Valuation of Equity at the End of the Financial Year 2010-11

Question: Do Valuation of Equity at the End of the Financial Year 2010- 11 for the Selected Company. Answer: Introduction The following study aims to present the valuation of equity at the end of the financial year 2010- 11 for the selected company Webjet Limited by considering the real earnings and dividend forecasts over the next five years. The valuation has been conducted by using the approach of discounted free cash flow as well as the residual earnings together with the explanation on possible discrepancies. The study further highlights the analysis and valuation of active investing by evaluating the related strength, weakness and potential risks based on the companys financial statement. Background of the company Webjet Limited, a public company based on the travel industry was formed in 1998 in Australia, which is engaged in the business of travel booking for flights booking, hotels, holiday package and other services (Webjet.com.au 2017). The organization has been largest business entity in the travel industry, which expanded its business in the region of United Kingdom in the year 2005. In the recent years, the company earned revenue around $152 million while the profit amounted to $22 million. The company has total assets valued to $377 million while the value of net assets amounted to $151 million (Webjet.com.au 2017). Valuation of equity Value of equity using discounted free cash flow Present year 2011 2012 2013 2014 2015 2016 Real Earnings ($ millions) 13.61 6.49 19.13 17.5 22.22 Less: Dividend ($ millions) 5.16 5.56 5.76 5.88 7.78 Free Cash flow ($ millions) 8.45 0.93 13.37 11.62 14.44 Industry average cost of equity 8.00% 1.08 1.166 1.26 1.36 1.469 Discounted value of free cash flow ($ millions) 7.82 0.80 10.61 8.54 9.83 Total discounted cash flow ($ millions) 37.61 Value of equity using residual earnings Equity Capital ($ millions) 40.22 32.9 60.81 69.28 82.45 151.56 Cost of equity % 8.00 8.01 8.10 8.00 8.22 9.00 Equity charge ($ millions) 3.22 2.64 4.93 5.54 6.78 13.64 Less: Net Income ($ millions) 11.00 13.61 6.49 19.13 17.5 22.22 Residual charge ($ millions) -7.78 -10.97 -1.56 -13.59 -10.72 -8.58 Table 1: Valuation of equity (Source: Created by author) Considering the financial position statement of the company Webjet Limited for the financial year 2011, it has been observed that the actual value of equity amounted to $40.03 million. However, as per the fair value of equity determined by using discounted free cash flow method amounted to $37.61 which is lower than the actual value (Webjet.com.au 2017). The difference in the equity valuation is due to incorporation of discount rate based on the average cost of industry that provides fair value as per time value of money. Fair valuation of equity has been done by using discounted free cash flow as well as residual earnings for the financial year 2011. As per the discounted free cash flow, equity value is lower than the actual value that indicates the overvaluation of stock price. Besides, residual earnings indicate the efficiency of the company in generating income after considering the value of equity charge. In case of Webject Limited, it has been analyzed that the residual earning s in each forecast year is negative reflecting the inefficiency to generate income after considering the equity charge. Active Investing In order to evaluate the efficiency of the company for investment, active investing can be considered as a process to manage investment portfolio in accordance to the companys benchmark index. The investment strategy can be managed by considering asset allocation or companys performance (Xiao et al. 2014). In case of Webjet Limited, it has been noticed that the value of non- current assets amounted to $11.62 million during 2011 while net profit amounted to $10.86 million reflecting earnings per share $14.41 (Webjet.com.au 2017). Accordingly, it can be said that investment in Webjet Limited would provide positive return in the short- term period as the residual earnings for long- term reflects negative value. Financial statement analysis In order to determine the efficiency of company for investment purpose, companys performance and financial position can be evaluated by considering financial statement analysis (Easton 2016). Considering the income statement of Webjet Limited for the period 2010- 11, it has been noted that the company generated revenue at an increasing trend along with the generation of profit amount. It has been observed that the earnings per share of the company has been positive and reflects increasing trend that is $14.41 in the year 2011 while $ 18.81 in the year 2012 (Webjet.com.au 2017). FY 2011 Activity ratio Accounts receivable turnover Total sales/ Accounts receivable 18.69 Average collection period 365/ Accounts receivable turnover 19.53 Profitability ratio Net profit % Net Profit/ Total Revenue 0.25 Gross profit % (Total Sales- Cost of Goods Sold)/ Total Sales 0.79 Return on assets Net Income/ Total Assets 0.20 Liquidity ratio Working capital ratio Current Assets/ Current Liabilities 3.91 Liquidity ratio (Current Assets- Inventory- Prepaid expenses)/ Current Liabilities 3.91 Solvency ratio Equity ratio Total equity/ total assets 0.73 Table 2: Financial ratio analysis (Source: Created by author) As the activity ratio of the company that is average collection period for accounts receivable represents 19.53 days, it can be said that the company is efficient in collecting the cash from credit sales. In addition, profitability ratio for the financial year 2011 reflects positive margin in net profit, gross profit and return on assets. Therefore, the company is said to be efficient in generating income from assets and operating costs. Current ratio of the company reflects higher than one that is 3.91 indicating that Webjet has been efficient in meeting current obligations from the source of current assets (Webjet.com.au 2017). Similarly, company is efficient in generating return on equity from the value of asset resources. On the contrary, financial statement analysis incorporates certain weaknesses with respect to the performance measure together with its competitors. Financial statement has been prepared by using accounting policies and methods, which may not reflect the fair value. For instance, the valuation of equity reflected higher value than the fair value since that was determined by using present value factor. Hence, the major risk involve in financial statement analysis is determination of true value of assets and liabilities as well as the value of non- financial factors that affects the companys growth. In case of Webjet Limited, fair value of investments in associates and financial assets might not reflect the true and fair value hence the risk of investment return becomes high. Conclusion As the fair value of equity of Webjet Limited reflected lower value than the actual value of equity using the method of discounted free cash flow which indicates the companys shares has been overvalued hence investment is not recommended. Further, residual earnings of the company reflected negative balance, which means the company is not efficient in deriving investment return. On the contrary, financial statement analysis of Webject reflects positive values in profit margin, liquidity and solvency value therefore, it can be said that the investors can invest in the companys share for short- term period and not for long- term period. References Easton, P., 2016. Estimating the Cost of Capital Using Stock Prices and Near?term Earnings Forecasts.Journal of Applied Corporate Finance,28(3), pp.87-94. 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