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P'tP'/(r-g) (1r)
t
,
G retention times rate oI return Irom investment, and
NPV Eb (k/r-1) Eb (k/r-1),
V0 stands Ior the value oI the company
E expected earnings,
R Ior required rate oI return,
g Ior growth rate,
b Ior retention,
k Ior investment rate oI return and
PVGO Present Value oI Growth Opportunity
Earnings Valuation of Fortune Oil Plc (2009 to 2014)
Let g growth oI the Fortune Oil oI the revenue generated, assumed to be 23 evenly Irom
2009 to 2014.
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Let b Retention the earnings aIter interest and tax Ior six years subtracts dividend paid, hence
average retentions rate obtained and get 77 and (1-b)dividend payout 23.
According to the theory g bk assumed that earnings is anticipated to grow at constant rate.
From assumed b is 77 and g is 23 hence k g/b 0.23/0.77 0.298729.87k30
The company-required rate oI return also assumed to be constant the average rate oI
shareholders Iunds r 23.
Year 2005 2006 2007 2008 2009 Average(2005-2009)
ROSFr 19.26 13.16 25.5 25.43 31.7 r23
Earning model:
V0 E/r PVGO, but PVGO NPV
1
/ (1r)
1
NPV
2
/ (1 r)
2
......NPV
n
/ (1r)
n
Amount in million
V0 1,169 273.95 337.23 415.25 511.17 629.25 774.60
0.23 1.23 (1.23)
2
(1.23)
3
(1.23)
4
(1.23)
5
(1.23)
6
6,421.91 million
3.2.4 Net Assets Valuation
Book-value Assets - Liabilities i.e. the book value oI the company is the cost oI assets less
accumulated depreciation, i.e. it is the sum value net asset oI the company. Book value can be
deIined as total value oI the company`s assets that investors would notionally receive in case oI
company`s liquidation. The book value can show whether the inventory is over or under priced
when compared to market value. It is the same as net assets value taking the cost oI tangible
assets less accumulated depreciation add working capital less long-term liability. The book value
may be aIIected by the management decisions on the provisions made on depreciation and
debtors hence some companies may decide to have large amount oI provision on bad debts.
38
Table 2.5 Fortune Oil`s Book Value
Year 2005
(million)
2006
(million)
2007
(million)
2008
(million)
2009
(million)
Book value 70,198 64,756 114,297 219,242 228,996
change in
book value
13 -9 76.5 91.8 4.4
The Fortune Oil`s book value grew to 13 in 2005 beIore Ialling by 9 in 2006 and the growth
shoot up to 76.5 and 91.8 in 2007 and 2008 respectively with a marginal growth oI 4.4 in
2009(see Table 40 above).
Figure 2.11 Fortune Oil Book Value Trend
3.2.5 Price-Earnings Model
The price earnings ratio (PE) is a widely method used to measure how much the market is
willing to pay Ior a unit oI earnings Irom a company. It shows how much shareowners are
willing to pay per a unit oI currency oI the reported proIits. P/E ratios are higher Ior companies
with high growth prospects, all else being equal, but they are lower Ior riskier companies.
2003 2006 2007 2008 2009
70198
64736
114297
219242
228996
8ook Va|ue 1rend (|n ||||on)
Iortune C||
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A high PE has two interpretations:
A higher than average PE may mean that the market expects earnings to rise in the Iuture.
A high PE may indicate that the market thinks the company`s earnings are very low risk
and is thereIore willing to pay a premium Ior them.
Assumptions of the P/E model:
The price earnings ratios are expected to remain constant over time.
A number oI inIerences are drawn based on results oI the analysis.
The expected rate oI return (k) is constant over time.
Market 'alue ('o) Earnings *P/E ratio
Table 2.6 Fortune Oil`s Price Earnings Valuation Model
2005 2006 2007 2008 2009
Earnings Per Share 0.16 0.24 0.25 0.49 0.47
Market Share price (GBP) 6.5p 5.7p 6.4p 8.7p 6.8p
P/E 40.625 23.75 25.6 17.7551 14.4681
Earnings (million) 2,792 4,307 4,487 8,897 8,842
Vo(million)
113,425 102,291 114,867 157,967 127,927
From Table 2.6, Fortune Oil`s earnings Ior 2009 were 8,842 million and P/E ratio oI 14.468, the
lowest compared to the company`s perIormance in the preceding Iour years and this gives the
value Ior the company to be 127,927 million in 2009.
