British Telecom and Vodafone are two giants in the telecom industry. After the financial burst of 2008 in the US Economy and the financial troubles in Europe, the telecom sector got badly impacted. In fact the whole sector instead of growing has slid into a negative growth which has affected almost all the telecom companies. British Telecom and Vodafone are trying to diversify their portfolios by making efforts to come up with innovative product packages to fuel growth. So far the initiatives have not shown much improvement in the results. In such conditions it is becoming very difficult for those companies to deliver value to the shareholders on an ongoing basis. Revenue is falling and so does the profit. This is affecting the company’s ability to invest in long term value generating projects. This essay will discuss how both the companies were able to deliver value to its shareholders in the recent past and what are the valuation of both company’s stock using different methods. This essay will also recommend whether making investment in these companies’ stocks is recommended or not.
Shareholder Value Creation
Wealth creations for shareholders are measured using many parameters. The most common of them are Return on Equity. Other measures like earnings per share, dividend growth are also common measures used by the shareholders to analyze their investment outcome.
For British Telecom, return on equity showed really great numbers till 2008. In fact between 2005 and 2008 the average return on equity change for British Telecom was more than 50%. However since 2009 the growth has stalled. In 2009 British Telecom has registered a small growth of 2% in terms of change in Return on Equity (Investors Chronicle #1, 2014). Since then the company only registered negative return on equity growth. Although many other players have shown similar negative growth during the period, some telecom players were also able to register positive ROE. However, all was not bad for the shareholders of British Telecom. British Telecom continued to give dividend to its shareholders. In 2013, dividend grew by almost 14.46% from previous year. However, overall cumulative 5 year dividend growth still remains in negative. Earnings per share for the company grew by 4.37% in 2013 (Investors Chronicle #1, 2014). Even the earnings per share growth of 3.83% over the last 5 years were at par with the industry average. The stock price for the company has not been affected by the slowdown. In fact between 2009 and 2013 the stock price rose by almost 202% from £20 per share to almost £62 per share (Investors Chronicle #1, 2014). Even though the shareholders could not get much return from the company profits, the overall share price movement more than compensated it.
For Vodafone, Return on Equity was managed much more effectively than BT. In fact between the years 2009 and 2013 the average return on equity was 23.58%, much superior to any other company in telecom segment during that period (Investors Chronicle #2, 2014). However, the only concern is that Vodafone has posted a huge decrease in ROE during 2013. Dividend of Vodafone also grew at a very healthy rate. In fact Vodafone increased the dividend growth rate every year from 2009. Even in 2013 when it posted a very small profit then also its dividend growth remained unaffected. Over the last 5 years the average dividend growth rate was 6.29% which was more than the industry average (Investors Chronicle #2, 2014). However, for the investors the major concern was that the earnings per share growth continuously decreased due to challenging business conditions.
Due to heavy reduction in earnings in 2013, earnings per share growth went down drastically. In fact the EPS came down from £0.16 in 2010 to almost £0.01 in 2013. Share price also has done well during the last five years. From £137 in 2009 the share prices have increased 71% by 2013 to almost £237 (Investors Chronicle #2, 2014). Overall both British Telecom and Vodafone have created decent value for the investments during the last 5 years. None of the company’s performance from the perspective of shareholders was stellar but definitely they were decent when we need to consider the recessionary macroeconomic conditions.
This shows that British Telecom is more than covered its cost of capital.
Valuation of Equity
There are several ways the valuation of a company is done. The most common one is known as the comparative valuation method. This is done using ratios and multiples. It uses ratios like price earnings ratio, P/B ratio, Enterprise value/ EBITDA ratio of the company and then compares it with a benchmark and or with similar peer group. This method is easy to calculate but may have many errors. For example, finding a right peer group or right benchmark is often a very challenging task as each company may operate differently. Especially for new companies and industry leaders in a sector it is difficult to find proper benchmark.
P/E ratio is the most common ratio used to measure a company’s value. It is measured by the current share price/ earnings per share. For British Telecom the P/E ratio for 2013 was 14.91. For BT the price to book value ratio is 114.50 (Investors Chronicle #1, 2014). Earnings per share for BT in 2013 were 0.26. From the three values we found that we can calculate the book value per share as 3.4. This is based on the data for the last 12 months when the earnings for the company significantly rose compared to its performance in last 4 years. For Vodafone the price earnings ratio is 272.41, earnings per share is 0.87 and price to book value ratio is 1.58 (Investors Chronicle #2, 2014). The book value per share is 146. This value seems extremely large because the earnings for Vodafone significantly decreased in 2013 compared to its earlier years pushing the P/E ratio extremely high. These are very crude measures to value a company. Drawing a conclusion for cyclical industry using this ratio method is crude and will give low P/E ratio when the earnings are high. This may indicate that the shares are lowly priced and favorable for buying but in reality this is the worst time to buy a share in a cyclical industry. To supplement the P/E ratio many analysts recommend looking at ratios like earnings yield and PEG ratio. What PEG ratio does is that it divides the growth rate with the growth rate of earnings. Then it becomes easy to compare companies with different growth rates. Let us look at the PEG ratio for both the companies. For Vodafone, the PEG ratio for the next 5 year is expected to be -2.88. It shows that the growth rate expected is negative. For British Telecom, the PEG ratio expected is 2.22 for next 5 years. It shows that the company is slated to grow in the coming days. This means that the share price of Vodafone is not expected to grow much from the current level. On the other hand British Telecom share price will grow in future years.
