Proctor & Gamble Co Financial Report
Business valuation is a process of estimating the economic value of a firm based on the owners’ interests. In respect to this, valuation is used by the financial market to calculate the price that they are willing to pay to acquire the firm (Brigham and Gapenski, 1977). These valuations are used in the events of acquisitions, litigation or in the case of value disputes. Business valuation is always conducted with the main purpose of providing a true and correct snapshot of a company’s financial position for the benefit of both the existing and potential investors.
One of the methods that can be used is the Free Cash Flow Method. This method is also called the discounted cash flow method. The discounted cash flow (DCF) analysis values the company or asset concerning the time value of money (Brigham and Gapenski, 1977). DCF estimates the attractiveness of investment opportunities using free future cash flow estimations and discounting them to calculate the present value projection which is used by financial analysts in the evaluation of the most viable investment opportunity amongst different projects.
Future cash flows are calculated and discounted by using the cost of capital to get their present values (PVs). The total addition of all future cash flows, both inflows, and outflows, is the net present value (NPV), which considered as the value or price of the cash flows (Stewart, 1991). NPV is meant to make accurate comparisons of the amount of capital outlay invested in the current period to the present value of future cash receipts from the investments made by an investor, and this is after the cash amounts have been subjected to a uniform rate of return within the accounting period. This is a student sample: ORDER YOUR PAPER NOW
The DCF analysis is used to calculate the Net Present Value taking into account the input cash flows and a discounting rate and then consequently the present value (Stewart, 1991) . On the other hand in the bond market, the yield is calculated as the opposite process where the cash flows and a price as inputs and provides as output the discount rate.
In this method, free cash flow (FCF) or free cash flow to firm (FCFF) is viewed as a business’s cash flow to take the residue cash flow that is available for distribution to all the stockholders of a corporate entity (Brigham and Gapenski, 1977) . It is useful to parties when they want to see how much money can be withdrawn from a company without affecting its operations such as equity holders, debt holders, preferred stock holders, and convertible security holder. It requires one to produce pro forma financial statements as based upon the additional funds needed, a percentage of sales and constant ratio methods.
The FCF is discounted to arrive at the present value by the WACC, which consequently gives to the firm value as follows. The present value of the FCFs is equal to the Value of Operations.
The Forecast Period & Forecasting Revenue Growth
The Forecast Period
The first step of the DCF is to identify the how long we are going to forecast the growth of the company for the purpose of the valuation. The forecast period also called the horizon period should reflect the time the company should take to achieve the stable growth and also a stable capital structure (McKinsey et.al, 2005). This period should also be within a period that the firm can quickly predict the performance. For the purpose of the analysis, I have used a forecast period of five years based on the assumption that by the fifth year, The Procter & Gamble Company (PG) will have achieved a stable performance. Based on past performance the company has been declining but the projection period is that in the next financial year the company will start growing (McKinsey et.al, 2005) . It relies on the assumption of the investment done in the current fiscal year and the reported dividend for the first and second quarter. By this year in my forecast, the company will have achieved a stable growth.
Revenue Growth Rate
The revenue growth is assumed to grow by 5% due to the investment and the research done by the company. It based on an optimistic management that the decline in sales will result in future.
|Industry||PROCTER & GAMBLE CO (PG)|
|Panel A: Inputs||Actual||Actual||Forecast|
|Sales growth rate||5%||-1%||-8%||5.0%||5.5%||6.0%||2.0%||2.0%|
The above assumption is based on the industry average growth if the company operates in then existing market operatives.
Student sample: ORDER YOUR PAPER NOW
Forecasting Free Cash Flows
The FCF Free cash flow (FCF) is a defined as a measure of financial performance calculated as the firm’s operating cash flow subtracting capital expenditures. Free cash flow (FCF) represents the cash that a company can generate after laying out the money required to sustain or increase the asset base (Jensen, 1986). Free cash flow is important because it allows a company to pursue opportunities like expansion which can result in the primary objective of a firm which is to enhance shareholder value (Jensen, 1986) . Without cash, it’s tough to venture into new activities like developing new products, new acquisitions, dividend payout and servicing of debt.
FCF is measured as
EBIT (1-Tax Rate) + Depreciation & Amortization – Net Working Capital changes – Capital Expenditure. It can also be calculated by taking operating cash flow and subtracting capital expenditures.
