Abstract

The main purpose of this empirical project is to analyse the financial performance of
Treatt plc from the standpoint of a potential investor, assessing four different
aspects. Firstly, the market economy conditions, where the company operates, and
the main competitors of the examined firm are taken into consideration. Then,
financial statements and the share price performance of the company are evaluated
(the peer’s financial statements are also included in the analysis, in order to increase
the efficiency of the results). Moreover, this paper estimates three of the financial
management policies of the firm: the dividend policy, the capital structure and the
risk management. Finally, five different approaches are used in order to estimate the
value of the company.

1
“List of Abbreviations”

ABHR “Abnormal Buy-and-Hold Return”

CAPEX “Capital Expenditure”
CCC “Cash Conversion Cycle”
D/E “Debt to Equity ratio”
DPS “Dividends per Share”
EBIT “Earnings before Interest and Tax”
EPS “Earnings per Share”
FCFE “Free Cash Flow to Equity”
FCFF “Free Cash Flow to Firm”
FTSAS “Financial Times Stock Exchange”
GDP “Gross Domestic Product”
GPM “Gross Profit Margin”
IMF “International Monetary Fund”
LSE “London Stock Exchange”
P/E “Price to Earnings ratio”
PVGO “Present Value of Growth Opportunities”
ROA “Return on Assets”
ROCE “Return on Equity Employed”
ROSF “Return on Shareholders’ Funds”
WACC “Weighted Cost of Capital”

2
“List of Contents”

“Chapter 1: Introduction”........................................................................................................7
“1.1: Company basic information and background”............................................................7
“1.2: Competitors and industry background”......................................................................8
“1.3: UK economy”..............................................................................................................9
“Chapter 2: Financial Performance and Position of Treatt plc”.............................................12
“2.1 Profitability Ratios”....................................................................................................12
“2.1.1 Return on Capital Employed”..............................................................................13
“2.1.2 Return on Shareholder’s Funds”.........................................................................14
“2.1.3 Gross Profit Margin”...........................................................................................15
“2.1.4 Return on Assets”...............................................................................................16
“2.2 Liquidity Ratios”.........................................................................................................18
“2.2.1 Current Ratio”.....................................................................................................18
“2.2.2 Quick Ratio”........................................................................................................19
“2.3 Efficiency Ratios”.......................................................................................................20
“2.3.1 Inventory Turnover”............................................................................................20
“2.3.2 Receivables Days”...............................................................................................22
“2.3.3 Payable Days”.....................................................................................................23
“2.3.4 Cash Conversion Cycle”.......................................................................................24
“2.4 Capital Structure Ratios”............................................................................................25
“2.4.1 Gearing”.............................................................................................................25
“2.4.2 Interest Cover”....................................................................................................27
“2.5 Investment Ratios”....................................................................................................28
“2.5.1 Earnings per Share”............................................................................................28
“2.5.2 Price/Earnings ratio”...........................................................................................29
“2.6 Share Price Performance”..........................................................................................31
“Chapter 3: Financial Management Policies”........................................................33
“3.1 Dividend Policy”.................................................................................................33
“3.2 Capital Structure”.............................................................................................36
“3.3 Risk Management”...........................................................................................38
“Chapter 4: Valuation of Treatt”............................................................................................41
“4.1: Growth Rate”............................................................................................................41

3
 “4.2: Discount Rate”..........................................................................................................43
“4.3: Dividend Valuation Model”.......................................................................................44
“4.4: Earnings and Investment Model”..............................................................................45
“4.5: Free Cash Flow Model”.............................................................................................47
“4.5.1: Free Cash Flow to the Firm”...............................................................................48
“4.5.2: Free Cash Flow to the Shareholders”.................................................................51
“4.6: Price to Earnings Multiplier”.....................................................................................52
“4.7: Critical Analysis of Empirical Results”.......................................................................54
“Chapter 5: Conclusion”........................................................................................................56
“Bibliography”.......................................................................................................................58
“Appendices”.........................................................................................................................64
“Appendix A”.....................................................................................................................64
“Appendix B”.....................................................................................................................68
“Appendix C”.....................................................................................................................70

4
“List of Tables”

“Table 2.1: Key fundamentals of companies in 2017”.............................................................8

“Table 2.2: Return on Capital Employed”..............................................................................13
“Table 2.3: Return on Shareholders ‘Funds”.........................................................................14
“Table 2.4: Gross Profit Margin”............................................................................................15
“Table 2.5: Return on Assets”................................................................................................17
“Table 2.6: Current Ratio”.....................................................................................................18
“Table 2.7: Quick Ratio”........................................................................................................19
“Table 2.8: Inventory Turnover”............................................................................................21
“Table 2.9: Receivable Days”.................................................................................................22
“Table 2.10: Payable Days”....................................................................................................23
“Table 2.11: Cash Conversion Cycle”.....................................................................................24
“Table 2.12: Gearing Ratio”...................................................................................................26
“Table 2.13: Interest Cover Ratio”.........................................................................................27
“Table 2.14: Earnings Per Share”...........................................................................................29
“Table 2.15: Price to Earnings”..............................................................................................30
“Table 2.16: EPS, DPS, Pay-out and Retention ratio of Treatt plc”.........................................34
“Table 2.17: DPS and Net Profit of Treatt plc”.......................................................................35
“Table 2.18: Dividend Yield and Dividend Cover of Treatt plc”..............................................35
“Table 2.19: Capital Structure of Treatt plc (£’000)”..............................................................37
“Table 2.20: Key indicators of the Growth Rate”...................................................................42
“Table 2.21: Estimated Growth Rate of Treatt”.....................................................................43
“Table 2.22: Cost of Equity of Treatt”....................................................................................43
“Table 2.23: Dividend Valuation Model (£)”..........................................................................45
“Table 2.24: Estimated ROCE and Retention Ratio of Treatt”................................................46
“Table 2.25: Earnings and Investment Model (£)”.................................................................47
“Table 2.26: FCFF of Treatt in 2016 (£’000)”..........................................................................48
“Table 2.27: Weighted Cost of Capital of Treatt (£’000)”.......................................................50
“Table 2.28: FCFF Model (£’000)”..........................................................................................51
“Table 2.29: FCFE Model (£’000)”.........................................................................................52
“Table 2.30: P/E Multiplier”..................................................................................................53
“Table 2.31: P/E Valuation Model”........................................................................................53
“Table 2.32: Value of Treatt: Approaches vs Real Market”....................................................55

5
“List of Figures”

“Figure 2.1: The GDP of UK between 2008 and 2018”..........................................................10

“Figure 2.2: The Unemployment rate of UK between 2013 and 2018”.................................10
“Figure 2.3: Return on Capital Equity”..................................................................................14
“Figure 2.4: Return on Shareholders’ Funds”........................................................................15
“Figure 2.5: Gross Profit Margin”..........................................................................................16
“Figure 2.6: Return on Assets”..............................................................................................17
“Figure 2.7: Current Ratio”....................................................................................................19
“Figure 2.8: Quick Ratio”.......................................................................................................20
“Figure 2.9: Inventory Turnover”...........................................................................................21
“Figure 2.10: Receivables Days”............................................................................................23
“Figure 2.11: Payables Days”.................................................................................................24
“Figure 2.12: Cash Conversion Cycle”....................................................................................25
“Figure 2.13: Gearing Ratio”..................................................................................................26
“Figure 2.14: Interest Cover Ratio”........................................................................................28
“Figure 2.15: Earnings Per Share...........................................................................................29
“Figure 2.16: Price to Earnings”.............................................................................................31
“Figure 2.17: ABHR for Treatt and peer company”................................................................32

6
 “Chapter 1: Introduction”

“1.1: Company basic information and background”

Treatt plc is mainly a UK-based company, which was established in 1886. It operates
in the chemicals industry and more specifically in the sector of basic and diversified
materials. However, to collaborate with customers worldwide and distribute its
products (in more than 90 countries), bases in the USA, Kenya and China also exist.
Its major responsibility is to produce ingredients and provide solutions for the
fragrance, flavour and consumer goods markets. Among others, characteristics
products of this firm are the essential oils (Amyris, Citrus, Organic), Treattarome
(Pineapple, Honey and Cucumber), functional ingredients (beverage specialties) and
chemicals (fine and household fragrance).

