Valuation Report General Electric

Question: Discuss about the Valuation Report General Electric. Answer: Introduction Valuation implies the process of estimating the worth of something. In regards to the valuation of firm, it is the value of firms assets that is put under consideration in the valuation exercise. The valuation of the firms assets is a challenging task because it involves application of various techniques and different perceptions (Kruschwitz and Loeffler, 2006). It is to be noted that the value of firms assets could be determined differently by different people pursuing different purposes. For example, the valuation of the firms assets may be required for the purposes of computation of income tax liability or it may be required for computation of sales price in case of merger and acquisitions. Thus, it is in effective the purpose that is required to be kept in mind while carrying out the valuation of the firm (Kruschwitz and Loeffler, 2006). Further, there are various techniques and methods which are applied in valuation such as net assets method, earnings growth rate method, discounted free cash flow method. These methods involve application of different methodologies, for example, net assets method computes the value of asset based on the balance figures (Larrabee Voss, 2012). However, the balance sheet figures can also be adjusted in the light of market values. Further, the earnings growth rate method provides for valuation of the firm based in the estimation of future earnings of the firm. In the same manner, the discounted cash flow method provides for computation of the value of firm based on the present value of the free cash flows. Among these all methods, the discounting of free cash flows is the most commonly applied method for the purpose of valuation of the firm (Larrabee Voss, 2012). In the context developed above, the report presented here covers the valuation of General Electric Company, which operates for infrastructure development and generation and distribution of electricity (General Electric, 2016). The valuation of the company has been carried out by applying the discounting of free cash flows to the firm. Further, two analytical techniques have been adopted in computing the value of the company. In the first technique, the value of overall company has been computed by taking the free cash flows to the company. In the second technique, the free cash flows to the equity have been computed separately and the value of equity has been arrived based on discounted value of the free cash flows attributable to the equity holders. Growth and Cash Flow Projections Computation of free cash flows and growth rate is the primary step in the valuation process. The free cash flows represent cash flows generated by the business after meeting all the spending requirements. Thus, the free cash flows represent the amount available with the company to infuse in the expansion activities (Wahlen, Baginski, Bradshaw, 2014). In other words, the free cash flows also represent the resources available with the company to enhance the value of the shareholders and therefore, the use of cash flows is considered the most suitable to compute the value of firm. The firms value is computed by discounting the future expected free cash flows by the appropriate discount rate. Thus, there are two most critical elements that play essential role in determining the value of the firm those elements are future expected cash flows and discount rate (Wahlen, Baginski, Bradshaw, 2014). The computation of future expected cash flows involves analysis of the past cash flows of the firm and determination of the expected growth rate that can be perceived to be maintained in future. The past years cash flows are taken as the basis to estimate the future cash flows applying the future expected growth rate. In regards to use of past years cash flows, it is always advisable to use of the average figures (Wahlen, Baginski, Bradshaw, 2014). For example, in the case of valuation of General Electric, the average of past five years cash flows can used to determine the future expected cash flows. After arriving at the average past free cash flows, it becomes essential to compute the future growth to determine the future expected cash flows. The computations in regards to General Electric have been shown below. Average Free Cash Flows General Electric: Past five Year Free Cash Flows for Firm 2016 ($M) 2015 ($M) 2014 ($M) 2013 ($M) 2012 ($M) Earnings before interest and tax 14,055.00 11,649.00 26,711.00 26,267.00 29,788.00 Less: Tax @35% 4,919.25 4,077.15 9,348.85 9,193.45 10,425.80 After tax EBIT 9,135.75 7,571.85 17,362.15 17,073.55 19,362.20 