traveling, so it's difficult to answer a question in detail.

However, the answer lies in the assumptions about a firm, such as:
*  how information flows (efficiently)
*  debt levels of a firm
*  expected returns under the capital asset pricing model (CAPM)

There's a cute story about Merton Miller in this Google Answer --
though it's really just a footnote to the whole question:
http://answers.google.com/answers/threadview?id=512793

If you still have the question open after May 24, I'll be glad to
address it.  But there are several other researchers who know finance
topics well.

Best regards,

Omnivorous-GA

Request for Answer Clarification by beringela-ga on 20 May 2005 09:14 PDT
Hi Omnivorous

Many thanks. Have a nice holiday and I will be posting up other questions soon.

Regards,
Beringela-ga

Clarification of Answer by omnivorous-ga on 20 May 2005 10:48 PDT
Looking forward to them!

Best regards,

O.
beringela-ga rated this answer:5 out of 5 stars
Many thanks for the clarification and reading suggestions. Beringela

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