Financial Statement Analysis The Stock Market

Question: Describe about the Financial Statement Analysis for The Stock Market. Answer: Introduction:- The stock market is very much volatile in comparison to other investment options. Therefore, the investors have to rely on various valuation models for the future stock performance of any company. The methods can be classified into two sections. The first section correlates the stock prices with the overall market index and various external factors, which can affect the market index as well as the individual stock prices. The other section focuses on the internal performance of the company for evaluating the stock prices. It also helps to measure the financial performance of the company. Thus the investors and other stakeholders can determine the proper valuation of the company and take proper investment related decisions accordingly. There are various models, which are used to measure the financial performance and valuation of the company. However, Residual income, Return on Operating Income, Free Cash Flow and Dividend Discount Model are considered as the most reliable and effective metrics for ascertaining the fair value of the company and its stocks (Gibson 2012). Cochlear Ltd. is an Australia based company, which designs and manufactures implant hearing products. It is one of the largest hearing implant companies in world and holds over almost 30% of the worldwide market. The company is enlisted in Australian Stock Exchange and maintains a good repute in the stock market. The report is prepared to demonstrate the financial evaluation models, which focuses on the financial performances of the company, to evaluate the fair value of Cochlear Model. The future performances of the company have been forecasted through its financial performance of last 5 years. The forecasted performances are analyzed through the aforementioned models to derive the fair value of the stock prices. Prospective Analysis:- As discussed above, the fair value of the company and its share price are evaluated on the basis of the future prospect of the company. Therefore, it is very necessary to forecast the financial performances of the company to depict the prospect of the company. The forecasted financial performance of Cochlear Ltd. for the upcoming 5 years, starting from 2017 to 2021, has been calculated on the basis of the financial data of the last 5 years. The financial data has been derived from the last 5 years annual reports of the company. The key components of forecasting are listed below: Sales Growth Asset Turnover Dividend Payout Profit Margin Cost of Capital (Brigham and Ehrhardt 2013) Assumptions for Key Components:- The key components are mainly computed through ratio analysis of last 5 years financial performance. However, some assumptions have been done to forecast the performance with more realistic approach. The assumptions are mentioned below: It has been observed that the sales growth rates were quite higher in the last 2 years in comparison to the previous years, which has caused the average sales growth rate higher than the normal rate. Therefore, in 2017, the actual average growth rate is applied to predict the revenue and in 2018 and 2019, the growth rates are reduced by 5% from the previous year. On 2020 and 2021, the growth rates are remained same as the previous years (Casey et al. 2015). As the fixed assets are not traded frequently, the asset turnover ratio, which is the average of last 5 years asset turnover ratio, is kept unchanged for the next 5 years. The dividend payout ratio has been very fluctuating in the last 5 years. Hence, instead of applying the average dividend-payout ratio for the last 5 years for forecasting, it is set at 60%, which is the general benchmark for the market. The profit margin rate of the next 5 years is assumed to be same as the average profit margin of last 5 years. The cost of debts of the company had reduced constantly in the last 5 years. Therefore, for forecasting purpose, the average cost of debt for last 5 years has been applied and kept unchanged for the next 5 years (Cantoni 2012). The weighted average cost of capital is considered as the most authentic cost of capital for any evaluation purpose. It is derived by adding the cost of debt and cost of equity capital in weighted average method. For Cochlear Ltd., the average cost of debt of last 5 year, is considered as the cost of debt. The cost of equity is computed under Capital Asset Pricing Model on the basis of the stock market return of the company and its correlation with the market index (Fabozzi and Peterson 2013). The calculations for the key components are shown in the appendices. Forecasting of Future Financial Performance:- Based