Add: Depreciation and amortizations 4,997.00 4,847.00 9,283.00 9,762.00 9,192.00 Add/Less: Decrease (increase) in GE current receivables 1,514.00 383.00 (1,913.00) (485.00) (879.00) Add/Less: Decrease (increase) in inventories (1,389.00) (314.00) (872.00) (1,368.00) (1,274.00) Add/Less: Increase (decrease) in accounts payable 1,198.00 (541.00) 305.00 360.00 (437.00) Add/Less: Increase (decrease) in GE progress collections 1,836.00 (996.00) (515.00) 1,893.00 (920.00) Total 17,291.75 10,950.85 23,650.15 27,235.55 25,044.20 Less: Capital expenditure (2,775.00) (4,289.00) (7,465.00) (7,575.00) (8,935.00) Free cash flows to the firm 14,516.75 6,661.85 16,185.15 19,660.55 16,109.20 Average 16,617.91 Note: In the year 2015 company incurred net loss of $6,145 million and the free cash flows of the company are also deviating from the normal trend. Therefore, the year 2015 has been considered as abnormal and hence ignored in computing average free cash flows. The free cash flows as computed above shows that the company has capability to produce $16,618 million cash flows on a per year basis. It could be observed that the free cash flows to the firm include the cash flows generated for the debt holders also, beside the equity. However, the free cash flows for equity are computed after deducting the re-payments of debt. Further, in computing the free cash flows for equity, the net earnings attributable to equity are taken into consideration rather than EBIT. In respect of General Electric, the computation of free cash flows for equity is shown in the table given below: General Electric: Past Five Year Free Cash Flows for Equity 2016 ($M) 2015 ($M) 2014 ($M) 2013 ($M) 2012 ($M) Net earnings (loss) attributable to GE common shareowners 8,176.00 (6,145.00) 15,233.00 13,057.00 13,641.00 Add: Depreciation and amortizations 4,997.00 4,847.00 9,283.00 9,762.00 9,192.00 Add/Less: Decrease (increase) in GE current receivables 1,514.00 383.00 (1,913.00) (485.00) (879.00) Add/Less: Decrease (increase) in inventories (1,389.00) (314.00) (872.00) (1,368.00) (1,274.00) Add/Less: Increase (decrease) in accounts payable 1,198.00 (541.00) 305.00 360.00 (437.00) Add/Less: Increase (decrease) in GE progress collections 1,836.00 (996.00) (515.00) 1,893.00 (920.00) Total 16,332.00 (2,766.00) 21,521.00 23,219.00 19,323.00 Less: Capital expenditure (2,775.00) (4,289.00) (7,465.00) (7,575.00) (8,935.00) Free cash flows to the firm 13,557.00 (7,055.00) 14,056.00 15,644.00 10,388.00 Less: Net Debt payments (1,135.00) (24,459.00) (6,112.00) (14,230.00) (2,231.00) Free cash flows for equity 12,422.00 (31,514.00) 7,944.00 1,414.00 8,157.00 Average 7,484.25 Note: In the year 2015 company incurred net loss of $6,145 million and the free cash flows of the company are also deviating from the normal trend. Therefore, the year 2015 has been considered as abnormal and hence ignored in computing average free cash flows. It could be observed that the company has the ability to generate free cash flows of an amount of $7,484.25 million on per annum basis. Estimations of Growth The growth rate has been computed at two stages. At the first stage the variable growth rate (discrete cash flows) has been computed and at the second stage, the stable growth rate has been calculated. It is assumed that the free cash flows of the firm will grow at rate computed at the first stage for the next 10 years and then the growth would stabilize at the rate computed at the second stage. Estimation of a discrete cash flow growth (First Stage): ROE*Retention ratio Year Net profit for equity ($M) Equity ($M) ROE (%) Retention ratio Growth rate 2012 13,641.00 128,430.00 10.62% 49.28% 5.23% 2013 13,057.00 136,783.00 9.55% 41.06% 3.92% 2014 15,233.00 136,833.00 11.13% 5.32% 0.59% 2015 (6,145.00) 100,138.00 -6.14% 0.00% 0.00% 2016 8,176.00 77,491.00 10.55% 7.00% 0.74% Average growth of past five years 2.10% Note: It is assumed that for the next 10 years, the free cash flows of the company will grow at the average rate computed above. The growth rate as arrived at the first stage is 2.10% which is computed using return on equity and the retention ratio. The second stage growth rate has been calculated with reference to the growth in the gross domestic product as shown below: Year GDP ($M) (World Bank, 2017) Growth rate 2012 16155255 2013 16691517 3.32% 2014 17393103 4.20% 2015 18036648 3.70% 2016 18415418 2.10% Average GDP growth rate 3.33% It could be observed that the average growth rate of gross domestic product of the United States has been 3.33% in the past five years. In the long term, the company can not grow more rapidly than the overall economy; therefore, it is assumed that the growth