Treatt has more than 100 years of experience and this has allowed the company to
root deep relationships with their clients and their environment. Because of this,
many of the most talented people in the chemicals industry work for the company,
allowing Treatt to be at the forefront of the industry. Treatt believes that its most
important asset is people, and as expertise plays a vital role in the effective function
of the firm, it does great efforts to hire the most qualified people and retain their
talent. Also, with 355 (222 male and 133 female) experts working across the globe,
Treatt delivers a truly integrated service.

The company illustrates a market capitalization of £273.492m (share price= 470.00p)

and is listed on the FTAS index. Financial Times Stock Exchange All Share is a proxy,
which represents a stock index of companies capturing a significant high market
capitalization and therefore, it reflects the performance of the UK capital market.

The chemical industry is characterised by an intensive competition. Therefore, Treatt

expands and invests a considerable amount of its profit on marketing, trying to
maintain its market share. With an efficient business model, an evident strategy and
a highly-expertized staff, the firm continues to generate profits, develop further and
ensure its long-term existence. For instance, Treatt has already established its plan

7
for the reallocation of tis offices in UK and the expansion in USA. This plan
constitutes the most significant project of the company until now, as it will affect
almost every area of its business.

“1.2: Competitors and industry background”

As it already mentioned above, the chemical industry is characterised by an

increasingly high competition, especially during the last years. Therefore, to be
analysed more efficiently and objectively the financial performance of Treatt, it is
appropriate to compare the examined company with other firms, operating in the
same industry. Thus, for this evaluation, it is created an industry which is constituted
from four different companies; Treatt, Zotefoams, Porvair and Versarien. There are
three major reasons for “encouraging these three companies to represent as the
compare firms.” First of all, all these companies are running their business in the
same industry and as they operate at least in the United Kingdom, they can be
considered as competitors. Secondly, there are small deviations in their market
capitalizations, something that is major to compare them. Lastly, they are all listed
on the London Stock Exchange (LSE) and thus, the same social situation and a
uniform benchmark are available for these four companies.

“Table 2.1: Key fundamentals of companies in 2017”

Zotefoams plc is a world leader in cellular materials technology. It is headquartered

in Croydon, UK with additional manufacturing sites in Kentucky and Oklahoma, USA.
IT mainly operates in automotive, pharmaceutical, food and beverage and

8
healthcare and cosmetics market and was established in 1921. Zotefoams has been
listed on LSE since 1995 and illustrates a market capitalization of £262.787m.

Porvair plc constitutes a worldwide leader in the supply of basic and diversified
materials and distributes its products mainly in the UK and the USA. This company
is highly-expertized in provide solutions and applications for filtration, providing a
whole new technology for this area. It also operates in pharmaceutical and food and
beverage industry. Porvair illustrates a market capitalization of £217.913m.

Versarien plc constitutes a start-up company, which was founded in 2010 and
operates in chemicals. Among other sectors, it does business in industry and
advanced materials sector. Just five years ago, the firm floated in the LSE and
demonstrates a market capitalization of £181.371m.

“1.3: UK economy”

Generally speaking, the economy of United Kingdom is one of the largest in the
world and is characterised as a highly-developed market. To evaluate more
objectively this economy, it is crucial to examine two macroeconomic factors; the
Gross Domestic Product (GDP) and the unemployment rate.

The first one is a significant statistic, which measures the aggregate value of goods
and services that are produced in a specific period. Therefore, it can illustrate
whether an economy is at a growth or recession. In the graph below (figure 2.1), it
can be observed the GDP of UK between 2008 and 2017. As a general trend, it
constantly increases from 2009 to 2014, reaching to its maximum of US$ 3022.83
billion. After this high-speed development period, it illustrates an aggregate
difference of 15.27%, falling to US$ 2622.43 billion. A noteworthy fact is that in
2009, the GDP plunges from US$ 2890.56 to US$ 2382.83 billion, mostly because of
the economic crisis that was occurred in 2008.

9
 “Figure 2.1: The GDP of UK between 2008 and 2018”

The unemployment rate of an economy is highly associated with the economic

conditions that exist. For instance, when an economy is expanding, jobs are
relatively abundant and therefore, this rate is expected to remain in small
percentages. On the other hand, when an economy is facing financial difficulties, it
is expected to rise. In the presented figure (figure 2.2), it can be noticed that the
unemployment rate facing a decreasing trend, ranging from 8% (2013) to 4% (2018).

“Figure 2.2: The Unemployment rate of UK between 2013 and 2018”

10
Regarding the examined industry, chemicals constitute a vital base for the economic
social and environmental life of the UK, as many services and products from the
chemical companies are widely used. Furthermore, the chemical industry
contributes around £15 billion per year to the UK economy and is one of the UK’s
largest economies (CIA, 2017).

More specifically, there is high demand for the basic material sector over the last
years and most companies, using a low-cost production, rides a wave of renaissance
(Collins, 2015). However, this sector is deeply cyclical and therefore, it is more
appropriate for a potential investor to examine all the macroeconomic conditions,
before investing in a basic material company.

11
“Chapter 2: Financial Performance and Position of
Treatt plc”

For evaluating more efficient the performance of Treatt plc, it is essential to

calculate and present the financial ratios of the company. This occurs because ratios
convert financial information to a standardized format and can be used to compare
companies to the industry average. To increase the creditworthiness of results, the
same financial ratios are calculated for the peer companies. Therefore, the industry
created consists of Treatt plc, Zotefoams plc, Porvair plc, Versarien plc. All
calculations are based on the annuals reports of the companies during the last five
financial years. Furthermore, trying to make the financial statements more
comparable, some adjustments were made.1 More specifically, these adjustments
were occurred in the unusual or exceptional items and the operating leases, which
are taken into consideration on balance sheet. Nevertheless, for a more complete
and accurate evaluation of the company’s financial performance, apart from the
financial ratios, also the stock price performance is taken into account. At this point,
it must be mentioned that one of the peers, Versarien, did not disclosure any official
financial report in 2013 (remained unaudited). Therefore, for this year, financial
ratios were not able to be calculated.

“2.1 Profitability Ratios”

According to Nissim and Penman (1999), the role of profitability ratios is to show
whether the company is producing enough return for its owners, as manager’s
inducement is to maximize shareholders’ value. There are many ratios that
contribute to businesses’ profitability measurement. Below, the most important of
them are analysed: Return on Capital Employed (ROCE), Return on Shareholders’
Funds (ROSF), Gross Profit Margin (GPM) and Return on Assets (ROA).

1 For the adjustments made in the financial statements, see Appendix A

12
 “2.1.1 Return on Capital Employed”

“ROCE is an essential measure of business’s performance, which expresses the

relationship between the profit produced by the business and the long-term capital
invested in the business. The formula that is usually used to calculate this ratio is:

Profit before interest ∧taxation

“ ROCE= '
×100 ”
Shareholder s funds+ Long term debt

“Table 2.2: Return on Capital Employed”

It can be easily noticed from the graph below (figure 2.3) that Treatt is not only
continuously above the industry’s average during this period, but also it shows the
most satisfactory performance among the whole industry. This can be explained by
the fact that the industry average is mainly affected by the negative results of
Versarien. The main competitor of Treatt is Porvair, which illustrates an average of
15.46%, fluctuating from 14.34% (in 2016) to 16.15% (in 2014). Regarding the
examined company, it is noteworthy the fact that Treatt, keeping the long-term debt
and profit before interest and taxation stable, increases its ROCE alongside with its
revenue. Therefore, the most adequate financial year is 2013, when its revenue
reaches the top of £109.627m. During this specific period, Treatt demonstrates an
aggregate change in ROCE of 6.15%, keeping its average in 21.69%.