Cash flow forecasting is critical. If a firm depletes its cash and is not able to acquire new sources of finance, it is considered insolvent. Cash is the lifeblood of any enterprise particularly start-ups and small enterprises. As a result, it is important therefore that a firm’s management can predict how to manage the cash flow well to ensure the business has enough to survive. How often management should forecast cash flow is dependent on the financial security of the firm (Jensen, 1986) . If the company is struggling or is keeping a watchful eye on its finances, the business owner should be forecasting and revise his or her cash flow on a daily basis.
Calculating Free Cash Flow
When calculating, the free cash flow investors will use Free Cash Flow to assess a company’s performance. In essence, it is less susceptible to manipulation than income statement accounts like earnings before depreciation and before income taxes (EBITDA) and Net Income (Ross, Westerfield, and Jordan, 2008). The income statement is vulnerable to manipulation through the use of various unethical accounting practices, on the other hand, but actual cash balances are far harder to influence.
Some additional formulas used to determine the Free Cash Flow as follows:
Free Cash Flow = Net Profit + Interest Expenditure – Capital Expenditure – Changes in Working Capital – Tax Shield on Interest Expense
Free Cash Flow = Net Profit after Tax – Changes in Capital Expenditure + Amortization – Changes in Working Capital.
The forecasted future cash flow has been shown in the attached excel worksheet.
The forecasted future cash flow has shown in the attached Excel worksheet.
Future Operating Costs
When doing business, a company incurs operational costs – such as the cost of goods sold (CoGS), salaries and wages, advertising costs, electricity, selling and distribution costs, general administrative expenses (GAC), and research and development (R&D). These are essentially the expenditures incurred in the running of the business (Ross, Westerfield, and Jordan, 2008) . If such current operating costs have not been explicitly disclosed on a company’s income statement, they are calculated by subtracting net operating profits – or earnings before interest and taxation (EBIT) – from total revenues. To get the effective contribution or profit of a certain investment, all variable expenses are subtracted from the sales.
Looking at figure 2 the future operating forecast is shown based on the historical performance of the company.
Most companies do not pay taxes based on the net income they report. It is because based on the capital expenditures companies get tax breaks to enhance their investments (Brealey, Myers, and Allen, 2005). Regulatory changes and the current market trends have diversed the focus of various tax and accounting roles towards compliance based operations, such as financial statement reporting and mitigating internal control system effectiveness.
In our case Procter & Gamble Co (PG) based on historical data the company has calculate the tax based on a tax rate of 25 percent hence we forecast our tax rate on the same rate. PG tax management team adopts an integrated and holistic perspective to assists all the tax departments create value for their entity. All the capital outlays in every accounting period will be subjected to a tax rate of 25 percent as per the company’s policy.
In finance, net investment refers to an activity of expenditure that results in the increased availability of non-current goods or means of production and goods inventories (Brealey, Myers, and Allen, 2005). It is the total spending on newly produced physical capital (fixed investment) and on stocks (inventory investment) which is, gross investment–minus replacement investment, which just replaces depreciated equipment. Net investment helps the company’s management in deriving a rationale of how effective money of a firm is being spend on the capital items such as plant, property, and equipment (PPE), which are utilized for effective operations of the company.
To sustain such growth, companies need to keep investing in capital items such as property, plants, and equipment (Jensen, 1986). Net investment calculated disclosed in an enterprise’s statement of cash flows, and subtracting non-cash depreciation charges found on the income statement.
Change in Working Capital
Net working capital also called the working capital is simply current assets subtracting the current liabilities. Hence, an increase or decrease in the total amount of current assets without a change of similar amount in current liabilities will result in a change of working capital and vice versa (Jensen, 1986). For Proctor & Gamble Co, working capital management is a crucial factor and is used to ensure that the entity sustains its operations sufficiently and that the ability of attracting maturing short term dept and upcoming operational expenditures.