rate of General Electricity in the long run would be 2.50% i.e. is less the average GDP growth rate. Estimated Future Free Cash Flows Using the average free cash flows of past years and the growth rates as computed above, the free cash flows for the next 10 years and the terminal value have been computed as shown in the table given below: Estimated Free cash flows for firm Year FCFF ($M) Remarks 2017 16,966.35 16617.91*(1+2.10%) 2018 17,322.10 ------Do--------- 2019 17,685.31 2020 18,056.13 2021 18,434.72 2022 18,821.26 2023 19,215.90 2024 19,618.81 2025 20,030.18 2026 20,450.16 Terminal cash flows 21,131.29 21131.29*(1+3.33%) Estimated Free cash flows for equity Year FCFF ($M) Remarks 2017 7,641.18 7484.25*(1+2.10%) 2018 7,801.40 -----Do---------- 2019 7,964.97 2020 8,131.98 2021 8,302.49 2022 8,476.58 2023 8,654.31 2024 8,835.77 2025 9,021.04 2026 9,210.19 Terminal cash flows 9,516.95 9210.19*(1+3.33%) Determination of Discounting Rate The future expected free cash flows of General Electric have been computed as shown in the above section. Now, the next step is to determine the appropriate discount rate to calculate the present value of these cash flows. The appropriateness of the discount rate would depend upon the fact that whether the cash flows for the firm are used or cash flows for equity are used. When the valuation is carried out using the cash flows to the firm, the appropriate discount rate is weighted average cost of capital (Pratt Grabowski, 2010). However, in case when the cash flows to equity are used, the cost of equity is considered to be appropriate discount rate. The weighted average cost of capital represents the cost of using all the capital resources which includes both the debt as well as the equity (Pratt Grabowski, 2010). However, the cost of equity represents the cost of using equity funds only. For the purpose of computation of weighted average cost of capital, it is essential to work out the cost of equity and cost of debt. The cost of debt can be computed by referring to the interest cost and the total amount of outstanding debt. However, the computation of cost of equity is not that simple (Pratt Grabowski, 2010). There are various considerations and different perceptions of the people about the cost of equity. Few consider dividend as the primary factor for computation of cost of equity and others relate it to the market risk premium on the stock. The dividend growth model provides solution to those who prefer dividend and capital asset pricing model provides solution for those who consider that market risk premium drives cost of equity (Pratt Grabowski, 2010). The dividend growth rate model is applied to compute the intrinsic value of the stock. The calculation of intrinsic value as per this model is carried out with the help of expected dividend, cost of equity, and the growth rate (Shapiro, 2008). This model provides that discounting the values of dividend to be received in future at the cost of equity would yield the intrinsic value. The dividend growth rate model assumes that the dividend will growth in future at the rate that is currently prevailing and it further assumes that the cost of equity will remain constant (Shapiro, 2008). This model provides following formula to calculate the intrinsic value of the stock: Intrinsic Value of Stock= D1/(Ke-g) Here, D1 is the expected dividend, Ke is the cost of equity, and g is the dividend growth rate (Shapiro, 2008). This formula can also be applied in computing the cost of equity. The cost of equity can be calculated if the expected dividend and growth is available and current prevailing price of the stock is assumed to be the intrinsic value of the stock. The cost of equity of General Electric by applying the dividend growth rate model has been computed as under: Cost of Equity: Dividend model A. Market Price of Stock (Po) (Yahoo Finance, 2017) 30.02 B. Expected dividend 0.998 C. Growth rate of dividend 7.36% D. Cost of Equity 10.69% Dividend growth rate Year Dividend per share ($) 2012 0.700 2013 0.890 2014 0.890 2015 0.920 2016 0.930 Growth Rate 7.36% Further, apart from dividend growth rate model, there is another most widely used model for computation of capital assets pricing model. The capital asset pricing model computes the expected return by using risk free rate of return, risk premium, and systematic risk. The CAPM model is based on the analogy that the investor would want as minimum return that equals the risk free rate plus the premium for risk (Sharifzadeh, 2010). Further, the premium for risk is also adjusted for the systematic risk which is represented by beta of the security. The beta measures volatility of the securitys