13
 ROCE
35.00%
25.00%
15.00%
5.00%
-5.00% 2013 2014 2015 2016 2017
-15.00%
-25.00%
-35.00%
TREATT ZOTEFOAMS PORVAIR
VERSARIEN INDUSTRY

“Figure 2.3: Return on Capital Equity”

“2.1.2 Return on Shareholder’s Funds”

“ROSF is a measure of business performance which expresses the relationship

between the profit generated by the business and the equity capital invested in the
business. The formula that is usually used to calculate this ratio is:”

Profit attributable
“ ROSF=¿ equity shareholders ¿ ×100 ”
Shareholder s ' funds

“Table 2.3: Return on Shareholders ‘Funds”

Concerning Treatt’s average ROSF, the proportion of 16.31% seems to be enough,

especially in comparison with the industry’s average during the last five financial
years. However, the great fluctuations that are being observed (from 12.68% in 2013
to 20.54 in 2017), are mainly caused from the difference in the shareholder’s fund

14
 and the profit attributable to the owners that exist each period. 2017 is the most
efficient year for Treatt, illustrating a ROSF 20.54% (as its profits attributable to
equity shareholders this year was more than £9.5m). Moreover, the fall that is being
noticed in 2016, is caused by the increase in the available funds.

“Figure 2.4: Return on Shareholders’ Funds”

“2.1.3 Gross Profit Margin”

“Gross profit represents the difference between sales and the cost of sales. The ratio
is thus a measure of profitability either in buying or producing and selling goods
before any other expenses are considered. Its formula is:”

Gross profit
“ Gross profit margin= ×100 ”
Revenue

“Table 2.4: Gross Profit Margin”

15
 A higher ratio is more desirable as it indicates the ability of the company to expand,
using money from its gross profit. From the graph below (graph 2.5), it can be
illustrated that Treatt’s gross profit ratio is constantly below industry’s average in
every financial year. This occurred not only because the huge percentages of
Versarien, but also because of the enormous cost of sales that are existed in Treatt.
Therefore, despite all the other companies demonstrate an average around 31%,
Treatt’s average just reaches the percentage of 23%. Another remarkable fact is that
the variations for every company are not considerable. Continuing the previous
pattern, 2017 seems to be the most profitable year for the examined company,
mostly because on the increase in its revenue.

“Figure 2.5: Gross Profit Margin”

“2.1.4 Return on Assets”

“This ratio is a profitability measurement that gauges how well a company is using its
assets to generate revenue and it is especially vital for a retail company, as it relies
on its inventory to generate assets. Its formula is:”

Net income
“ ROA= ×100 ”
Total Assets

16
 “Table 2.5: Return on Assets”

As indicates in the figure below (figure 2.6), Treatt uses properly its assets to
generate revenues. Each year is over the industry’s average and scores a positive
percentage, fluctuating from 6.60% (2013) to 10.88% (2017). Nevertheless, although
the other firms illustrate many fluctuations, Treatt shows a stable increase during
these financial years. The main competitor of Treatt in this profitability ratio is
Porvair, which demonstrates an average of 6.61%. From 2014 to 2017 the industry
average seems to be not so reliable as it is mainly affected by the huge negative
values of Versarien.

“Figure 2.6: Return on Assets”

17
 “2.2 Liquidity Ratios”

“The role of liquidity ratios is to examine the relationship between liquid resources
held and amounts due for payment in the future (Eckbo and Norli, 2004). The main
two ratios in this category are Current Ratio and Quick Ratio (Acid Test).”

“2.2.1 Current Ratio”

“The Current Ratio compares the business’ liquid assets with its short-term liabilities
(creditors due within one year). The formula for calculating this ratio is:”

Current Assets
“ Current Ratio= ”
Current Liabilities

“Table 2.6: Current Ratio”

In the graph below (figure 2.7), it is characteristically stated that Treatt seems to
present more satisfactory liquidity compare to industry. As it can respond to its
liabilities, it appears to have a competitive liquidity management (current ratio
constantly over 2.5). However, during 2014 and 2017 there are noticed slightly
decreases in Treatt’s quick ratio. This exists mostly because of the increase in the
current liabilities of the firm (and more specific on the request of short term
borrowings). Despite the increase that exist during these financial years in the work-
in-progress inventory, the increase of 28.16% and 64.78% in 2014 and 2017
respectively in the current liabilities of the firm led to the reduction of this ratio.

18
 “Figure 2.7: Current Ratio”

“2.2.2 Quick Ratio”

“The Quick Ratio is the similar to the Current Ratio but excludes inventory on the
grounds that inventory is often not immediately convertible into cash. Its formula
is:”

Current Assets−Inventory
“ Quick Ratio= ”
Current Liabilities

“Table 2.7: Quick Ratio”

Concerning Treatt, among these five financial years, inventories constitute the main
division of current assets, and as it was expected, it illustrates lower results in acid
ratio. Comparing to the peer companies, Treatt is constantly below the industry’s
average during the first two financial years. In 2017, both numbers are equals, and
2016 is the only year, when Treatt demonstrates more satisfactory results than the

19
 other firms. This exist mainly because the greater part of peers’ assets does not
derive from the inventories, but from the intangible assets. Despite the low
numbers of quick ratio that Treatt indicates, it constitutes a company that faces no
difficulty in converting receivables into cash or covering its financial obligations.

“Figure 2.8: Quick Ratio”

“2.3 Efficiency Ratios”

“As characteristically Dunn, Koch and Steward (2014) state, efficiency (or working
capital) ratios used to measure the efficiency with which certain resources have
been utilized within the business. Below, the most significant of them are analysed:
inventory turnover, receivables days, payables days and cash conversion cycle
(CCC).”

“2.3.1 Inventory Turnover”

“Inventory turnover is a ratio that measures the average period for which stocks are
being held. Obviously, it is desirable for this period to be as short as possible as it
reflects how quickly inventory can be converted into cash. The formula that is
usually used to calculate this ratio is:”

20
 Inventory
“ Inventory Turnover= × 365 ”
Cost of sales

“Table 2.8: Inventory Turnover”

It is difficult to conclude whether the average of 162 days (ranging from 141 in 2015
to 189 in 2017) is adequate or not. This mostly depends on the nature of the
company. But as it can be noticed from the graph below (figure 2.9), Treat illustrates
more days than the other businesses that run in the same sector and this seems to
be a proof that the examined company is less financially efficient. This exists
because, as it is already mentioned before, Treatt is a firm which contains many
inventories. During the examined time-period, Treatt’s most efficient year for this
ratio was 2015, when any piece of inventory was spending around 140 days “on the
shelf”.

“Figure 2.9: Inventory Turnover”

21
 “2.3.2 Receivables Days”

“This ratio calculates how long, on average, credit customers take to pay the amounts
that they owe to the business. Again, it is desirable for this ratio to be as short as
possible. The formula that is usually used to calculate this ratio is:”

Trade receivables
“ Receivable Days= ×365 ”
Revenue

“Table 2.9: Receivable Days”

In this case, Treatt remains constantly below industry’s average during the last five
financial years and the biggest difference is noticed in 2017. In this year, other
chemical companies need to amortize their debtors more than 86 days, while Treatt
needs only 66. General speaking, this fact is quite optimistic, as it illustrates the
company’s efficiency in collecting cash over a specific period. It does not display any
dramatically changes among the years, as it slightly increases from 65 to 75 days
(2015) and ends up in 69 days. These smoothly changes are due to the growth or
decrease of revenues. For instance, regarding Treatt, its revenues in 2013 were
£74,097m, while in 2017 were £109,627m.

