Quantifying Returns Using CAPM

Part A

CAPM Quantification of return from investment this indicates if the relationship will exist between systematic risk and expected return from an investment, the higher the risk, the higher the expected return. This can be calculated as:

E(rj) = rf + βj ( E(rm) - rf)

CAPM

Ke=rf+ β (rm-rf)

Lenders who own 5.9% bond due 2032

Cost of Debt (Kd) for Vodafone 5% bond

Closing net debt = 31469

Financing Costs/Interest Cost = 749+27 = 776

Cost of Debt = 776/31469 = 2.47%

The closing net debt of Vodafone Plc as on 31st March 2018 was £31469 thousands. Total financing costs or interest costs for the company was £776 thousands. Therefore, cost of debt for Vodafone was 776/31469 = 2.47%. This means that Vodafone pays £2.47 for every £100 of debt .

Guess desired return -calculate PV 2 different try’s

Cost of Redeemable Debt: (not perpetuity) this type of debt is recoverable and is calculated as the redemption yield on the debt. The smallest guess is taken for the cost of capital, and ‘NPV’ means the net present value of cash flows at this guess.

Kd = A + NPVA x ( B - A )

= 2 + (101.90-100)*(3-2) = 3.90%

In this case, we have discounted outflows by two different cost of debt. When Vodafone raises debt in form of bonds, it receives an inflow £100 (supposedly). Thereafter, the company makes coupon payments on an annual basis and returns back principal at the conclusion of bond redemption tenure. So, the above example has been cited using two different desired rate of return and computations have been made accordingly. The desired rates of return have been assumed at 2% and 3%. Thereafter, all calculations have been made to calculate cost of debt (Kd). According to this method, cost of debt stands at 3.90%, which means that Vodafone pays £3.90 as interest on every £100 of debt.

Two types of trial calculation are based on the formula:

(Kd) IRR= A + NPVA (B-A) A is smallest guess

= 2 + 0.25(4-2) = 2.5%

In this case, two interest rates considered are 2% and 4%. After calculation, cost of debt is 2.5%. This implies that Vodafone pays £2.50 as finance cost for every £100 of debt.

Part B

Stock market value:

London stock exchange states a price of £141.68p per share of Vodafone. This would mean that to buy one share of Vodafone you need to pay £141.68p for one share in Vodafone. Market value is also known as market capitalization of publicly traded company. To find out the total value of shares multiply the number of outstanding shares by the current share price:

£1.41 x 276m = £389m worth of share in Vodafone.

Balance Sheet value:

The value of Goodwill as on 31st March 2017 and 31st March 2018 were €26,808 milion and €26,734 million respectively.

ROCE 20%

P/E Ratio:

Current P/E = Market value per share/ earnings per share

= £141.68/ 0.0876 = 1617.35 times

Current Price to Earnings Ratio (P/E ratio) or also called earnings multiple or price multiple is the ratio for valuation of a firm. This ratio measures its current stock price to its present earnings per share (EPS). In this case, Market value per share = £141.68

2018 Earnings per share = 0.0876

Current P/E = £141.68/ 0.0876 = 1617.35 times

Therefore, this means that stock of Vodafone Plc trades 1617.35 times its 2018 earnings per share. The current P/E ratio is very much on the higher side and shows that the company’s stock is highly overvalued. In other words, an investor is ready to pay £1617.35 for £1 of current earnings.

Average P/E

For calculation of average P/E ratio, we have taken average share price for last 5 years and average earnings of last 5 years.

Average share price = Price Total/Number of Trading Days

= 225344.38/1265

= £178.14

EPS for 2014 £2.69

EPS for 2015 £0.27

EPS for 2016 -£0.20

EPS for 2017 -£0.23

EPS for 2018 £0.09

Average EPS = £2.69+ £0.27 -£0.20 - £0.23+ £0.09 = £0.524

Average P/E = Average share price/ Average EPS

=£178.14/£0.524 = 339.96 times.

The average P/E of Vodafone Plc is 339.96 times. It means that the stock trades at 339.96 times its average 5 year earnings.