return in comparison to the overall market return. The CAPM return is computed using the following formula: CAPM= Rf + Beta (Rm-Rf) Here, Rm is the market return and Rf is the risk free rate of return In respect of General Electric, the CAPM return has been computed as under: Cost of Equity: CAPM model A. Risk free rate (CNBC, 2017) 2.38% B. Market rate of return (SP500 2016 return) 15% C. Beta (Yahoo Finance, 2017) 1.1 D. CAPM 16.66% It could be observed that the cost of equity of the company by applying the dividend growth rate model is 10.69% while as per CAPM model it is 16.66%. It depicts that when dividend is considered as the primary parameter, the company seems less risk, however, when the stock price is taken as basis, the company appears to be more risky. Considering these fluctuations in the cost of equity arrived under two different models, it is advisable to use average for the purpose of computation of weighted average cost of capital. The average cost of equity is worked out to be 13.67%. Besides the cost of equity, two other important elements of weighted average cost of capital are cost of debt and cost of preferred stock (Pratt Grabowski, 2010). In respect of General Electric, it has been observed that preferred stock is negligible and hence it has been ignored in computing the weighted average cost of capital (General Electric, 2016). The cost of debt has been computed as under: Cost of debt: Net finance cost ($M) 5,025.00 Less: Tax @35% 1,758.75 After tax cost of debt 3,266.25 Borrowings amount 135,794.00 After tax cost of debt (%) [3517.50/135794] 2.41% The after tax cost of debt of General Electric has been worked out to be 2.41%. Further, it is essential to work out the market value weights to compute the weighted average cost of capital, which is shown below: Market Value Weights Debt Equity Total Market value of equity shares ($M) (Yahoo Finance, 2017) 261,440.00 Add: Retained Earnings 139,532.00 Value of debt (short term borrowings+ long term borrowings) 135,794.00 Total 135,794.00 400,972.00 536,766.00 Weights 0.25 0.75 It could be observed that the market value of companys common stock has been taken based on the current prevailing price of the stock. Further, since, most of debt of the company is in the form of borrowings from banks and financial institutions, therefore, the value of debt has been taken as per the latest audited statement of financial position (General Electric, 2016). Considering the above shown calculations in respect of cost of equity, cost of debt, and market value weights; the weighted average cost of capital of the company is worked out as under: Weighted Average Cost of Capital Debt Ordinary Shares Total Cost of Finance 2.41% 13.67% Market Weights 0.25 0.75 WACC 0.61% 10.21% 10.82% Final Valuation of Equity Shares The two crucial steps of valuation of the firm such as calculation of free cash flows and discount rate have been completed. Now, the final step is to compute the value of firm and value of equity by applying present value technique. In order to compute the value of firm, the calculation of present value is divided in two parts such as present value of discrete cash flows and present value of terminal cash flows (Larrabee Voss, 2012). In respect of General Electric, the value of equity has been computed under two approaches. The first approach seeks to compute value of overall firm and then the value of equity is arrived at after deducting there from the value of debt. In this approach, the free cash flows are computed for the overall firm and discounting of these cash flows is carried out at the weighted average cost of capital. The second approach seeks to compute the value of equity directly. In this approach, the free cash flows are computed for equity only and discounting of these cash flows is carried out by applying the cost of equity. In respect of General Electric, the value of equity under the first approach is arrived at as follows: Present value of discrete cash flows for next 10 years Year FCFF ($M) PVF @10.82% PV of Cash Flows ($M) 1 16,966.35 0.902 15,309.83 2 17,322.10 0.814 14,104.71 3 17,685.31 0.735 12,994.46 4 18,056.13 0.663 11,971.60 5 18,434.72 0.598 11,029.25 6 18,821.26 0.540 10,161.08 7 19,215.90 0.487 9,361.25 8 19,618.81 0.440 8,624.37 9 20,030.18 0.397 7,945.50 10 20,450.16 0.358 7,320.07 Total 108,822.12 Present value of terminal cash flows Terminal cash flows ($M) 21,131.29/ (10.82%-3.33%) 282,063.06 Total value of Firm ($M) (108,822.12+282,063.06) 390,885.18 Less: Value of Debt 135,794.00 Total value of Equity 255,091.18 No of Shares Outstanding Yahoo (Finance, 2017) 8,710.00 Per share value of value of equity (255,091.18/8,710) 