on the calculations and assumptions, various important financial items, required for the four aforementioned four models, have been forecasted accordingly. The financial data of last year,i.e., 2016 is considered as the base of the forecast. The process of forecasting various financial items, required for the four models, are described below Forecasted Sales = Sales of Previous Year + (1+ Sales Growth Rate) Net Operating Assets (NOA) = Sales/ATO Net Operating Profit after Tax (NOPAT) = Sales x Profit Margin Free Cash Flow (FCF) = NOPAT Change in NOA Dividend Payable (d) = NOPAT x Dividend Payout Ratio Net Payment to Debt Holders (F) = FCF d Net Financial Expenses after Tax (NFEat) = Net Financial Obligation of previous year x Cost of Debt Net Financial Obligation of Current Year (NFOt) = NFOt-1 + NFEat F Comprehensive Income (NI) = NOPAT NFEat Equity (OE) = NOA NFOt Based on the aforementioned formulas the projected financial performance of Cochlear Ltd. from 2017 to 2021 is given in the following table: Forecasts for Cochlear Ltd. Actual Forecast Forecast Forecast Forecast Forecast 2016 2017 2018 2019 2020 2021 1.Forecast sales Sales growth rate - estimated 7.38% 7.01% 6.66% 6.66% 6.66% Sales 1,130,552 1,214,012 1,299,152 1,385,708 1,478,030 1,576,503 2.Forecast ATO and calculate NOA forecast ATO 1.91 1.91 1.91 1.91 1.91 1.91 Calculate NOA (NOA=sales/ATO) 590,540 634,135 678,608 723,820 772,044 823,482 3.Revise sales forecasts 4.Forecast PM and calculate NOPAT Forecast PM 16.14% 16.14% 16.14% 16.14% 16.14% 16.14% Calculate NOPAT (NOPAT = Sales x PM) 195,995 209,740 223,714 238,619 254,517 5.Forecast any other operating income (unusual items) 0 0 0 0 0 0 6.Calculate free cash flow (NOPAT change in NOA) change in NOA 43,595 44,473 45,212 48,224 51,437 calculate FCF 152,400 165,268 178,502 190,395 203,080 7.Forecast net dividend payout estimated as a % of NOPAT 60% 117,597 125,844 134,229 143,171 152,710 8.Calculate net payments to debt holders payments = FCF - dividend 34,803 39,423 44,274 47,223 50,370 9.Forecast cost of debt and debt balance Forecast cost of debt after tax 4.69% 4.69% 4.69% 4.69% 4.69% 4.69% Opening debt balance 212,711 187,884 157,273 120,376 78,798 Calculate cost of debt (net financing after tax) 9,976 8,812 7,376 5,646 3,696 Calculate closing debt (opening + interest - repayment) 193238 187,884 157,273 120,376 78,798 32,124 check leverage (d/noa ratio) 33% 30% 23% 17% 10% 4% 10.Calculate comprehensive income NOPAT - NFEAT 186,019 200,928 216,338 232,973 250,821 11.Calculate equity (and check it works both ways) 448,557 equity = assets - liabilities 446,251 521,335 603,444 693,246 791,357 closing equity = opening equity + income - dividend 516,979 592,063 674,172 763,974 862,085 Evaluation of the Company under 4 Models:- Residual Income Model:- The residual income is mainly based on the Comprehensive Income and Owners Equity. The residual income is the total of comprehensive income and cost of owners equity. In the Residual Income model, the forecasted residual incomes for the future years are used to determine the terminal value and then the discounted terminal value is added with opening comprehensive income and owners equity to derive the net value of the company (Healy and Palepu 2012). Residual Operating Income Model:- Residual operating income model is a modified form of RIM, which focuses on NOPAT and Net Operating Assets. In this model, residual operating earnings is calculated by adding the NOPAT with the cost of net operating assets. Then, the discounted terminal value of forecasted ROEs is added with net present value of total ROIs and NOA to compute the total value of the firm. The net value of the firm is derived after deducting the total debt from the total value of the firm (Patterson 2013). Free Cash Flow Model:- The free cash flow model considers the free cash flow of the company for its valuation purpose. The projected free cash flows of the future years are discounted by the cost of capital. The discounted free cash flows are then used for calculating the net value of the company (Robinson et al. 2015). Dividend Discount Model:- In the dividend discount model, the forecasted dividends amounts are used to compute the discounted terminal value. The discounted terminal value is then used as the base of the net value of the company. The details of the calculation of each model are attached in appendices. However, the fair value of Cochlear Ltd.s shares under each method is shown in the following table: Share Price of Cochlear Ltd. under different models:- Particulars Amount Market Price as on 30/06/2016 121.25 Fair Value as per RIM 33.39 Fair Value as per ROIM 41.69 Fair Value as per FCF 109.77 Fair Value as per DDM 3.15 Sensitivity