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Company use : http://www.frenckengroup.com
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Explanation & Answer
Attached.
Part 1: Financial Performance and Current Issues
(D) Estimation of ROE for the Five Years Using Du-Pont ROE Approach
Du-Pont analysis involves with de-composition of the earnings’ components to assess the quality
and sustainability of earnings. In the Du-Pont analysis, return on equity (ROE) of a company is
decomposed into three components including net profit margin, assets turnover, and financial
leverage to observe the impact of these on the earnings of the company. The higher the value of
these components, the higher the impact of these on the earnings of the company.
The ROE of Frencken for 2012, 2013, 2014, 2015, and 2016 based on the Du-Pont ROE Approach
are -6.32%, 8.64%, 5.49%, 4.53%, and 7.48% respectively. Even though, ROE of the company
has been declined in 2015, in 2016 ROE has been increased. This increase of the ROE is an
indication of the recovery of the profitability of the company. The earnings of the company can be
said as of good quality and sustainable as it is mainly driven by leverage and efficiency in cost
management (as implied from the increase of financial leverage and net profit margin after 2014).
The company is getting more efficient in managing of its cost of sales and other operational
expenses to increase net earnings of the company. Also, the efficiency of the company is managing
external funds to gear-up the return for the shareholders has been improved.
Year
2012
2013
2014
2015
2016
Du-Pont Analysis for Frencken Group Limited
Components
ROE
Net Profit
Total Assets
Margin
Turnover
Financial Leverage
=
(Net Income/
(Net Income/
(Revenue/ Total
(Total Assets/Total
Shareholders'
Revenue)
Assets)
Shareholder's Equity)
Equity
-6.32%
=
-3.27%
1.01
1.90
8.64%
=
3.99%
1.33
1.63
5.49%
=
2.40%
1.34
1.70
4.53%
=
2.10%
1.29
1.67
7.48%
=
3.41%
1.28
1.71
Table 1: Du-Pont Analysis of Frencken Group Limited
2016
7.48%
2015
4.53%
=
2014
5.49%
=
-6.32% 8.64%
2012
=
2013
Du-Pont Analysis of Frencken Group Limited
=
=
Net Profit Margin
Total Assets Turnover
Financial Leverage
Figure 2: Du-Pont Analysis of Frencken Group Limited
The ROE of Frencken in 2016 is higher than that that of MSM International and IEV Holdings. In
2016, the ROE of MSM International was very low, and ROE of IEV Holdings was negative. The
ROE of IEV Holdings even though has been increased in 2014 and 2015 but has been significantly
decreased in 2016. Based on the review of ROE of three companies it can be said that currently
among the three companies, Frencken is most efficient in managing of its shareholders funds to
generate return.
ROE of Frencken, MSM International, and IEV Holdings
20.00%
15.00%
10.00%
ROE
5.00%
0.00%
-5.00%
-10.00%
-15.00%
-20.00%
-25.00%
-30.00%
-35.00%
Frencken Group
2012
2013
2014
2015
2016
-6.32%
8.64%
5.49%
4.53%
7.48%
MSM International
6.15%
3.24%
13.58%
-2.90%
0.35%
IEV Holdings
-4.35%
-5.04%
5.76%
12.02%
-30.83%
Figure 3: ROE of Frencken, MSM International, and IEV Holdings
PART: B Valuation
(1) Beta Estimation
Beta is a measure of the systematic risk as well as security return’s volatility in comparison to overall market’s volatility. Beta of a
stock is calculated by the dividing the covariance of market and stock return by the variance of market return (Beta = Covariance of
Stock and Market Return/ Variance of Market Return). The unadjusted (raw) beta of the Frencken stock is calculated as 0.624
[Detailed in Appendix 04]. Here, the monthly stock price data of Frencken and Straits Times Singapore (STI) for 2013-2017 (five
years) has been considered for the beta estimation [Detailed in Appendix 04].
The beta tends to depict mean reversion tendency (Reilly & Brown, 2011), and thus the raw beta estimated with the historical data is
required to adjust [Adjusted beta = (2/3)*(Unadjusted Beta) + (1/3)*(1.0)]. The adjusted beta of the Frencken stock is calculated as
0.748 [(0.67*0.624) + (0.33*1.0)].
Beta Estimation
Covariance of Index and Stock Return
Variance of Index Return
Variance of Stock Return
Unadjusted Beta of Frencken Group
Adjusted Beta of Frencken Group
0.00065
0.00104
0.00929
0.624
0.748
Risk Free Rate of Return: The risk free rate of return is the theoretical rate of return of an investment with zero risk (Petty, Titman,
Keown, & Martin, 2015). Risk free rate actually represents the opportunity cost of holding money over a specified period of time. The
risk free rate considered here is 2.390%. In this case, the current yield of the Singapore 10-Year Bond has been considered as the proxy
of the risk free rate (Investing.com, 2018).
Risk Premium: The risk premium refers to the additional return offered for undertaking additional risk (Petty, Titman, Keown, & Martin,
2015). Market risk premium refers to the additional market return over the risk free rate. The expected market return is estimated here
as 10.8230%. It should be noted that Straits Times Singapore (STI) has been considered as a proxy of the market. The annual return of
1983-2016 (28 years) have been utilized to develop forecasting technique for predicting the market return [Detailed in Appendix 05].