29.29 The intrinsic value per equity share of General Electric as worked above is $29.29, which is approximately equal to the current prevailing price of the company. The current prevailing price of the company is $30.02 (Yahoo finance, 2017). This implies that the stock of the company is correctly valued at the moment. The value of equity of General Electric under the second approach that is taking the free cash flows for equity is arrived at as under: Present value of discrete cash flows for next 10 years Year FCFF ($M) PVF @13.67% PV of Cash Flows 1 7,641.18 0.880 6,722.25 2 7,801.40 0.774 6,037.83 3 7,964.97 0.681 5,423.09 4 8,131.98 0.599 4,870.94 5 8,302.49 0.527 4,375.01 6 8,476.58 0.464 3,929.57 7 8,654.31 0.408 3,529.49 8 8,835.77 0.359 3,170.13 9 9,021.04 0.316 2,847.37 10 9,210.19 0.278 2,557.47 Total 43,463.15 Present value of terminal cash flows Terminal cash flows 9,516.95/ (13.67%-3.33%) 92,046.11 Total value of Equity $M (43463.15+92046.11) 135,509.26 No of Shares Outstanding 8,710.00 Per share value of value of equity 15.56 It could be observed that the intrinsic value of equity share as worked above is $15.56, which is lower than the value arrived at as per the first approach. Further, this intrinsic value is also lower than the current prevailing market price, which implies that the stock is overvalued. Conclusion This report deals with the valuation of General Electric by applying the free cash method with two different approaches. Under the one approach, the overall value of the firm is computed and then the value of debt is deducted to arrive at the equity value. On the other hand, the second approach seeks to compute the value of equity directly by discounting the free cash flows for equity. From the analysis carried out in this report, it could be observed that there are three main steps to complete the valuation of a firm. These three steps are computation of free cash flows, discount rate, and the present value of the free cash flows. The computation of free cash flows involves analysis of the past trend and the estimations in regards to future growth. In regards to General Electric, it has been found out that the average free cash flows of the firm are $16,617.91 million while the average free cash flows to equity are $7,484.25 million. Further, it is estimated that these cash flows will growth at the rate of 2.10% per annum for next 10 years and then the growth rate would stabilize to 3.33% forever. Further, it has been observed that the discount rate should be selected carefully. The weighted average cost of capital is considered to be best when free cash flows to the firm are to be discounted. However, the cost of equity is taken as the discount rate when the free cash flows to equity are to be discounted. In respect of General Electric, the weighted average cost of capital has been found to be 10.82% and the cost of equity is 13.67%. Further, it has been observed that while calculating the present value, it is essential to divide the cash flows into two categories such as discrete cash flows and terminal value. This bifurcation of cash flows is necessary because different discounting parameters are applied on the discrete cash flows and the terminal value. The final value of equity of General Electric under the firm approach is arrived at $29.29 while it drops to $15.56 when computed under equity approach. References CNBC. 2017. US 10 year bond yield. Retrieved April 7, 2017, from https://www.cnbc.com/quotes/?symbol=US10Y General Electric. 2016. Annual report of General Electric for 2016. Retrieved April 7, 2017, from https://www.ge.com/ar2016/assets/pdf/GE_AR16.pdf Kruschwitz, L. Loeffler, A. 2006. Discounted Cash Flow: A Theory of the Valuation of Firms. John Wiley Sons. Larrabee, D.T. Voss, J.A. 2012. Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options. John Wiley Sons. Pratt, S.P. Grabowski, R.J. 2010. Cost of Capital: Applications and Examples. John Wiley Sons. Shapiro. 2008. Capital Budgeting and Investment Analysis. Pearson Education. Sharifzadeh, M. 2010. An Empirical and Theoretical Analysis of Capital Asset Pricing Model. Universal-Publishers. Wahlen, J.M., Baginski, S.P., Bradshaw, M. 2014. Financial Reporting, Financial Statement Analysis and Valuation. Cengage Learning. World Bank. 2017. Data GDP: USA. Retrieved April 7, 2017, from https://data.worldbank.org/indicator/NY.GDP.MKTP.CD Yahoo Finance. 2017. General Electric Company: Summary. Retrieved April 7, 2017, from https://in.finance.yahoo.com/quote/GE?p=GE Yahoo Finance. 2017. General Electric Company: Valuation Measures. Retrieved April 7, 2017, from https://in.finance.yahoo.com/quote/GE/key-statistics?p=GE