22
 “Figure 2.10: Receivables Days”

“2.3.3 Payable Days”

“This ratio measures how long, on average, the business takes to pay its trade
payables. In contrast with the previous ratio, in this case it is preferable for the
company to delay the payments to its suppliers for some time. However, this time
should not be very long, as it has resulted in the company finding it difficult to
obtain credit if it becomes insolvent and creates a poor reputation. The formula that
is frequently used to calculate this ratio is:”

Trade payables
“ Payable Days= × 365 ”
Cost of sales

“Table 2.10: Payable Days”

Despite most of the years Treatt’s payable days ratios fluctuates around 75, in 2015
it suddenly drops to 59 days. This exists mainly because of the significant increase

23
 on the cost of sales of the company and the decrease in the trade payables that
were noticed that year. Although the first two years Treatt is above the industry’s
average, the last two is constantly below, illustrating a difference of 7 and 28 days (in
2016 and 2017 respectively). On the one side, Versarien seems to be the most
defective company as it faces many creditworthiness problems. On the other side,
Porvair needs the least time to pay back its suppliers.

“Figure 2.11: Payables Days”

“2.3.4 Cash Conversion Cycle”

“This ratio measures the average number of days that working capital is invested in
the operating cycle. More specifically, it indicates the length of time cash spends
tied up in current assets. The formula that is frequently used to calculate this ratio
is:”

“Cash Conversion Cycle = Inventory + Receivable Days – Payable Days”

24
 “Table 2.11: Cash Conversion Cycle”

Generally speaking, the cash conversion cycle of Treatt as compared to the industrial
average, remains in high levels during the last five financial years. Mainly affected by
the inventory turnover and the payable payment period, it fluctuates from 145 to
177 days. A noteworthy fact is that Porvair needs the least days to sell its inventory
and to collect its cash from its customers. But this can easily be explained by the
minor quantity of inventories that this firm has.

“Figure 2.12: Cash Conversion Cycle”

“2.4 Capital Structure Ratios”

“According to Pareja (2012), these ratios examine the relationship between the
amount financed by the owners of the business and the amount financed by
outsiders such as banks. Two very important ratios for this purpose are Gearing and
Interest Cover.”

25
 “2.4.1 Gearing”

“This ratio quantifies the relationship between debt and equity and especially
measures the composition in long-term financing of a company. The higher the
proportion of debt, the higher the ratio, and the more the company is said to be
exposed to risk. Its formula is:”

Long - term debt

“ Gearing= ×100 ”
Long -term debt + equity

“Table 2.12: Gearing Ratio”

This is probably the most worrying statistic for the examined company. As it can be
easily illustrated from the figure below (figure 2.13), Treatt is constantly above the
industrial average during this specific time-period and therefore, it is more exposure
to a potential risk. The noticeable decrease from 2013 to 2017 (an overall change of
10.91%) cannot cover this deviation, as the industry’s average is affected by Porvair,
which did not demonstrate any long-term debt in 2015 and 2016.

26
 “Figure 2.13: Gearing Ratio”

“2.4.2 Interest Cover”

“With the help of this ratio we can quantify the capacity of the company to meet
interest payments due out of operating profits. The formula that is usually used to
calculate this ratio is:”

Profit before interest∧tax

“ Interest cover= ”
Interest expense

“Table 2.13: Interest Cover Ratio”

As it is expected interest cover ratio illustrates the same results with gearing ratio.
Treatt seems to be constantly above the industrial average, except the first year,
where Versarien is not included. However, these results are not so objectively, since
Versarien’s significant losses affect the industrial average (negative values constitute
one of the drawbacks of financial ratios). From 2013 to 2017 Treatt not only shows a

27
 considerably amount of borrowings, but also its EBIT does refrain from the revenues
because of the huge cost of sales. More specifically, Treatt demonstrates a slightly
but constantly increase in its interest cover, ranging from 10.33 to 15.12.

“Figure 2.14: Interest Cover Ratio”

“2.5 Investment Ratios”

“Trying to evaluate more efficiency the attractiveness and the financial performance
of a company, most times investors use as a measure the investment ratios.
Therefore, these ratios tend to be extremely significant and as it can be
understandable, almost every decision is based on these results (Stein, 2003). The
ratios that from a major part of investment ratios are the earnings per share (EPS)
and the price to earnings ratio (P/E).”

“2.5.1 Earnings per Share”

“It measures the potential benefit that shareholders derive from the profitability of a
company in which they have invested irrespective of actual dividend distributions.
EPS constitutes a key indicator of corporate performance from a shareholder
perspective. The formula that is typically used is:”

Net Profit after tax∧ preference devident

“ EPS= ”
Number of ordinary shares∈issue

28
 “Table 2.14: Earnings Per Share”

As an overall trend, Treatt’s EPS ratio gradually increased during the last five
financial periods, mainly because of the growth that is noticed in the company’s net
profit. For instance, the considerable difference between 2016 and 2017 is due the
changes of company’s net profit, which has been increased more than 55.24%,
climbing from £6,169m to £9,545m. It can also be observed from the graph below
(figure 2.15) that it remains above industry’s average, apart from 2013, where the
whole industry illustrates an average of 9.81p.

“Figure 2.15: Earnings Per Share

29
 “2.5.2 Price/Earnings ratio”

“It compares the benefit derived from owning a share with a cost of purchasing such
a share. Moreover, P/E ratio reflects the market’s assessment of amount and the risk
of earning and it is based on current market price and past earnings. Its formula is:”

P Market Price per Share

“ ratio= ”
E Earnings per Share

“Table 2.15: Price to Earnings”

As a general trend, it can be noticed that Treatt, compares to the industrial average
illustrates satisfactory results on the ratio, as it constantly remains above industry all
over the financial periods. A noteworthy fact is the huge P/E ratio of Treatt in 2013,
which is mainly occurred from the high share price of this year. It must also be
mentioned that the industry’s average has been affected by Versarien, which
constitutes a firm that drops the overall trend (because it faces significant losses all
over the financial years). Therefore, the difference between Treatt and industry is
much more noticeable in 2013, where Versarien is excluded from the calculations.
All in all, Treatt constitute an attractive-to-invest firm, as its high results in the ratio
indicates the strong confidence that exists in the market about the functionality of
this company.

30
 “Figure 2.16: Price to Earnings”

“2.6 Share Price Performance”

Trying to evaluate more efficient the past financial performance of Treatt, it is

appropriate to take also into account its share price performance. The use of this as
an indicator, will lead to a better estimation of the firm’s wealth, during the
examined financial years. A formula that would be used for this calculation is the
“Abnormal Buy-and-Hold Return (ABHR) and is presented as:”

N N
ABHR i = �(1+ ri,t ) - �(1+ rbenchmark,t )
“ t =1 t=1 ”

“where Π implies the cumulative multiple, N the period and r the stock returns.”

The result of ABHR implies the return that an investor could have received from
buying and investing the company’s stock for a long period of time, comparing to
other investors who have financed the same amount of money (and for the same
time-period) to the benchmark.

In this specific assignment, the FTAS is used as benchmark, as all companies are
listed on this. The examined period is from October 1 in 2014 to September 30 in
2017. The result equals to the total of 1 plus daily stock return less the total of 1
plus benchmark return for everyday of period.”