Competitors

The Competitors of Vodafone Plc are AT&T Business Solutions, BT Business & Public Sector, BT Global Services, Deutsche Telekom T-Systems, Orange Enterprise, Verizon Enterprise Solutions.

Industry average P/E ratio = 20 times

Industry average P/E ratio of 20 times means that industry comprising of all companies trades at 20 times of average earnings of all companies operating in the industry.

Competitors/industry average:

Cash flows we expect to receive:

Free Cash Flow = Net Income + (Depreciation & amortization) + Stock based compensation + Gains/losses on investments] – [Change in Working Capital + Depreciation & Amortization]

= 2788 + 9910 + 128 –2121 (-400+9910)

= £5437 (thousands)

Free Cash flow refers to cash produced by an organization through its operations. Vodafone produced free cash flow of £5437 (thousands) in financial year 2018.

Business valuation based on Fundamental analysis theory

Constant Dividend Payout

Present value: We assume a minority holding investor and annual dividend received forever is £0.15. Therefore, cost of equity (Ke) = D/Po

= (0.15/141.68)*100 = 0.11%

The cost of equity has been calculated considering dividend payment of £0.15 and market price of Vodafone’s common stock at £141.68. £0.15 dividend was paid by the company for FY17-18. Using the formula, we get cost of equity 0.11%. In this case, we have assumed that an investor would continue to hold company’s common stock forever and company would also pay dividend of £0.15 forever.

Assumed dividend growth per year, g% = 5%

Po = Do ( 1 + g) + g

Ke

Price of Share, Po = 0.15(1+0.05)/0.0011 +0.05 = £143.23

Using the above formula, we have calculated price of company’s equity share. Such valuation methodology helps to compute and arrive at a stock’s intrinsic value. After inputting all values and considering growth at 5% per year and cost of equity = 0.11% (computed earlier), value of Vodafone’s share = £143.23

Value based on Earnings per share (EPS)

Po = EPS/ Ke

2018 Earnings Per Share = 0.09

Cost of Equity, (Ke) = 0.11%

Price of Share (Po) based on EPS = 0.09/0.11% = £81.82

This valuation methodology values a company’s share based on its current earnings. For FY18, Vodafone’s EPS stood at £0.09. Cost of equity (calculated earlier) stood at 0.11%. Therefore, price of company’s stock based on 2018 EPS = £81.82

Assuming profits would rise to 5% per year; then

Po = EPSo ( 1 + g)/ Ke + g F

Assumed profit growth per year = 5%

Earnings Per Share, EPSo = 0.09

Cost of equity (Ke) = 0.11%

Therefore, Po = EPSo ( 1 + g)/ Ke + g

= 0.09*(1+0.05)/0.0011 + .05 = £85.96

The only difference between this method and earlier method is incorporation of growth rate of 5% in company’s Earnings per Share (EPS). As such, after inputting all values, we arrive at company’s share value, i.e. £85.96. This value is higher in contrast to earlier value since growth rate of 5% has been factored in. Since there is growth rate involved, stock would have high intrinsic value. In essence, high growth rate means high stock valuation.

Share valuation based on Free cash flow:-

Po = free cash flow/ Ke

Free Cash Flow = Net Income + (Depreciation & amortization) + Stock based compensation + Gains/losses on investments] – [Change in Working Capital + Depreciation & Amortization]

= 2788 + 9910 + 128 –2121 (-400+9910)

= £5437 (thousands)

Free Cash Flow = £54.37 million

Number of outstanding shares = 276 million

Free Cash Flow per share = 54.37/276= 0.20

Cost of Equity (Ke) = 0.11%

Po based on Free cash flow = FCF/Ke = 0.20/0.0011 = £179.08

This valuation methodology makes use of Free Cash Flow for valuation of the company. We have used Free cash flow as the key parameter. Free Cash flow is defined as cash generated by a company through its operations. Free Cash flow produced by Vodafone for FY2018 was £54.37 million. Number of outstanding shares was 276 million. Therefore, Free cash flow per share = 54.37/276= £0.20. Cost of equity (computed earlier) was 0.11%. Therefore, value of company’s stock stands at £179.08 based on 2018 free cash flow generated by the company.

