Applied valuation project

Objective:

The main objective of this study is to find out the intrinsic value share price and then compare it with the current share price to check whether the share of the company taken is undervalued or overvalued. Here the company in study is Wotif.com Holdings Limited (ASX:WTF).

Models used:

Two stage dividend discount model:

The two stage dividend discount model is the most appropriate tool for equity valuation. According to the financial theory, it has been states that the value of a stock is equals to all of the future cash flows expected to be generated by the firm discounted by an appropriate risk-adjusted rate of return. Here dividends have been used as a measure of the cash flows returned to the shareholder. If we look at the dividend discount models, there are several dividend discount models (DDMs) but two of the more basic forms of the DDM, the stable model and the two-stage model are most in use models.

Stable Model

The stable model is generally used by the firms experiencing long-term stable growth in its earning and business. Due to the stable growth rate, stable firms are assumed to grow at the rate equal to the long-term nominal growth rate of the economy (inflation plus real growth in GDP). In other words, the model assumes it is impossible to grow at 30% forever; otherwise, the company would be larger than the economy.

If the growth rate of the firm exceeded the required rate of return, you could not calculate the value of the stock. This is because if g>Ks, the result would be negative, and stocks do not have a negative value. Another caveat is that models are often very sensitive to the assumptions made regarding growth rates, time frame, or the required rate of return.

Finally, the dividend discount model generally understates the intrinsic value of the firm. Important considerations such as the value of patents, brand name, and other intangible assets should be used in conjunction with the DDM to assess the value of a firm’s equity. These intangibles should be added to the result of a DDM calculation to arrive at a more appropriate valuation.

The Two-Stage Model

The two-stage model attempts to cross the chasm from theory to reality. The two-stage model assumes that the company will experience a period of high-growth followed by a decline to a stable growth period. The first issue to deal with when using the two-stage model is to estimate how long the high growth period should last. The next point is that the model makes an abrupt transition from high growth to low growth. In other words, the model assumes that the firm may be growing at 30% for five years only to then grow at 6% (stable growth) until eternity. Finally, just like the stable growth model, the two-stage dividend discount model is very sensitive to the inputs used to determine the value of the equity.

What Is the Usefulness of the DDM?

It depends on how you apply the model. Since the model is highly sensitive to the assumptions made about growth rates and discount rates, performing a sensitivity analysis would be appropriate. Sensitivity analysis allows the investor to view how different assumptions change the valuation using the dividend discount model. Secondly, the dividend discount model is a good starting point to begin thinking about the valuation of equity, but it is not the Holy Grail. Finally, the DDM is a good thinking exercise. It forces the investors to begin thinking about different scenarios in relation to how the market is pricing the stock.

FCFE Valuation versus Dividend Discount Model Valuation

If the FCFE and DDM are similar the dividends is equal to the FCFE where the FCFE is greater than dividends, but the excess cash is invested in projects with net present value of zero.

But when FCFE is different than the DDM, i.e. when the FCFE is greater than the dividend and the excess cash either earns below-market interest rates or is invested in negative net present value projects the payment of smaller dividends than can be afforded to be paid out by a firm, lowers debt-equity ratios and may lead the firm to become underleveraged, causing a loss in value. Also in the cases where dividends are greater than FCFE, the firm will have to issue either new stock or new debt to pay these dividends leading to at least three negative consequences for value of the share this includes the flotation cost on this security issue.

Wotif.com Holdings Limited (ASX:WTF):

Company Profile:

Wotif.com Holdings Limited is a provider of online accommodation booking services in Australasia. The company sells accommodation online in more than 45 countries. Every month the Company’s Website attracts almost 3.4 million visits with customers making more than 205,000 bookings through its 28-day booking window period. The company operates in three geographical segments across the glob. The Australian geographic region includes accommodation booked at properties located within Australia, Fiji, Vanuatu and Papua New Guinea. The Asian geographic region includes accommodation booked at properties located within Asia and French Polynesia. The rest of the world includes all other countries. As of January 4, 2008, the Company held an 83% interest in Travel.com.au Limited. In February 2008, it acquired Asia Web Direct (HK) Limited.

Share information:

Prev Close $3.45 Open $3.31

Day’s High $3.31 Day’s Low $3.05

52-wk High $6.05 52-wk Low $2.75

Beta 0.62 Volume 755,364

Avg. Vol 745,163 Mkt Cap. $717.96M

Shares Out 208.11M EPS (TTM) $0.17

Div & Yield 0.15 (4.84) Ex Div Date 3 Sep 2008

GROWTH

1 Year

3 Years

5 Years

Sales %

39.65

43.09

46.58

EPS %

29.40

41.06

46.78

Dividend %

15.38

63.21

—

Share Price valuation:

Equity Multiples from a DDM Model

Enter the following inputs for the two-stage DDM

Current Inputs

Current Earnings per share =

$0.17

(in $ per share)