31
 “Figure 2.17: ABHR for Treatt and peer company”

In the graph above (figure 2.17), the ABHR of the four companies is illustrated. 2 On
the on hand, as the result of Porvair and Versarien, ABHR is -14.71% and -31.24%
respectively. This means that investors would get less return for buying those firm’s
stock than investing the market if they invested an equal amount of money. On the
other hand, Treatt illustrates an ABHR of 21.64%. That significantly better
performance means that this company constitutes the most attractive option for the
investors, as it gets more yield than the benchmark during the examined time-
period. Regarding Zotefoams, ABHR stands at 4.56%, meaning that there is almost
no difference between the performance of the firm and the performance of the
FTSE All-Share, and this makes Porvair the second worthy invest company.

2 For the calculations of ABHR, see Appendix B

32
“Chapter 3: Financial Management Policies”

As it can easily be understandable, it is more than significant for an organization to

clearly set its financial policies, not only to achieve its goals and targets in an
effective way, but also to increase its viability and transparency. Characteristically
Bodie et al. (2011) state that almost all financials decisions and plans are executed in
compliance with the financial management policies that has been formed.
Therefore, in this section it will be analysed the dividend policy, the capital structure
and the risk management, of Treatt plc.

“3.1 Dividend Policy”

According to Fama and French (2002), the dividend policy is a financial decision that
refers to the proportion of the firm’s earnings to be paid out to the
shareholders. Most times, the dividend policy that a firm will follow constitutes a
controversial issue. On the one side, there are those who believe that it is more
appropriate to distribute a considerable amount of the profits to existence
shareholders. On the other side, there are those who believe that it is more efficient
for the functionality of the company, most of its profits to be retained in the
business for further investing and expanding.

Many theories have been developed, trying to make clear the advantages and
disadvantages of each one dividend policy. They can be divided in two opposing
categories; the “Dividend Irrelevance Theories”, which support that the stock prize is
irrelevant from whether a firm pays dividends or not, and the “Dividend Relevance
Theories”, which state the opposite.

One the one hand, Miller and Modigliani (1958, 1961) are supporters of the first
category, but their theorem is objected to many assumptions. For instance, they
assume that the capital market is perfect, there is a perfect investment policy and
no taxes exist. Furthermore, the “Residual Theory” states that the dividends will be

33
paid, only after the desirable amount of cash for investments have been retained in
the company, but this theory faces many empirical issues (Koch and Shenoy, 1999).

On the other hand, the dividend relevance theories have been developed, mainly
because of the unrealistic nature of the previous theories. Lintner (1962) and
Gordon (1963), focusing mostly on the dividend yield, state in their theorem (Bird-
in-the-Hand Theory) that the paid dividends determine the value of a firm.
Continuing this aspect, Walter (1963) mentions in his model that an opportunity
cost of the firm exists, as companies could utilize this money to expand their capital.
He also assumes “that Retained earnings are the only source of financing
investments and the cost of capital and the rate of return on investment are
constant.” Supporting these theories, three other subsidiaries hypothesis have been
stated; the “Tax-Preference Theory”, the “Agency Hypothesis” and the “Signalling
Hypothesis” (Lipson and Maquieira, 1998).

”
“Table 2.16: EPS, DPS, Pay-out and Retention ratio of Treatt plc”

Despite the possible fluctuations that may me noticed in its earnings, Treatt tries to
increase, or at least to maintain, the returns to the shareholders. Therefore, the
company has created a stable dividend policy; its pays two dividends per year, an
interim (which is given in the summer) and a final dividend (which is given in the
spring).

The dividend policy of Treatt plc can easily be illustrated from the table above (table
2.16). On the one hand, from 2013 to 2017 the average earnings per share (EPS) is
12.33p, fluctuating from 8.64p (2013) to 18.29 (2017). On the other hand, the

34
average dividends per share (DPS) among these years is 4.15p, range from a
minimum of 3.70p in 2013 to a maximum of 4.80p in 2017. A noteworthy fact is the
increasing trend for both EPS and DPS. This stable growth profit can constitute an
attractive approach of distribution of the profits for any possible investor, as it
shows the confidence of the managers to their company. Therefore, the share price
of the firm can be remained in a satisfactory level. However, the decreasing trend
that is observed in the pay-out ratio implies the vital profitability of Treatt plc.

”
“Table 2.17: DPS and Net Profit of Treatt plc”

The Net Profit and the growth of dividend per share (DPS) between 2013 and 2017
can be demonstrated in the table above (table 2.17). As it can be easily
understandable, there is a positive relationship between Net Profit and DPS. Among
these financial years, 2015 and 2017 seem to be the most profitable years for the
company as it shows an increase of 51.68% and 55.23% respectively in its net profit.
Following the same pattern, the most significant growth of DPS is illustrated in those
two years.

“Table 2.18: Dividend Yield and Dividend Cover of Treatt plc”

35
From the table above (table 2.18), can be illustrated the dividend yield and the
dividend cover of the company. The first one measures the yield that shareholders
receive based on the market value of the shares, while the second one expresses
the possibility of those dividends to remain stable in the future. On the one hand,
dividend yield fluctuates from 0.60% to 2.40% and it is highly associated with the
market price per share. Therefore, it reaches on its maximum in 2014, where the
market price per share is just 1.41£, meaning that this year the shareholders receive
the highest income. On the other hand, dividend cover constantly increases during
the last five financial years, meaning that more and more profits are remained
within the business.

“3.2 Capital Structure”

The term capital structure refers to the way that a company has decided to finance
its operations, using its equity or debt (Dybvig and Zender, 1991). Both choices have
their advantages and drawbacks. For instance, debt many times can deduct the
overall payable tax, but simultaneously, equity illustrates the confidence for future
earnings and there is no need to be paid back. Nevertheless, debt seems to be less
expensive. Therefore, each firm must find the optimal combination and to decide
whether to increase equity or debt.

Over the years, many theories have been developed, each one trying to find out the
most appropriate model of capital structure. Among others, the “Trade-Off Theory”
and the “Picking Order Theory” constitute the most acceptable. They are both based
on Modigliani and Miller’s (1958) “Irrelevance Theory of Capital Structure.” This
publication is the first ever theory which tries to explain the term capital structure
and it states that in a perfect market, there is no difference is a firm uses its debt or
equity to finance its operations. However, many unrealistic assumptions are existed
in this theory, and this explain the fact that it was difficult to be empirically tested.
For instance, it assumes that no taxes, bankruptcy costs or information asymmetry
exist.

36
 The “Trade-off theory” suggest that firms, in order to find the optimal capital
structure, they must take into account the benefits and the cost of debt, and decide
each time based on what the firm wants to show or achieve. For example, Jensen
and Meckling (1976) point out that the use of debt could lead to financial distresses.
Despite, Graham (2000) mentions as a benefit of the debt, the tax shield. According
to “The Pecking Order Theory”, the use of debt first and then equity is more
desirable, as it minimizes the information asymmetry and it constitutes a less
information-sensitive security. As Myers and Majluf (1984) characteristically claim,
internal managers are better informed than investors and therefore, the issue of
securities to raise funds is highly associated with the mispricing. However, both
these theories are criticized, mainly because of their inadequate theoretical
background.

Regarding Treatt, it tries to manage its capital structure to maximize the returns to
the shareholders. Therefore, the company’s net debt position is assessed and
monitored on a weekly basis. As general trend, the firm prefers to operate using
short-term, rather than long-term borrowings.

“It has a mix of facilities, including a £2m three-year revolving credit facility with
Lloyds Banking Group and a $9m four-year revolving credit facility with HSBC in the
UK, together with a $6m four-year line of credit facility with Bank of America in the
US. None of these facilities expire in the same financial years and all bank facilities
are operated independently and are therefore not syndicated.