3.2.6 Market Valuation Method
The market capitalization reIers to the value oI the outstanding shares oI company. The market
value is equal to the total number oI shares multiplying by the market share price. The market
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capitalization depends on the share price and on occasion may misinIorm users as they believe
that the higher the market share price the larger the value oI the company.
Market value
The method assumes that shareowners will buy investments oI equal value interchangeably and
the company value is determined in the Iollowing way:
Market value per share dividend per share divided bv dividend vield
Assumptions of market value method:
A constant ratio oI earnings is reserved in each time.
All investment is Iunded by retentions
The rate oI return on investment is constant over time (The earlier a shareholder receives
his or her Iunds the more value it has).
The cash Ilow generated Irom investment are constant in inIinity
The rate oI return on existing assets remains constant over time
A constant ratio oI dividends is paid out.
Market Prospects
Market measures are valuable Ior analyzing companies registered in stock exchange. The market
measures use share prices, which reIlect the market`s prospects oI both company return and risk
as the market perceives it.
Fair Market Value
'Fair market value is deIined as the price, expressed in terms oI cash equivalents, at which
assets would change hands between a theoretical willing and able purchaser and a theoretical
willing and able broker, acting at arm`s length in an open and unrestricted market, when neither
is under Iorce to acquire or sell and when both have rational knowledge oI the relevant Iacts. The
Iair market value standard incorporates deIinite assumptions, including the assumptions that;
the theoretical buyer is rationally prudent and logical but is not stimulated by any
synergistic or planned inIluences;
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the business operates as a going concern the theoretical transaction will be conducted in
cash or equivalents;
The parties are willing and able to consummate the transaction.
These assumptions might not, and probably do not, reIlect the actual situation oI the market in
which the business might be sold. However, these conditions are assumed because they yield the
same standards oI value, aIter applying generally-accepted valuation methods, which allows
meaningIul comparison between businesses which are similarly situated.
The market approach to business valuation is rooted in the economic principle oI competition:
that in a Iree market the market Iorces will drive the price oI business assets to certain
equilibrium. Buyers would not pay more Ior the business, and the sellers will not accept less,
than the price oI a comparable business enterprise. It is alike in many respects to the
'comparable sales technique that is regularly used in real estate evaluation. The market price oI
the shares oI publicly traded companies engaged in the same or a similar line oI business, whose
shares are actively traded in a Iree and open market, can be a valid indicator oI value when the
transactions in which shares are traded are adequately similar to allow meaningIul comparison.
The problem lies in identiIying public companies that are adequately comparable to the company
Ior this purpose. Also, as Ior a private company, the equity is less liquid (in other words its
shares are less easy to buy or sell) than Ior a public company, its value is taken to be somewhat
lower than such a market-based valuation would give.
3.3 SUMMARY OF VALUATION OF FORTUNE PLC
Based on the calculations and discussion oI the valuation models presented above, the valuation
oI the Fortune Plc can be summarized as shown in Table 3.7 below. The summary Iocuses on
Fortune Plc`s valuation Ior years 2007, 2008 and 2009.
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Table 3.7 Summary Valuation of Fortune Plc
Valuation Model 2009
(Millions)
Gordon Dividend
Valuation Model
24,503
Earnings Valuation 6,421
Net Assets Valuation 228,996
Price Earnings Model 127,927
Market Value
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CHAPTER FOUR
CONCLUSION
Financial analysis through various techniques including balance sheet structure and income
statement structure analysis and the use oI ratios has been Iound to be very helpIul in evaluating
the company perIormance, compared to previous years and to competitors and the industry,
setting benchmarks or standards Ior perIormance, highlighting areas that need to be improved, or
areas that oIIer the most hopeIul Iuture potential and enable external parties, such as investors or
lenders, to measure the creditworthiness and proIitability oI the company.