Current Revenues per share =

$0.45

High Growth Period

Length of high-growth period (n) =

5

(Number of periods)

Growth rate during period (g) =

13.09%

(in percent)

Payout ratio during period (_) =

88.89%

(in percent)

Cost of Equity during period =

15.54%

(in percent)

Stable Growth Period

Growth rate in steady state =

7.61%

(in percent)

Payout ratio in steady state =

90.57%

(in percent)

Cost of Equity in steady state =

12.28%

(in percent)

Output

Value of Equity per share =

$3.81

Price/Earnings Ratio =

22.92

Price/Book Value Ratio =

20.04

Price/Sales Ratio =

8.40

The equity multiple from DDM model has been used to calculate the intrinsic value of the share. Here the two stage Dividend discount model has been used to find out the share price of the share. Using DDM we can find out that the current share price is $3.81.

Comparing DDM and FCFE Models: Two Stage Valuation Model

Inputs for FCFE Calculation

Current Net Income =

$34.45

(in currency)

Current Dividends =

$0.15

(in currency)

Current Capital Expenditures =

$6.10

(in currency)

Current Depreciation

$4.80

(in currency)

Current Revenue =

$83.50

Current Working Capital =

($44.25)

(in currency)

Net Debt Cashflow =

$0.00

Enter length of extraordinary growth period =

5

(in years)

Enter growth rate for high growth period =

13.09%

Inputs for cost of equity

Beta of the stock =

0.62

Riskfree rate=

6.00%

(in percent)

Risk Premium=

13.00%

(in percent)

Enter growth rate in stable growth period?

7.61%

(in percent)

Return on equity in stable growth =

80.69%

Will the beta to change in the stable period?

No

(Yes or No)

If yes, enter the beta for stable period =

0.62

To reconcile the dividend discount model and the FCFE model, you have to input the following:

Do you want to assume that the cash buildup that will occur if dividends < FCFE get reinvested at the cost of equity =

No

If not, enter the rate of return you expect to earn on this cash (assuming that it is invested at current risk level) =

13%

Output from the Model

Cost of Equity =

15.92%

Net Income =

$34.45

Expected growth rate in net income =

13.09%

Growth Rate in capital spending, depreciation and working capital

High Growth

Stable Growth

Growth rate in capital spending =

13.09%

7.61%

Growth rate in depreciation =

13.09%

7.61%

Growth rate in revenues =

13.09%

7.61%

Working Capital as percent of revenues =

-52.99%

(in percent)

Cash builds up gets invested at

13.09%

The FCFE for the high growth phase are shown below (upto 6 years)

1

2

3

4

5

Terminal Year

Net Income

$38.96

$44.06

$49.83

$56.35

$63.73

$68.58

– (CapEx-Depreciation)

$1.47

$1.66

$1.88

$2.13

$2.40

$12.70

– Change in Working Capital

($5.79)

($6.55)

($7.41)

($8.38)

($9.47)

($6.23)

+ Net Debt Cash flow

$0.00

$0.00

$0.00

$0.00

$0.00

$0.00

Free Cashflow to Equity

$43.28

$48.95

$55.36

$62.60

$70.80

$62.11

Dividends

$0.17

$0.19

$0.22

$0.25

$0.28

PV of FCFE

$37.34

$36.43

$35.54

$34.67

$33.82

PV of Dividends

$0.15

$0.14

$0.14

$0.14

$0.13

Cash Build up (invested at specified rate)

$43.11

$97.52

$165.42

$249.43

$352.60

$352.60

FCFE

DDM

Growth Rate in Stable Phase =

7.61%

7.61%

FCFE (Dividends) in Stable Phase =

$62.11

$62.11

Cost of Equity in Stable Phase =

15.92%

15.92%

Price at the end of growth phase =

$747.42

$747.42

Additional cash build up over high growth period =

$352.60

FCFE

DDM

Present Value of FCFE in high growth phase =

$177.80

$0.70

Present Value of Terminal Price =

$357.09

$357.09

Present Value of Cash build up in terminal year =

$168.46

Value of the stock =

$534.89

$526.24

$4.10

If we look at the Comparing DDM and FCFE Models: Two Stage Valuation Model, we can find out that the intrinsic value of share using this model is $4.10. In this model FCFE and DDM has been compared to find out the share price of the Wotif.com Holdings Limited.

Conclusion:

Looking at both of the model we can find out that at present the share price of Wotif.com Holdings Limited is $3.45 and according Equity Multiples from a DDM Model the share price comes out to be a $3.81 this indicates that the company shares are under valued by 36 cents.

If we compare current share price with the Comparing DDM and FCFE Models: Two Stage Valuation Model, we can find out that the company share price is under valued by 0.65 cents. Hence from this valuation we can conclude that this is a right time to buy Wotif.com Holdings Limited shares.

Reference:

www.asx.com.au

www.finance.google.com

www.finance.yahoo.com

http://pages.stern.nyu.edu/~adamodar