Analysis:- The forecast is done on the basis of previous years financial data and assumptions. In the future, the forecasted figures may vary with the actual amounts due to change in the assumed scenarios. Therefore, it is very necessary to conduct sensitivity analysis on the outcomes of each model. The evaluation process of each model is based on the key components, which are either assumed or computed from the financial performances of previous years. Hence, the sensitivity analysis is conducted to check the stock prices are how much sensitive to the key components (Sridharan 2015). The analysis is done under two approaches- optimistic and pessimistic. Under optismistic approach, all the key components are increased by 25% and. The components are subsequently decreased by 25% under pessimistic approach. The outcomes of the analysis are shown in the following table: Sensitivity Analysis:- 2017 2018 2019 2020 2021 RIM ROIM FCF DDM Sales Growth Rate 7.38% 7.01% 6.66% 6.66% 6.66% 33.39 41.69 109.77 3.15 Sales Growth Rate + 25% 9.23% 8.77% 8.33% 8.33% 8.33% 39.33 47.07 -187.45 3.46 Sales Growth Rate - 25% 5.54% 5.26% 5.00% 5.00% 5.00% 29.25 37.82 52.3 2.92 ATO (Average Turnover) 1.91 1.91 1.91 1.91 1.91 33.39 41.69 109.77 3.15 ATO + 25% 2.39 2.39 2.39 2.39 2.39 33.64 44.1 115.53 3.15 ATO -25% 1.44 1.44 1.44 1.44 1.44 32.97 37.68 100.18 3.15 PM (Profit Margin) 16.14% 16.14% 16.14% 16.14% 16.14% 33.39 41.69 109.77 3.15 PM + 25% 20.18% 20.18% 20.18% 20.18% 20.18% 42.35 53.89 145.26 3.94 PM - 25% 12.11% 12.11% 12.11% 12.11% 12.11% 24.42 29.99 74.29 2.36 Dividend Payout Ratio 60% 60% 60% 60% 60% 33.39 41.69 109.77 3.15 Dividend Payout Ratio + 25% 75% 75% 75% 75% 75% 34.2 41.69 109.77 3.94 Dividend Payout Ratio - 25% 45% 45% 45% 45% 45% 32.57 41.69 109.77 2.36 Results under Optimistic Approach:- The table, shown above, describes that the increase in sales growth would affect the fair values of each model positively, except the FCF model. The rise of profit margin would have the same affect on the values of each model. The upward change in ATO would reduce the values under RIM and ROIM model, but affect positively for FCF model. Due to increase in dividend payout ratio, the fair value under DDM RIM would improve, whereas, the values under ROIM and FCF would remain unchanged. Results under Pessimistic Approach:- The fall of sales growth would cause all the values decrease, except the value under FCF model. If the ATO would decrease, then the values under RIM and ROIM would rise and FCF would decrease, whereas, for fall in profit margin, all the values under all the methods would decrease. Due to fall in dividend payout ratio, the value under DDM and RIM models would move downwards. Recommendation:- From the fair values of Cochlear ltd., determined under four models, it can be concluded that currently the market price of the company is overvalued. The investors will not prefer any stock, which are overvalued, as they will not get adequate return from such shares in term of dividend. Moreover, there is high chance of fall in the market prices of such overvalued shares in near future. Hence, in such scenario, if Cochlear Ltd. intends to raise capital through share issue, it should take corrective measures to increase the fair value of its shares. The possible way to increase the fair value is to focus on its key components, which can trigger the fair value upwards. Amongst all the models, the FCF model have predicted the fair values closer to the market price. The company may adopt the following strategies for the improvement of the fair values: Cochlear Ltd. is a reputed brand in the implant hearing sector. It should utilize its brand name and adopt such marketing strategies, which can increase its sales volume. Due to good market repute, it may also increase its product price to generate more profit and increase the profit margin accordingly. It may introduce new cost affective structure to reduce its costs and increase the profit margin. The company should expand its market for generating more sales. Such market expansion may reduce the profit margin in the initial stage due to high expenses. However, if it will be done with proper planning, the company may increase its profit in the future periods. References and Bibliography:- Brigham, E.F. and Ehrhardt, M.C., 2013.Financial management: Theory practice. Cengage Learning. Brigham, E.F. and Houston, J.F., 2012.Fundamentals of financial management. Cengage Learning. Cantoni, E., 2012. Financial statement analysis and insolvency forecast models: a proposal for local firms.Economia Aziendale Online, (4), pp.1-17. Casey, R.J., Gao, F., Kirschenheiter, M.T., Li, S. and Pandit, S., 2015. 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