Asset based valuation technique is most popular in industries where there are lot of investment done on assets to do business. For example, telecom, shipping, airline are some of prime example of industries very dependent on the assets. These assets play a significant role in generating revenue and profit for those companies. This approach may not be suitable for a typical information technology firm. For British Telecom, the calculation of NAV/ Share is calculated as below:
It shows that the NAV/ Share is 2.04. This tries to estimate the book value of the share of British Telecom. Actual book value per share for British Telecom is 1.89. This shows that British Telecom, to some extent, overvalues its assets and hence the value stemming from the Asset Valuation method is actually more than the market value. It can also happen when a market underestimates the asset value of the company. For example, for British Telecom the book value of properties is estimated as £14 billion but market may value the properties as £10 billion. This also shows that the market is actually conservative about the company’s assets and hence there is a chance that the company share prices will go up in the future to the calculated levels.
Discounted Cash flow approach is the most sophisticated among the three. Let’s use this method to calculate the value of the company.
Let’s first calculate the cost of debt for British Telecom. The corporate tax rate for the year 2012 was 16.7 % and for the year 2011 it was 18% (Investors Chronicle #1, 2014). We will take the average corporate tax rate for British Telecom as 17%. Average interest rate paid by British Telecom is 7.0%. It paid a loan interest of £1.57 billion in 2012. Total long and short term loan outstanding for BT is £20,720.
So effective interest rate after tax paid by the company is = 7.0 * ( 1-0.17) = 5.81 %.
Total Debt/ Equity =0.7 or in other words debt to total capital is 0.28.
So weighted average cost of debt is = 0.28 *5.81% = 2.38%
Cost of equity is the compensation the market demands in exchange for investing in the company and bearing the risk of owning assets in the company. It is not always easy to calculate the cost of equity correctly but we will use a simplistic methodology to come up with the cost of equity for British Telecom. As share capital does not have any explicit cost so it is not easy to come up with the cost of equity. As seen in the above calculation the cost of debt calculation is relatively easy. In case of cost of debt, a company needs to pay interest and that gives a clear guidance about the cost of the capital borrowed in form of debt. Cost of equity is trickier. Capital asset pricing model is the most used model for calculating cost of equity. Cost of equity equation as per the capital asset pricing model is as below:
Re = rf + (rm – rf) * β
- rm – rf = the market risk premium
- β = beta coefficient = unsystematic risk
- Re = the required rate of return on equity
- rf = the risk free rate
Risk free rate is the rate that can be obtained from investing in securities deemed almost risk free. For all practical purposes, U.S. Treasury Bill is used as the proxy rate for risk free rate (Jennergren, 2011). In this case the rate for U.S Treasury bill is around 1-1.2% for 90 days and so we will take our risk free rate as 1.2 %.
Beta on the other hand measures the risk of owning the stock compared to the market movements. There are stocks which do not fluctuate much even if the market is extremely volatile. Some other stocks are more sensitive to market fluctuations. Stocks which have higher fluctuations have high beta (Herbohn and Harrison). British Telecom has a relatively stable stock price and the growth is not constant irrespective of market volatility in recent years. The beta as obtained from Bloomberg is 0.87 for British Telecom.
Equity market risk premium is nothing but the risk of holding stock instead of investing in risk free securities. This is the extra return investors expect from the stock for the risk they are taking. In the last few years due to poor market conditions and stock price volatility the risk premium has gone up (Jennergren, 2011). As per the paper published by World Finance Council in 2013, the median risk market premium range for UK stocks is 5-8%. We will take the Equity market risk premium as 8% for our calculation.
- Cost of Equity = 1.2% + 8% * 0.87 = 8.16%
- Equity to total capital employed is 59%.
- Weighted average cost of equity = 8.16 * E/v = 8.16*0.59 = 4.81
Let us now go back to our cost of capital calculation.
- WACC = E/V * Re + D/V * Rd (1-Tc)
- We have calculated our weighted avreage cost of equity = 4.81
- And weighted average cost of debt = 2.38
- So cost of capital for Kingspan is = 4.66 + 2.38 = 7.04%
- For all our subsequent calculation we will take 7 % as the cost of capital for British Telocom Group.
Discounted cash flow analysis helps calculate how much one is liable to get in future and how much he needs to invest today for the company. Discounted cash flow is a method that determines the intrinsic value of a company. This analysis assumes that a company is worth all of the cash it will make available to its investors in future. The future cash flows are discounted by cost of capital as future cash flows are worthless today (Damodaran, 2012). For making a discounted cash flow analysis, there are several assumptions to be made which is deemed by many as the weakness of discounted cash flow model. Free cash flow of a company is defined as the net of = net operating profit + Depreciation +/- Working Capital -capital expenditures (Herbohn and Harrison).