”
“Table 2.19: Capital Structure of Treatt plc (£’000)”

37
Trying to analyse the capital structure of Treatt, many ratios and indicators can be
used. To my point of view, it is essential to calculate its Debt-to-Equity (D/E) ratio. It
illustrates how aggressive or conservative the capital structure is. A company which
demonstrates a high leverage ratio can achieve higher growth rates, while a
company with lower debt ratio shows lower growth rates. To have a more objective
result, it is appropriate to compare the firm with the industry’s debt-to-equity ratio,
because each one industry illustrates different rates. From the table above (table
2.19), it can easily be observed that Treatt, achieves a significantly lower leverage
ratio than industry from 2013 to 2015. Although this ratio is even lower in 2016,
comparable to industry’s is higher. Continuing this pattern, the debt-to-equity ratio
of the firm drops from 0.22 to 0.21 in 2017, despite the increased of short-term
borrowings and the plan of expansion of the company in USA. it could be concluded
that Treatt demonstrates a conservative capital structure, as it prefers to pay for its
operations using its equity more.

“3.3 Risk Management”

As characteristically Stulz (1996) mentions, risk management is the estimation,

evaluation and prioritization of the possible risks which a company may face,
followed by the appropriate usage of the available resources, to minimize the
probability of unexpected events. Therefore, an effective and structured risk
management framework should exist in any company which wants to succeed its
goals and secure its existence in a long-term period. As it can be easily
understandable, the risks that a firm may face can derive from various sources,
including the current market and economy conditions, the credit liabilities and the
nature of each company. Thus, the Board must identify these risks, assess their
likelihood of happening and enact an appropriate strategy report to manage and
overcome the potential threats, creating so value for the business. However, this
procedure constitutes a complicating issue, as these risks are not only difficult to be
spotted, but they also need different approach. Furthermore, an internal audit work

38
by an independent organization could be proved very useful, as it could identify any
weaknesses, quantify any associated risk and mitigate any harmful action that may
threat the future performance and liquidity of the firm (Prawitt, Smith and Wood,
2009).

Regarding Treatt, the potential threats are multidimensional, as the company is

operating in many different subsectors. Therefore, while the Board has the main
responsibility for the enactment of an efficient risk management, a group of
executive directors is responsible for the everyday implementation of this strategic.
This groups works in parallel with the management teams and they try to re-assess
and monitor any risk. However, the Board must take the final decision, as it
evaluates twice a year the registered risks and points out the three most worrying.

At this point, I think it is essential to mention some of the major risks that the
company faces. To commence with, although Treatt’s functional currency is the
British Pound, most of the purchases are transacted in US dollars, as the company
operates also in USA. Hence, the foreign exchange exposure exists. The company
can lose or earn money from the fluctuations of those two currencies and the
differences in their exchange rates. The same issue could also exist with the value of
Euro, but in a less material effect. Trying to overcome this issue, Treatt maintains
most of its available cash in US dollars and follows some specific treasury policies,
hedging each time the appropriate options or contracts. For instance, last year the
weakness of GBP against the stable US dollar proved beneficial for Treatt. The firm
eliminated the short-term volatilities hedging options, and this led to an increase
profitability.

As it is already mentioned above, during the recent years, Treatt focuses mainly on
the beverage industry, as it seems to be more and more profitable. The consumers
demonstrate their preference in sugar free products. Thus, the sugar reduction
constitutes a basic trend in this sector, although it is quite complicated. Considering
that sugar adds sweetness, the only way to overcome sugar is to use sugar flavour.
Nevertheless, consumers can change their preference in any time. Even though

39
Treatt is a reputable company, it tries to eliminate this threat by using stronger
qualification process and innovative commercial methods.

Finally, the possible Brexit could arise many doubts not only for Treatt, but for most
of the UK companies. For example, many academics and researchers claim that this
exit will not only have a negative impact the British Pound, but also will decrease
the transactions with other European countries. Therefore, the Board decide to
monitor this situation and its possible impacts, while the negotiations still exist. The
high level of volatility and uncertainty can be faced only with flexibility and
adaptability.

40
“Chapter 4: Valuation of Treatt”

As it can be easily understandable, there are many different methods that can be
used to evaluate effectively a company. Each one of them requires a different
approach, as it includes different information and values for any possible investor.
On the one side, there are some approaches which are easy to be implemented, but
they are not based on a strong theoretical basis. On the other side, there are those
which have a significant theoretical background, but they are more difficult to be
executed. The five different approaches that will be analysed in this chapter are: the
dividend valuation model, the earnings and investment model, the free cash flow to
firm model (FCFF), the free cash flow to equity model (FCFE) and the price-to-
earnings (P/E) multiplier model. The examined time-period for this empirical project
is from 2013 to 2017 and the estimated rates refers to time-period from 2018 to
2022.

“4.1: Growth Rate”

To my point of view, before analysing these approaches, it is essential to mention

the procedure that was followed to calculate the estimated growth rate of Treatt.
This is necessary, not only because this rate is used in every evaluation method, but
also because it constitutes the most crucial rate to predict the future value of a firm.

In the table presented below (table 2.20), the EPS and DPS of Treatt are illustrated.
Using these indicators, the pay-out and the retention ratio can be calculated. As it is
already mentioned above, the first one is that proportion of earnings which was
given to the existence shareholders of the company, while the second one is that
amount of earnings that was remained in the company for further investing.
Therefore, assuming the earnings are stable, the higher DPS the lower retention
ratio. The growth rate of Treatt can be simply calculated by the multiplication of the
retention ratio with ROCE. Over the last five years, Treatt demonstrates a constantly
increasing growth rate, fluctuating from 10.92% to 17.54%. This exists, because both

41
ROCE and retention ratio are increased. A noteworthy fact is the high percentage of
growth in 2017, which is mainly due to high EPS and retention ratio of this year.

”
“Table 2.20: Key indicators of the Growth Rate”

Solow (1956) characteristically states that the future growth rates cannot be
predicted using the historical growth rates. Thus, an estimation method for the
future growth rates of Treatt should be applied. In the long term, the estimated
growth rate of a company must be equal with the growth rate of GDP (Mc Kinsey,
2010). Therefore, the growth rate of UK GDP should be used to estimate the growth
rate of Treatt in the following years. Using the stats provided by “International
Monetary Fund” (IMF), it can be easily observed that the growth rate of UK GDP
demonstrates a decreasing trend, dropping from 1.8% (2017) to 1.6% (2022).
Moreover, as it is noticed in the annual reports of Treatt, despite the increasing
trend of retention ratio, the company has already announced a smaller amount of
retained earnings. Taking these into consideration, the estimated growth rate of the
firm will show a decreasing trend, dropping the same proportion with UK GDP in
2022. In this empirical project, it is assumed that the growth rate of the company
will be decreased each year by a stable proportion. More specifically, it will drop
each year by 3.19%, as this is the average percentage of decreasing from 17.54% to
1.6% in the next five years. To conclude, the estimated growth rate of Treatt is
14.35%, 11.16%, 7.98%, 4.79%, 1.6% in 2018, 2019, 2020, 2021 and 2022
respectively.

42
 “Table 2.21: Estimated Growth Rate of Treatt”

“4.2: Discount Rate”

Having already mentioned the way that the sustainable growth rate of Treatt has
been calculated, it is also important to measure the discount rate, based mainly on
the CAPM. This model is provided as:

“E(re)= rf + β(Ε(rm)-rf),”

where E(re) indicates the expected rate of return, rf the risk-free rate of interest, β
the systematic risk of the examined company, Ε(rm) the market return and Ε(rm)-rf
the market risk premium.