The expected market risk premium is 8.43% and expected equity risk premium is 6.31% given risk free rate of 2.390% and beta of the
stock of 0.748.
Estimation of Cost of Equity: Cost of equity refers to the return demanded by the equity investors or shareholders as compensation for
the risk undertaken in investing their capital (Petty, Titman, Keown, & Martin, 2015). Cost of equity represents the opportunity cost of
the equity investors or shareholders. The cost of equity can be determined with many techniques including dividend discount model
(DDM) approach, Bond yield plus risk premium approach, capital assets pricing model (CAPM) approach etc. (Vishwanath, 2007).
Among these, CAPM is most widely used approach to determine the cost of equity. Under the CAPM approach, additional risk premium
(that compensate against the sytematic risk of the stock) is added to the risk free rate to determien the cost of equity (Reilly & Brown,
2011). Given risk free rate of 2.390%, expected market risk premium of 8.43%, and beta of 0.748, the estimated cost of equity of
Frencken is 8.30%.
(2) Stock Valuation
Valuation models can be broadly categorized into two types including intrinsic value approach and ratio value approach (Petty,
Titman, Keown, & Martin, 2015). Intrinsic value approach involves with determining the stock value based on the review and forecast
of fundamental elements, and drivers that generate value for the company. On the other hand, ratio value approach involves with
determining the stock value based on linking of a comparable ratio (financial metric) to a specific financial statement item (earnings,
book value, cash flow etc.) (Petty, Titman, Keown, & Martin, 2015). Dividend Discount Model (DDM) and Free Cash Flow to Equity
(FCFE) Model are examples of intrinsic value approach, and price/earnings ratio (P/E) model and price to book (P/B) ratio model are
examples of ratio value approach.
(i) Dividend Discount Model (DDM)
The dividend discount model (DDM) involves with valuing a company’s stock based on the expected dividend payments (Nobles,
Mattison, & Matsumura, 2014). Under this model, the return to the stockholders are assumed to derive through dividend payments.
The summation of the discounted future expected dividends (net present value of future dividends) from a stock is considered as the
present value of the stock (Petty, Titman, Keown, & Martin, 2015).
The sustainable growth rate of the company has been estimated as 4.22%. This growth rate indicates that Frencken can sustain
maximum growth rate of 4.22% without having dependency on the outside (external) financing. This sustainable growth rate is
determined by multiplying the average ROE and Average retention ratio of the company for the last four years.
Average Retention Ratio Calculation
Particulars
2013
2014
2015
2016
DPS (SGD)
0.01
0.01
0.01
0.01
EPS (SGD)
0.04
0.03
0.02
0.03
Retention (Plaw-back) Ratio
75.00% 66.67% 50.00% 66.67%
Average Retention (Plaw-back) Ratio
ROE
Average
64.58%
Average Return on Equity (ROE) Calculation
Particulars
2013
2014
2015
8.64% 5.49% 4.53%
2016
7.48%
Average ROE
Average
6.54%
Particulars
DPS (SGD)
Growth Rate
Average Dividend Growth Rate
Average Dividend Growth Rate
2013
2014
0.01
0.01
0.00%
Average Retention (Plaw-back) Ratio
Average ROE
Sustainable Growth Rate
2015
0.01
0.00%
2016
0.01
0.00%
Average
0.00%
64.58%
6.54%
4.22%
The future expected dividends of the company for the next five years is expected to be SGD 0.01. After five years, the terminal growth
rate is considered as 4.22% (Sustainable growth rate). The terminal value of the dividends at the end of fifth year is estimated as SGD
0.23264. Given cost of equity of 8.70%, the intrinsic value of the stock of company under DDM is SGD 0.1925.
Particulars
DPS (SGD)
Current
Year 0
0.0100
Particulars
Dividend Forecast For Next Six Years
Forecast
Year 1
Year 2
Year 3
Year 4
0.0100
0.0100
0.0100
0.0100
Year 5
0.0100
Share Price Estimation with DDM Approach
Year 0
Year 1
Year 2
Year 3
0.01000
0.01000
0.01000
DPS (SGD)
Terminal Value
Total Cash Flow
PVIFA (8.70%)
Discounted Cash Flows
Theoretical Value of Stock (SGD)
0.0100
0.9200
0.0092
0.0100
0.8463
0.0085
0.0100
0.7786
0.0078
Perpetual
0.0104
Year 4
0.01000
0.0100
0.7163
0.0072
Year 5
0.01000
0.23264
0.2426
0.6589
0.1599
0.1925
Cost of
Equity
The stock price of the company calculated under DDM approach is very sensitive to cost of equity and terminal growth rate of
dividends after five years. Small change in the cost of equity or terminal growth rate of dividends after five years lead to high change
in the stock price of the company. The stock price of the company becomes higher when cost of equity is lower and terminal growth
rate of dividends after five years is higher, and stock price of the company becomes lower when cost of equity is higher and terminal
growth rate of dividends after five years is lower. In the Table 3, for different combination of cost of equity and terminal growth rate
of dividend, the stock prices are depicted. The combination for whose stock price is found higher than the initially estimated price of
SGD 0.1925 are marketed with green co...