The Iinancial statements oI Fortune Oil show that it was doing some how good in terms oI
revenue, gross proIit, operating proIits as well as proIit aIter tax and interest, especially Ior the
years under review. However, the Iinancing structure is set to be against the shareholders oI the
company as its Iinancial leverage hangs above 50. This puts the company at higher Iinancial
risk.
The analysis also evaluated the company`s capital structure and this involved a review oI the
irrelevancy theory propounded by Modigliani and Miller (1958). The irrelevancy theory oI
capital structure by Modigliani and Miller (1958) argued that the value oI the company is
independent with its capital structure. Friend and Puckett (1964) and Black and Scholes (1974)
were incapable to Iind any considerable relationship between dividend policy and total returns on
a risk-adiusted basis. Barnes, Haugen and Senbet (1981) concluded that as the level oI gearing
increases, the agency costs increase as well. The conIlicting interest between shareowners and
debt owners arise due to this agency costs. There are two assumptions presented by researchers
'the principle and the agent motivated by selI-interest and they are capable oI Iorming rational
anticipation concerning the likely outcomes and the actions oI the decision takers.
Modigliani and Miller (1995) explained that the dividend policy is irrelevant in company
valuation. Gordon and Lintner model explained that high dividend policy is the best one. The
results show that there are some general Iactors that determine dividend policy Ior both Iinancial
and non-Iinancial companies and there are other Iactors that aIIect only non-Iinancial companies.
44
SpeciIically, there are six determinants oI dividend policy Ior non-Iinancial companies, while
there are only three Iactors that inIluence the dividend policy oI Iinancial companies. The
general Iactors are proIitability, company size, and business risk, government inIluence, gearing
level, and the company age have a strong inIluence on the dividend policy oI non-Iinancial
companies but no eIIect on Iinancial companies. Agency costs, tangibility, and growth do not
appear to have any eIIect on the dividend policy oI either Iinancial or non-Iinancial companies.
The Iact that agency costs is not an important determinant oI dividend policy is not surprising
given that Arab companies are highly geared on bank debt where the role oI dividends in
alleviating the agency problems is less important.
With respect to the stability oI dividend policy, we Iind that the speed oI adiustment diIIers
substantially between Iinancial and non-Iinancial companies. While we Iind that non-Iinancial
companies adopt a policy oI smoothing dividends, this is not the case Ior Iinancial companies. In
Iact, Iinancial companies do not have stable dividend policies. It was Iound that shareholders
have a strong Iavourite to receive dividends. II the company cannot pay cash dividends, they
preIer to receive stock dividends compared to not receiving dividends at all. This clearly shows
that they are certainly not neutral towards the dividend policy. We do not Iind much support Ior
the 'irrational explanations oI the existence oI dividends, i.e. the uncertainty solution theory oI
Gordon (1961, 1962) and the behavioural explanation oI SheIrin and Statman (1984). We only
Iind support Ior the latter in case oI stock dividends. Furthermore, it was Iound that shareholders
partly want dividends because oI transaction costs. The results strongly reiect the agency theories
oI Easterbrook (1984) and Jensen (1986). On the other hand a strong support is Iound Ior the
signalling theories oI Bhattacharya (1979) and Miller and Rock (1985).
45
REFERENCES
Brealey, Richard A., Stewart C. Myers, and Franklin Allen (2008) Principles of Corporate
Finance. 9th ed., McGraw-Hill/Irwin, Boston
Gitman, L. J. (2004) Principles of Managerial Finance. 10
th
Edition, Pearson Education, London
Vance, D. I. (2003) Financial Analvsis and Decision Making. %ools and %echniques to Solve
Financial Problems and Make Effective Business Decisions. McGraw Hill, Chicago
Modigliani and Miller (1958) 'The Capital Corporate Finance and the Theory oI Investment,
American Economic Review, Vol. 48, 261-297
Gordon (1959) 'Dividends, Earnings and Stock prices, Review of Economics and Statistics.