”
“Table 2.22: Cost of Equity of Treatt”

First of all, to estimate the risk premium, I used the FTAS as the market and the UK-
6-month bond as the risk-free (trying mostly to avoid high risks and consequently
high yields). Then, I downloaded the monthly FTAS prices and the monthly UK 6-
month bond yields from September 2013 to August 2017 and using the average

43
rates of those two terms, I calculated the risk premium. For the estimation of beta, I
downloaded the daily prices of Treatt and FTAS and daily yields of the risk-free from
August 3rd, 2016 to August 2nd, 2017. Next, having measured first the excess returns
of the company and the market, I used the regression in a 95% significance level to
estimate the coefficient (beta). The results of the CAPM and the cost of equity (it is
the same with the discount rate) are being presented in the table above (table
2.22).3

“4.3: Dividend Valuation Model”

A widely used method for share valuation is the dividend valuation model. It
constitutes the first of the three models, which are known as discounted cash flows
approaches (the other two are the earnings-based model and the free cash flows
model). Overall, the value of a share can be measured as the present value of the
cash flows that investors expect to receive because of holding the share. This
method is based on the assumption that the company will continue to operate in
perpetuity and pay dividends in the long run. Apart from this, all the investment
operations are totally financed from retentions. It is also assumed that the cash
flows from investments, the rate of return (r) and the growth rate of the company in
perpetuity will be constant (Gordon, 1959). In this case, every next year after 2022 is
perpetuity. Thus, the sustainable growth rate of Treatt will be 1.6% and every year
until 2022, the growth rate will be progressively decreased. The formula that is
usually used is:

“ ”

“where Vo implies the present value of the company at year zero, r the rate of
return (discount rate), D1 and DN the dividend paid at year 1 and year N
respectively. VN is the terminal value of the company and is calculated using the
sustainable growth rate of the firm:”
3 For the calculations of the CAPM, see Appendix c

44
 1
V N =D N+1
“ r−g ”

”
“Table 2.23: Dividend Valuation Model (£)”

The procedure of the dividend valuation model is presented in table 2.23. The value
of the company (£ 282.29m) is simply calculated by adding the terminal value with
the present value of each dividend (each one dividend is discounted with the
appropriate factor).

“4.4: Earnings and Investment Model”

As it mentioned above, this method constitutes a discount cash flow approach, and
therefore it is subjected in the same assumptions with the dividend valuation
model. One the one hand, the earnings and investment model is used to be more
fundamental, but it also more complex. For its calculation, the earnings of the
company each year, the retention ratio, the ROCE, the growth and the discount. The
formula mostly used is:

1
“ Vo=E 1 + PVGO ”
r

45
 1 1 1
“ PVGO=NPV 1 + NPV 2 + NPV 3 + … ,”
(1+ r ) (1+r ) (1+r )

“where the Vo implies the value of the company, E1 the expected earnings, r the
discount rate. The present value of future investments opportunities (PVGO)
illustrates the present value of the growth opportunity.

The future retention ratio of Treatt will constitute an easy calculation, after having
measured the estimated ROCE of the company. It is assumed that this ratio will be
affected by the downward trend of the UK GDP and will drop to the same
percentage of discount rate in 2020 (therefore, this year NPV is equal to zero).
Continuing in the same pattern with the estimated growth rate, it will gradually be
decreased, each year by the average proportion (4.46%). The results for the
estimated ROCE and retention ratio of the company for the next five years can be
demonstrated in the table below (table 2.24).

”
“Table 2.24: Estimated ROCE and Retention Ratio of Treatt”

In table 2.25 it can be illustrated the value of the company, using the earnings and
investments valuation model. in this case, the earnings are assumed to be constant
from the year after 2022. It must be mentioned that the earnings of a year are equal
with sum of the earnings and the incremental earnings of the previous year. The
incremental earnings are mainly affected by the investment decisions of the
company and they illustrate the gain that was achieved by the establishment of a
new project. As it is estimated, Treatt, over the next five years shows a significantly
decreased retention ratio, ranging from 67.66% (2018) to 47.51% (2022). Despite

46
the increased amount on investments (except the last year), the incremental
earnings illustrate a downward trend, mainly affected by the ROCE. Therefore, the
investment program is estimated to contribute value to the firm, but in a
progressively decreasing pace.

”
“Table 2.25: Earnings and Investment Model (£)”

“4.5: Free Cash Flow Model”

It constitutes the third discount cash flow model and is a method based mainly on
the present value of the free cash flows that the company will demonstrate in the
future. Two different approaches are included in this model: the free cash flow to
the firm (FCFF) and the free cash flow to the equity (FCFE). The first one indicates
the cash flows that are distributed not only the shareholders, but also in the lenders
of the company and is calculated using the “weighted average cost of capital
(WACC)”. Instead, the second one implies the specific amount of cash flows that is
available only to the shareholders of the company and it measured using the cost of
capital. In both models it is assumed that these free cash flows will run definitely
into the future. Moreover, similar to the previous assumptions, it is assumed that

47
 the company’s growth rate will demonstrate a downward trend until 2022. Every
next year after 2022, the growth rate will be stable and equal to 1.6%.

“4.5.1: Free Cash Flow to the Firm”

“To estimate FCFF, it is required first to calculate the earnings before interest and tax,
the capital expenditures, the depreciation expenses and the change in the working
capital of the company. The formula can be used as follows:

“ FCFF t=EBIT t ( 1−t c ) + Depreciationt−Capital Expenditure t −Increase NWCt ”

“Table 2.26: FCFF of Treatt in 2016 (£’000)”

As it is illustrated in table 2.26, the increase in net working capital of Treatt from
2016 to 2017 is £ 3.18m. The capital expenditure (CAPEX) in 2017 stands at £ 5.2m
and indicates the specific amount that is disbursed from the company to purchase
or even upgrade the existence assets. Therefore, the final cash flows to the company
in this year is £ 4.063m.

The formula to estimate the value of the company is used as follows:

N
1 1
“ FirmValue=∑ FCFFt t
+V N ”
t =1 (1+WACC ) (1+WACC )N

1
“ V N =FCFF N +1 ,”
(WACC−g)

48
“where VN implies the terminal value and is calculated using the sustainable
growth of the firm, trying to avoid the perpetuity issue of cash flows.

The WACC indicates the possible cost for a company to borrow money. It is desirable
to be small, because a big number of WACC implies the difficulty of this firm to
create value. The formula for its calculation is:

D E
“ WACC= ki + k ,”
D+ E D+ E e

“where D illustrates the total debt of the company, E the total shareholder’s equity,
ke the cost of equity and ki the cost of debt. In this case, trying to achieve a
more appropriate WACC for Treatt, the average values were used (from 2013 to
2017). For instance, the percentage of the debt stands at 21.25% and the proportion
of the equity stands at 78.75%. To my point of view, because of the consecutive
changes and the instable political and economic environment, the use of an average
tax rate among the same years would be more suitable. Therefore, the tax rate for
the calculation of WACC is 20% and it is assumed to remain stable for the next five
years. In the table below (table 2.27) it is noticed the result of WACC for Treatt.

49
 “Table 2.27: Weighted Cost of Capital of Treatt (£’000)”

The procedure and the calculations of estimating the value of a company using the
FCFF model are observed in the table below (table 2.28). Every term of FCFF is
estimated to grow each year with the corresponded growth rate. The FCFF are
discounted back, each one with the appropriate rate ( (1+WACC )N , where N
indicates the number of the year, with 2018 being year 1). All in all, using the FCFF
approach the value of Treatt is estimated at £ 234.867m.

50
“

”
“Table 2.28: FCFF Model (£’000)”

“4.5.2: Free Cash Flow to the Shareholders”

Opposite the previous approach, interest expenses are not taken into consideration
in FCFE. As it is mentioned above, it is calculated using the cost of capital (it is
assumed that it remains stable). To estimate the FCFE, it is necessary first to identify
the interest charges and the change in the total debt of the company from 2016 to
2017, as its formula is used as follows:

“ FCFE=FCFF−Interest Expense ( 1−t c ) + Increases∈Net Debt ”

As it is observed in table 2.29, the interest expenses for the firm is £613,000, while
the increase in its total debt from 2016 to 2017 is £1.7m and therefore, Treatt
illustrates an FCFE in 2017 of £ 5.3m. Following the same pattern, each FCFE is
predicted to grow with the suitable growth rate and the terminal value of FCFE is

51
calculated based on the FCFE of 2023. In this case, the value of a company seems to
be much higher in comparison to the value of previous method.