In our case Procter & Gamble Co (PG) shown in the figure 3 below is further elaborated by the figure in the excel worksheet.
|B1. Sales Revenues||2015-06||2016-06||2017-06||2018-09||2019-06||2020-06|
|B2. Operating Assets and Operating Liabilities|
|B3. Operating Income|
|COGS (excl. depr.)||$38,876,000||$40,419,335||$40,819,800||$41,220,265||$41,220,265||$41,220,265|
|Other operating expenses||$22,479,000||$22,479,000||$22,479,000||$22,479,000||$22,479,000||$22,479,000|
|Net operating profit after taxes||$8,887,785||$1,204,714||$4,184,172||$7,662,208||$9,005,727||$10,376,117|
|B4. Free Cash Flows|
|Net operating working capital||$8,717,000||$9,593,821||$13,278,096||$12,877,632||$12,877,632||$12,877,632|
|Total operating capital||$28,985,000||$30,074,291||$34,559,496||$34,159,032||$34,159,032||$34,159,032|
|FCF = NOPAT – Δ op capital||$3,904,785||$115,423||−$301,034||$8,062,673||$9,005,727||$10,376,117|
Figure 3 – Free cash flow forecast calculation for Procter & Gamble Co (PG) based on net changes in the operating working capital.
Calculating the Discount Rate
Discounting rate refers to the rate of interest used in DCF for the analysis and determination of the present values of future cash flows at hand. After projecting the company’s free cash flow for the next five years, then we want to figure out what these cash flows are valued at today (Stewart, 1991). That means identifying an appropriate discount rate which shall be used to calculate the net present value (NPV) of the cash flows. Thus, the strategy is to use the weighted average cost of capital (WACC). The WACC will essentially incorporate the cost of equity and the after-tax cost of debt and the cost of preference shares if used in capital financing.
Therefore, one looks at how the cost of equity, cost of preference shares and cost of debt is calculated.
Cost of Equity
It is what the equity shareholders expect to earn as return on their equity investment in a company. From the enterprise’s view, the equity holders’ required rate of return is a cost to the firm (Stewart, 1991) . If the company does not honor the expected return, the stockholders will sell off their shares, causing the price to drop as elaborated by the signaling theory. A firms cost ofequity shows the amount of compensation that the market needs in direct exchange for owning the assets and bearing the risks of ownership.
Therefore, the cost of equity is what it will cost the firm to maintain a share price that is satisfactory to investors (Jensen, 1986). In practice, the best method of calculating the cost of equity is capital asset pricing model (CAPM), where:
Cost of Equity (Re) = Rf + Beta (Rm-Rf). Or;
cost of equity = Dividend per share(for next year0 + Growth rate of dividends
Current market value of stock
Rf – Risk-Free Rate – It is the rate of return from investing in securities considered free from default risk, such as government bonds. The interest rate earned from the U.S. Treasury bills or the long-term bond rate. It is because it is considered to be free from risk.
ß – Beta – It measures the extent at which a company’s share price moves against the market as a whole. If the beta is shown as greater than one, the stock price is more exaggerated but if less than one the stock is more stable.
When a company shows a negative beta like in a gold mining company, it means that the share price is moving in the other direction to the broader market of that share.
(Rm – Rf) = Equity Market Risk Premium is the equity market risk premium (EMRP) is the returns above the risk-free rate investors expect. It will compensate them for the extra risk of investing in the stock exchange. It is thus the difference between the risk-free rate and the market rate.
After calculating the cost of equity, adjustments can be made to take account of risk factors unique to the company in a particular market. Such factors include the company size, pending lawsuits, the concentration of company’s market and dependence on key employees (McKinsey et.al, 2005). They rely heavily on an investor’s notion and may vary from a company to another.
Cost of Debt
This is the interest that a company pays in respect to its borrowings and is usually expressed as a percentage rate. It is the rate applied to determine the cost of debt (Rd) should be the current market rate the company is paying on its debt (McKinsey et.al, 2005) . If the company is not paying market rates, an appropriate market rate payable by the firm should be estimated. An adjustment is made for the tax. The formula is
Cost of Debt (Rd) = Rd(1-t).
