In this assignment, you will apply the concepts of company valuation that you have just learned to determine whether company XYZ is overvalued.
We are currently at the end of year "t". You performed a thorough financial analysis of XYZ and forecast the following Free Cash Flows (FCF):
Year t+1: 352 million USD
Year t+2: 385 million USD
Year t+3: 407 million USD
From year t+3 onward, you expect the FCFs to grow at a constant yearly rate of 4%.
Through your analysis, you also determined that the appropriate Weighted Average Cost of Capital (WACC) for XYZ was 11%.
Finally, you know that XYZ has 1000 million USD in debt and 100 million shares outstanding
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To determine whether company XYZ is overvalued, we can use a valuation method called discounted cash flow (DCF) analysis. This method calculates the present value of projected future cash flows, adjusted for the time value of money.
Here's how you can calculate the intrinsic value of XYZ using DCF analysis:
1. Calculate the present value of the projected free cash flows (FCFs) for years t+1 to t+3:
- For year t+1: FCF / (1 + WACC)^1 = 352 / (1 + 0.11)^1 = 317.12 million USD
- For year t+2: FCF / (1 + WACC)^2 = 385 / (1 + 0.11)^2 = 312.03 million USD
- For year t+3: FCF / (1 + WACC)^3 = 407 / (1 + 0.11)^3 = 296.43 million USD
2. Calculate the terminal value, which represents the present value of all future cash flows beyond year t+3:
- Terminal value = FCF at year t+4 / (WACC - growth rate)
- The growth rate is given as 4%.
- FCF at year t+4 = FCF at year t+3 * (1 + growth rate) = 407 * (1 + 0.04) = 423.28 million USD
- Terminal value = 423.28 / (0.11 - 0.04) = 6,045.71 million USD
3. Calculate the total present value of all projected cash flows:
- Total PV = PV of FCFs for years t+1 to t+3 + Terminal value
- Total PV = 317.12 + 312.03 + 296.43 + 6,045.71 = 6,971.29 million USD
4. Subtract the value of debt from the calculated total present value:
- Enterprise value = Total PV - Debt
- Enterprise value = 6,971.29 - 1,000 = 5,971.29 million USD
5. Divide the enterprise value by the number of shares outstanding to get the intrinsic value per share:
- Intrinsic value per share = Enterprise value / Shares outstanding
- Intrinsic value per share = 5,971.29 / 100 = 59.71 USD/share
Now, to determine if company XYZ is overvalued, you can compare the intrinsic value per share (59.71 USD) to the current market price per share. If the market price is higher than the intrinsic value, the stock may be considered overvalued. Conversely, if the market price is lower than the intrinsic value, the stock may be considered undervalued.