Vol. 99-105
Lintner (1956) 'Distribution oI Incomes oI Corporations among Dividends, Retained earnings
and Taxes, %he American Economic Review Journal, Vol.46, No 2, 97-113
Myers S, (1984) 'The Determinants oI Corporate Borrowing, Journal of Finance, Vol.32, 147-
175
46
APPENDIX 1: BALANCE SHEETS (2005 - 2009) - FORTUNE OIL PLC
Millions of GBP
Annual Annual Annual Annual Annual
Period Period Period Period Period
Description 2005 2006 2007 2008 2009
Cash and Cash Equivalents 11,713 8,202 27,263 67,823 55,766
Short Term Marketable Securities 0 0 0 0 0
Accounts Receivable 6,272 6,302 8,759 18,937 14,817
nventory 2,151 1,070 1,064 4,672 5,260
Other Current Assets 0 0 0 0 0
%otaI C:rrent Assets 20,136 15,574 37,086 91,432 75,843
Property, Plant and Equipment 26,747 24,539 43,283 90,086 94,126
Accumulated Depreciation 0 0 0 0 0
Net Fixed Assets 26,747 24,539 43,283 90,086 94,126
Long-term nvestments 1,917 2,394 5,425 8,136 5,593
nvestments in Other Companies 19,410 21,083 22,593 27,405 31,326
ntangibles and Other Assets 1,988 1,166 5,910 11,937 12,354
%otaI Non C:rrent Assets 50,062 49,182 77,211 137,564 143,399
%otaI Assets 70,198 64,756 114,297 228,996 219,242
Trade and Other Payables 9,813 5,362 15,410 26,572 32,458
Borrowings 1,944 3,427 5,212 27,593 30,192
Short Term Portion of LT Debt 0 0 0 0 0
Other Current Liabilities 241 170 549 1,032 1,026
%otaI C:rrent LiabiIities 11,998 8,959 21,171 55,197 63,676
Long-term Debt / Borrowings 7,126 5,567 27,976 34,633 18,346
Other Long-term Liabilities 336 264 1,527 2,556 3,024
%otaI Non C:rrent LiabiIities 7,462 5,831 29,503 37,189 21,370
%otaI LiabiIities 19,460 14,790 50,674 92,386 85,046
Non-controlling nterests 11,726 11,288 18,473 49,944 44,110
Ordinary Shares 18,351 18,363 18,363 19,282 19,875
Share Premium 37,344 22 22 8,932 10,129
Retained Earnings (17,985) 23,805 28,291 37,618 47,157
Translation Reserves 2,062 (2,717) (932) 21,428 13,854
Treasury Shares (760) (795) (594) (594) (929)
%otaI SharehoIder Eq:ity 50,738 49,966 63,623 136,610 134,196
%otaI LiabiIities & Eq:ity 70,198 64,756 114,297 228,996 219,242
47
APPENDIX 2: INCOME STATEMENTS (2005 - 2009) - FORTUNE OIL PLC
Millions of GBP
Annual Annual Annual Annual Annual
Period Period Period Period Period
Description 2005 2006 2007 2008 2009
Net Sales 143,057 175,771 219,887 364,722 403,745
Other Operating Revenues -98,068 -132,500 -147,199 -232,586 -211,714
%otaI Reven:es 44,989 43,271 72,688 132,136 192,031
Cost of Goods Sold (36,851) (33,912) (61,831) (101,660) (157,013)
Other Operating Expenses 0 0 0 (11,192) (12,000)
%otaI Direct Expenses (36,851) (33,912) (61,831) (112,852) (169,013)
Selling, General & Administrative (4,617) (4,444) (5,169) (8,483) (9,522)
Operating Income 3,521 4,915 5,688 10,801 13,496
nterest Expenses (454) (471) (1,243) (2,722) (2,532)
Foreign Exchange (Loss) Gain 0 0 0 0 0
Associated Company (Loss) Gain 2,966 3,110 4,376 (1,051) 6,228
Other Non-Operating (Loss) Gain 0 0 0 0 0
ncome Tax Expense (544) (617) (619) (1,501) (2,784)
Reserve Charges 0 (834) 0 0 0
Income Before Extra Ord. Items 5,489 6,103 8,202 5,527 14,408
Extra Ordinary tems (Loss) Gain (629) 2,551 0 8,648 865
Tax Effects of Extraordinary tems 0 0 0 0 0
Minority nterests 0 0 0 0
Net Income 4,860 8,654 8,202 14,175 15,273