Cost of Preference Share Capital
The Cost of Preference
Cost of preference shares (Kp) is the cost of capital incurred by a company for the preference share capital and includes dividends that require to be met by the end of a given financial period for the respective number of shares held by preference shareholders (Brigham and Gapenski, 1977). It is that cost of capital where the amount payable to preference shareholders as dividends and has a fixed rate. They are not relieved from tax, but they take preference before the common stock shareholders
Kp = d/p0
Where d is the preference dividend and P0 is the market value of the preference shares
The dividends are paid in perpetuity
They do not have a tax relief
|Actual Historical Financing|
|Market value of equity = (Price x # shares)||$213,030,698||$225,612,864|
|Percent long-term debt||7.94%||40.96%|
|Percent short-term debt||6.25%||9.56%|
|Percent preferred stock||0.45%||3.41%|
|Percent market value of equity||85.36%||46.08%|
Figure 4 weights of the capital structure.
|3. Costs of Capital||Forecast|
|Rate on LT debt||9.0%||9%||9%||9%||9%|
|Rate on ST debt||10.0%||10%||10%||10%||10%|
|Rate on preferred stock (ignoring flotation costs)||8.0%||8%||8%||8%||8%|
|Cost of equity||14%||14%||14%||14%||14%|
Figure 5 forecasted cost of capital used for financing.
Subsequently, the cost of equity, cost of preference shares and cost of common stock are based on the previous year’s historical data that is then used for future forecasting.
Coming Up with a Fair Value
After estimating the free cash flow produced over the forecast period, then calculates the value of the company’s cash flows after that forecast period – when the company has settled into middle-age and maturity (Ross, Westerfield, and Jordan, 2008). For this the terminal value approach. It makes some assumptions about long-term cash flow growth.
Gordon Growth Model
The Gordon growth model determines the intrinsic value of a stock in particulat to a future series of dividends that grow consistently but at a constant rate(Ross, Westerfield, and Jordan, 2008) . There are several ways to estimate a terminal value of cash flows, but one well-known method is valuing the company as a perpetuity using the Gordon Growth Model. The model uses this formula:
Terminal Value = Final Projected Year Cash Flow X (1+Long-Term Cash Flow Growth Rate)
(Discount Rate – Long-Term Cash Flow Growth Rate
The next step is to calculate the PV of the horizon value the adding the present value of the FCF.
Then calculate the PV of the horizon value the adding the present value of the FCF.
DCF analysis calculates an intrinsic the value of a company today. It is based on projections or forecasts of how much money the company will generate in the future (Stewart, 1991). The company’s value is the addition of the cash flows that the firm will generate in the future. The company’s stock prices keep fluctuating on a constant daily basis and this needs investment professionals to keep in touch with the entire entity (Jensen, 1986). This amount is discounted to the present at an appropriate rate referred to as the Discounting rate.
To calculate the intrinsic value of the stock price as shown in the figure below
|Value of operations||$246,126,160|
|+ ST investments||$4,767,000|
|Estimated total intrinsic value||$250,893,160|
|− All debt||$30,350,000|
|− Preferred stock||$1,077,000|
|Estimated intrinsic value of equity||$219,466,160|
|÷ Number of shares||$2,883,600|
|Estimated intrinsic stock price =||$76.11|
Based on the calculations in the illustration above we find that this amount estimates the average current value of the current stock value. Therefore, companies should adopt the use of DCF method in the calculation of intrinsic value given that the method’s advantages outweighs its disadvantages (Brigham and Gapenski, 1977). Discounted cash flow valuations are one pricing system that investment analysts use to measure the value of stocks, and that when you create a discounted cash flow model for a company, calculation of the amount of cash the firm will retain after meeting all its liabilities, these are some of the best advantages of this method.
- Brealey, Richard A.; Myers, Stewart C.; Allen, Franklin (2005). Principles of Corporate Finance (8th ed.). Boston: McGraw-Hill/Irwin. ISBN0-07-295723-9.
- Brigham, E. F., & Gapenski, L. C. (1997). Financial Management – Theory and Practice (8th Edition ed.). Orlando: The Dryden Press.
- Jensen, Michael C. (1986). “Agency costs of free cash flow, corporate finance and takeovers”. American Economic Review 76(2): 323–329. doi:2139/ssrn.99580.
- McKinsey & Co., Tim Koller, Marc Goedhart, David Wessels. 2005. Valuation: Measuring and Managing the Value of Companies. John Wiley & Sons.
- Ross, Westerfield, & Jordan. (2008). Corporate Finance Fundamentals. New York McGraw-Hill Irwin.
- Stewart, G. Bennett, III (1991). The Quest for Value. New York: Harper Business. ISBN0-88730-418-4.