For calculating the value of the company we first need to predict how the future of the company looks like. Let’s look at the company income statement in details and try to make some assumptions about its future revenue stream.
- As we can see from the revenues of British Telecom Group that the revenue growth is negative by 4-5% for the past few years. We will assume the trend to continue for 2 more years and then from 2015 the revenue will grow at 2%.
- Cost of goods sold as a percentage of revenue for British Telecom has varied very little over the last 4 years. In fact it has always been between 82% and 83% of the total revenue. We will assume that it will continue to be 82.5% of the total revenue in future.
- In similar lines and based on the past four years data we will assume that taxes will be 16.00% respectively in future.
- We assume cost of capital as 7%.
Based on the above assumption we have created the income statement for British Telecom Group as below:
Projected Income statement as below
Projected Free Cash flow
This was calculated based on the financial results as posted till March, 2013 when the Market Value of the company was £20 billion and the book value per share was 2.4. Our calculation has found out that the value of the company is £18.43 billion which is pretty close to what the value market thinks of British Telecom.
Comparison of different methods
We have calculated the values based on three different methods for British Telecom. The book value per share values are very different in three methods we used. In the first method of using ratios we got the book value per share as 3.4 whereas we got the value as 2.04 using asset method and 2.33 using the discounted cash flow method. The ratio method gave lower value because of the market thinking positively of BT future and the price of share rose significantly. However, the asset value gave the most conservative estimate as expected as BT calculates its asset more conservatively than the actual market value. Discounted cash flow method seems a little higher than the actual market value but it is the closest among all three. This may be caused by many factors.
Actual enterprise value as calculated by asset method is £16 billion and that using discounted cash flow method is £18 billion.Current market value of the company is much more than that.
Conclusion and Recommendation
British Telecom and Vodafone are two giants in the telecom industry and have experienced rough waters after the recent recession. Although Vodafone has shown more resilience during and after the recession, it has now started getting the heat. British Telecom has suffered a lot after the recession and its revenue decreased year on year from 2009 onwards. Still British Telecom is trying to find ways to stop the bleeding. In recent years British Telecom has started showing some positive results. However, the investors are bullish about British Telecom always. In fact despite poor profits incurred by British Telecom in recent years after the recession, its shares soared 202% between 2009 and 2013. After doing an analysis using various models like asset model, discounted cash flow model and the ratio analysis we found that the current market value of the company is actually more than the intrinsic value of the company as calculated. This shows that in near future until and unless the company can do something drastically well the share prices should not rise much in medium to long term. British Telecom shares should be categorized as “Sell” or “No Invest” as per the current analysis. Similar analysis can be done for Vodafone to find out the stock price versus valuation.
Jennergren, Peter L. 2011. A Tutorial on the Discounted Cash FlowModel for Valuation of Companies.Stockholm School of Economics. Viewed on 5th January 2014 <http://swoba.hhs.se/hastba/papers/hastba0001.pdf>
Discounted Cash Flow (DCF) Analysis. Macabacus. Viewed on 5th January 2014 <http://www.macabacus.com/valuation/dcf/overview>
Discounted Cash Flow (DCF) Analysis. Wall Street. Viewed on 5th January 2014 <http://www.wallstreetwannabe.com/?page_id=643>
Knilans, Gerri. 2009. Mergers and Acquisitions: Best Practices for Successful Integration. The Global Consulting Partnership, Viewed on 5th January 2014 <http://www.tgcpinc.com/SiteData/doc/MergersAcquisitions-MBrenner-071409/976ceba14c4fae75a4bbcb514bb34762/MergersAcquisitions-MBrenner-071409.pdf>
Damodaran, Aswath. Basics of Discounted Cash Flow Valuation. New York University. Viewed on 18th December 2013 <http://pages.stern.nyu.edu/~adamodar/pdfiles/basics.pdf>
Hanham Hall Hospital. 2013. CEEQUAL. Viewed on 5th January 2014 <http://www.ceequal.com/awards_060.htm>
Herbohn, John and Harrison, Steve. Introduction to Discounted Cash Flow Analysis and Financial Functions in Excel. Viewed on 5th January 2014 <http://espace.library.uq.edu.au/eserv/UQ:8138/n11__INTRODUCTIO.pdf>
Investors Chronicle #1. BT Group. 2014. Viewed on 5th January 2014 < http://markets.ft.com/research/Markets/Tearsheets/Financials?s=BT.A:LSE>
Investors Chronicle #2. Vodafone. 2014. Viewed on 5th January 2014 < http://markets.ft.com/research/Markets/Tearsheets/Financials?s=VOD:LSE>
Measuring and Managing Shareholder Value Creation. Institute of Management Accountants (IMA). 2013. Viewed on 5th January 2014 <http://www.imanet.org/PDFs/Public/Research/SMA/Measuring%20and%20Managing%20Shareholder.pdf>