”
“Table 2.29: FCFE Model (£’000)”

“4.6: Price to Earnings Multiplier”

The last approach of valuation in this project involves the application of a multiplier
to the current earnings of the company. P/E ratio provides to investors vital
information about the financial performance of a firm, as a high P/E ratio indicates
strong investing opportunities. To be more appropriate and efficient, it must be a
multiplier based not on a specific company but on a whole industry. However, it is
necessary for the peer companies to illustrate the same risk characteristics and
accounting policies. Otherwise, adjustments in the recognition of earnings or in
other accounts should be done, trying to make these companies comparable.
Regarding this empirical project, it is assumed that the peers constitute the perfect
competitors for Treatt, as it is almost impossible to take into account all the critical
factors. Nevertheless, some adjustments were made in the financial statements of
the companies, trying to diminish any differences in the industry.

52
 “Table 2.30: P/E Multiplier”

In the table presented above (table 2.30), the P/E ratios of the companies and the
industry are illustrated. In this case, it is assumed that the multiplier is the average
of the industry (16.2%) between 2013 and 2017. As it is mentioned above,
chemicals constitute a cyclical industry, illustrating high rates of growth or recession.
Therefore, the P/E ratios of the five companies demonstrate many fluctuations. In
this industry, a high P/E ratio normally marks the bottom of the cycle, whereas a low
multiple often signals the end of an upturn (Damodaran, 1996). The number of
shares outstanding for Treatt is 52.192m (as it is stated in the Annual Report of the
firm in 2017), while the EPS in the same year stands at 18.29%. Taking these into
consideration, the value of Treatt using the P/E multiplier is demonstrated below:

“Table 2.31: P/E Valuation Model”

53
“4.7: Critical Analysis of Empirical Results”

Having mentioned the five different approaches, it is noticed in table 2.32 that each
one indicates different market value for Treatt. From a theoretical point of view,
these different valuation methods should indicate the same result. However, in
practice seems to be different, as these models are based in unrealistic
assumptions. For instance, the cost of capital or the rate of return cannot remain
constant over time. Furthermore, Treatt, like every other company, cannot achieve a
sustainable growth, as this will always be different, illustrating either desirable or
unpleasant percentages.

Although the dividend valuation and the earnings and investment model are based
on the same assumptions, they estimate different values for Treatt. This exist mainly
because Treatt uses a considerable amount of its debt to finance its investing
opportunities (i.e. USA reallocation). However, those two models seem to be the
most realistic, as they illustrate the least deviations from the real market
capitalization of the company.

The cash flows models use a more detailed analysis to evaluate the company,
focusing mainly in the financial statements. Nevertheless, fluctuations are noticed
even between those two methods. The FCFF model underestimates the value of the
firm, while the FCFE model overestimates it (more than £ 120m). The difference
occurs mainly because of the considerable increase in the net debt of the company
from 2016 to 2017.

Price to Earnings multiplier seems to be the least useful approach for any potential
investor, especially if the industry of Treatt is considered. The significant
overestimation of the value (almost £ 100m divergence) can be caused by many
factors. For example, the P/E multiplier is mainly affected by the negative
performance of Versarien and cannot be establish in the evaluation of Treatt, which
P/e ratio is constantly ranging in high proportions. Moreover, as Damodaran (2000)
clearly state it is almost unbearable to find companies which illustrating the same

54
characteristics, as most of them operate simultaneously in many different industries
and sectors.

“Table 2.32: Value of Treatt: Approaches vs Real Market”

55
“Chapter 5: Conclusion”

This empirical project tries to analyse the financial performance of Treatt plc,
assessing four different aspects.

The first part includes the market conditions of the UK economy and analyses two
key indicators: the GDP and the unemployment rate from 2008 to 2018. It is
observed that the first one increases constantly during the last ten years, while the
unemployment rate declines. Special reference is made in the chemicals industry,
where the examined company operates, trying to estimate the overall financial
performance of the industry. Moreover, four other companies, all of them operating
in the same market and industry are also included: Zotefoams, Porvair, Versarien.

In the second part of the project, the major financial ratios are evaluated, not only
for Treatt but for the peer companies as well. Apart from the profitability, liquidity,
efficiency, financial and investment ratios, also the share price performance is
measured. Trying to decline any differences among the financial statements of these
competitors, some adjustments were made. The result indicates that Treatt
constitute an attractive-to-invest company. More specifically, over the last five
financial years, Treatt demonstrates decreases in its revenues and profits. The firm
illustrates an appropriate liquidity and asset management, and this contribute to its
functionality. Furthermore, it shows no creditworthiness problems or disabilities to
pay its financial obligations, despite the large number of inventories. The investing
ratios of the company are the key indicators for its analysis. For instance, from 2013
to 2017 the EPS is stable growing, and this indicates the more yields that
shareholders enjoy. The result of the analysis of the share price performance of
Treatt (and the peer companies as well) shows that it constitutes the most attractive
option, as the potential investors would receive high returns.

Three of the financial management policies of the firm are examined as well: the
dividend policy, the capital structure and the risk management. Moreover, to
estimate better the companies’ policies, the theoretical background has also been

56
included. The analysis of dividend policy demonstrates that despite the increase in
the retention ratio, the DPS has been increased during the last five years. This
implies that there is a big possibility that the company will also generate profits in
the future. Regarding capital structure, Treatt seems to use more its equity to pay its
financial obligations. The D/E ratio of the firm is also lower than the industry’s
average and this shows the conservative capital structure of Treatt. Furthermore,
the company illustrate an efficient risk management not only because it recognises
and prioritizes promptly the potential risks, but also because it demonstrates many
actions to face them. The flexibility and adoptability constitute a high key
performance of Treatt. Even though potential risks will always exist, the elimination
of the uncertainty is significant for the functionality of the firm.

Finally, five different evaluation approaches are used to estimate the value of the
company. On the one hand, “P/E multiplier and FCFF” model tend to underestimate
the value of the company. On the other hand, “dividend evaluation, earnings and
investment and FCFE” model seem to overvalue the examined company. Dividend
evaluation model shows the least deviation from the real market capitalization,
mostly because “it takes into account the company's future strategy and corporate
shareholders' views.” Theoretically, they should not have been in differentiations in
the results, as most of these approaches are based on the same assumptions.
However, as it was expected, each one method demonstrates a different result. This
exists mainly due to the fact that most of these assumptions are unrealistic. “The
whole market economy is a key factor affecting the value of the company, thus the
obvious changes in the overall market economy will affect the accuracy of the
assessment methods.”

57
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62
“Appendices”

“Appendix A”

“Adjustments made in the financial statements: TREATT (1/4)

63
bnbn”

“Adjustments made in the financial statements: ZOTEFOAMS (2/4)

64
bnmnmn”

“Adjustments made in the financial statements: PORVAIR (3/4)

65
bnbv”

“Adjustments made in the financial statements: VERSARIEN (4/4)

66
bvnvbn”

“Appendix B”

“Share Price Performance: TREATT (1/4)”

67
“Share Price Performance: ZOTEFOAMS (2/4)”

“Share Price Performance: PORVAIR (3/4)”

68
“Share Price Performance: VERSARIEN (4/4)”

“Appendix C”

“CAPM (1/2): Calculating Risk Premium”

69
“CAPM (2/2): Calculating Beta”

70
“ ”

71