Assume profits would rise to 5% per year, then

Po = annual free cash flow ( 1 + g) / Ke + g

= 0.20(1+0.05)/0.0011 +0.05 = £190.96

In this method, we have factored in a growth rate of 5% in company’s annual free cash flow. This means that company’s free cash flow would be higher by 5% every year in comparison to its previous financial year free cash flow. As such, stock commands higher valuation because of growth rate of 5% of free cash flow.

Part C

Issues related to Vodafone foreign finance (bonds)

Some of the main risks related to Vodafone foreign finance (bonds) are foreign exchange risk and political risk. Foreign exchange risk or currency risk refers to the risk that arises due to change or volatility in exchange rate of pair currencies. On the other hand, political risk refers to risk associated with loss or decline in investments value on account of political changes or unstable political environment in a country. Vodafone Plc has raised international debt in form of bonds. The bonds have been issued in various international currencies such as U.S. Dollar and Euro (just to name a few). In foreign exchange markets, value of GBP in comparison to Euro, U.S. Dollar and other international currencies fluctuate. For instance, at time of bond issuance, exchange rate was 1 GBP equals to 1.32 USD. However, at the time of coupon payments or bond redemption, GBP depreciates against USD and exchange rate becomes 1.30 USD. This means that foreign currency (USD) has strengthened and Vodafone would have to spent more GBP for buying equivalent USD. Since international bond issuance by Vodafone plc is in excess of 1.1 billion, there remains high risk that the company might incur huge foreign exchange loss, if the home currency (GBP) depreciates against major global currencies.

To elaborate on the subject of foreign exchange risk, there are three main types of exchange risks. These risks are transaction risk, translation risk and economic risks. Transaction risk refers to a company’s risk as a result of transaction exposure in foreign currency denominated transaction. As the transaction would result in future foreign currency outflow, any change in exchange rate between transaction date and future settlement date would result in either profit or loss. This type of risk is commonly known as transaction risk. On the other hand, consolidation risk or translation risk has relation with assets and liabilities of company’s balance sheet denominated in foreign currencies. While consolidating books of accounts, Vodafone uses an exchange rate for transformation of accounts of a foreign subsidiary. This transformation results in change in consolidated profits on account of variation in foreign exchange rate. Economic risk or economic exposure refers to impact of changes in exchange rate on company’s future cash flows. In other words, economic risk can be defined as changes in firm’s present value because of uncertainty in exchange rate movements. Vodafone Plc confronts economic risk as it is subject to foreign competition (in case of sourcing inputs or raw materials). The measurement of economic risk is cumbersome as inflation effects have also to be taken into account together with changes in foreign exchange rate. As such, economic exposure cannot be solely hedged through financial hedging techniques.

Understanding prediction of future exchange rates

Currently, interest rate in England stands at 0.75%. In August 2018, Bank of England raised interest rates by 0.25% from 0.50% to 0.75%. The 2007-2008 global financial crises resulted in dwindling of businesses, slowdown in consumer demand and decline of asset prices globally. As such, England was also affected, however; in varying proportion. In order to boost demand in the country, Bank of England (BoE) slashed interest rates. However, this has taken toll on long term inflation rate in the country. Lower interest rates have acted as a catalyst for consumers to borrow from banks. This, in turn has resulted in higher demand and translated to high inflation. Considering the present situation of global and domestic economic recovery, central bank (BoE) might raise interest rates for capping demand in the country. With rising inflation in the country, Vodafone Plc ability to purchase raw materials, labour would decline as the company would have to pay more money for procurement of same resource. Also, rising interest rates would put pressure on the company to raise debt at a higher coupon rate in contrast to current rate of borrowing.

Vodafone Plc can enter into forward contract, swap and foreign denominated currency future contracts for managing foreign risks. The company can use money market hedging strategies for managing interest rate risk and inflation risk. Managing foreign risks through mentioned instruments would ensure that the company does not incur substantial losses on account of changes in foreign exchange. Hedging currency risk would also provide stability to company’s profits. On the other hand, money market hedges would ensure that Vodafone continues to pay lower interest rates than interest rates prevailing in the market.