FOSTERS COMPANY VALUATION REPORT BY FINANCE DIRECTOR

Table of Contents
SECTION A ............................................................................................................................................... 1 Type chapter title (level 2) .................................................................................................................. 2 Type chapter title (level 3) .............................................................................................................. 3 Type chapter title (level 1) ..................................................................................................................... 4 Type chapter title (level 2) .................................................................................................................. 5 Type chapter title (level 3) .............................................................................................................. 6

SECTION A
This business valuation report was prepared using a discounted Cash flow model and CAPM. The model has several elements which have been calculated and estimated in accordance to relevant literature, Fosters financial and Market Position. The report shows a dramatic undervalue by SABMiller. However this report cannot be the sole determinant of valuing Fosters, numerous factors and conditions can affect the selling price, therefore, its focus is only on helping the organization to identify a potential selling price. The Justification of the elements is seen below.

(i)

Horizon Period/ Competitive Advantage Period

The horizon period is the time during which a company is expected to generate returns on incremental investment that exceed its cost of capital (Mauboussin and Johnson, 1997). To identify the horizon period required for fosters, it is important to first identify the factors that influence the adequate length of time for the horizon period. These can be defined as three variables: Firstly if the current returns on capital are high than it is possible to lengthen the period of Horizon period. Secondly the rate of industry change is another important factor and finally the barriers to entry, the higher this is the longer the horizon period tends to be (Mauboussin, 1997). Fosters average returns on capital over the last 5 years have averaged 8.8% however returns on the (ttm) have been much higher (26.71%). The industry itself is old which Fosters has been apart for over 150 years, it has not seen many dramatic changes; also with high barriers to entry within the industry it is viable to say a 10 year period with a sensitivity analysis of 5 years seems to be sufficient. 10 year horizon period may not create the best value, however it captures 33% of corporate value what Damodaran and (Mauboussin,2006) both agreed upon.

(ii)

The spread between ROIC and Cost of Capital during and after the Horizon Period

During the horizon period the ROIC is at a greater level than cost of capital due to the demerger of the Treasury Wine Estates which lowered costs. The new experienced management teams are also showing the ability of fosters cost leadership. Also concluding the Ashwick tax litigation Fosters will receive $835 million cash benefits and lower income tax for future years. The ROIC used in the horizon period is a 5 year average found on the Reuters website, this seemed most reasonable because 2011 has showed a great increase in ROIC (26.61%) where previous years have been considerably less as seen in appendix B.

Their ability to maintain a good cashflow will strengthen the abilty to gain good returns on investment, but it is declining over time. However the factors mentioned above will be effective in the short term but not as effective in the long term (Lloyd and Davis, 2007), therefore in the perpetuity element the ROIC decreases to meet the increasing cost of capital in perpetuity.

(iii)

The expected Future Growth

In (Koller, 2010) he explains that of 10.1% of annual yearly growth achieved by the sample carried out, 6.6 percentage points came from the growth of market segments in its portfolio (Portfolio momentum). Fosters has shown a great deal of success within its cider market which has grown in demand in Australia by 20% in the last 12 months. Also by maintaining its share in their segmented markets they have the ability to capture and reap the benefits which continues to grow and has been successful. A study done by Efthimios et al (2004) states that the beverages sector is characterized by uniform and stable growth, this could be due to several factors. One of them is the age of the market growth levels will be stable and modest. Even though fosters strategy of consumer led growth and cost leadership will have potential benefits to future growth of Fosters, eventually growth will decrease and so will ROIC (Jiang and Koller, 2007). Write about the growth rates that other have for this market Write about growth rates within fosters

SECTION B
There are several methods of Valuation that an investor or a Finance director can use, however which is the most reliable and accurate model to use? This section focuses on the concept of each model (pros and cons) and then justifies why the model used within this report (DCF) is appropriate.

(i)

Price/Earnings Ratio (P/E)

This model is widely used by investors because it is simple formula and easily comparable to other firms within the industry. It is also a decent proxy for the present value of future cash flows (Mauboussin, 1997). It has shown to be a better indicator of current shares value than market price alone. Investors commonly used it to roughly estimate a valuation of a company by looking at its low P/E (both absolute and relative). However the major downfall is the simplicity of the multiples, there is too much responsibility on valuating a company on just one number. The ratio has no explicit consideration of risk. Differing versions of calculation and differing accounting standards even with GAAP can differ the end valuation. Another major downfall is the valuation commonly uses trailing historic EPS therefore it does give you a clear indication of the future, in addition it does not incorporate the time value of money.

(ii)

Book Value: Historical cost of assets (adjusted for depreciation) liabilities

Again, its a simple measure which can indicate a margin of safety and also has proven to be a good indicator of value creation (Mouboussin, 1997). What is concerning though is the accounting information used may be subject to change or manipulation depending on the accounting standards adopted. It also does not capture key issues such as; the explicit consideration of risk and the time value of money. Another issue with the Book model is Its use of historical figures, it is not forward looking and doesnt capture key qualitative measures.

(iii) Enterprise Value (EV) to EBITDA

The calculation used excludes depreciation and amortization which are non cash items thus, relating to enterprise value to cash flows which investors are primarily interested in. It is more commonly used in mergers and acquisitions analysis.

However it has shown to be more difficult to calculate than P/E especially if that company has subsidiaries. It is also misses out vital elements which all the valuation have missed out on is, the time value of money and the explicit consideration of risk. It also fails to consider the effects of taxation and costs of assets to the valuation figure.

(iv) Selected Method: Free Cash Flow/Discounted Cash Flow

The DCF was the chosen model to use Valuate Fosters; it showed several strengths in its validity and use of the model however there are several aspects that can affect the end valuation and reliability of the model as a whole. The use of model requires estimation and calculation of several variables which have been covered in Section A and C of the report. The benefits of using such a method rather than the alternatives is simple, when valuing a company to invest in you would want to know the future benefits that the firm can bring that is why the DCF model outshines others. It uses a competitive advantage period also known as horizon period that a firm has. Mouboussin (1997) suggests it allows an investor to define certain variables within the organization; the current return on variable, the rate of industry change and the barriers to entry, it helps give you a clear understanding of market expectations and the financial performance (income statement and balance sheet) of the firm. The model uses future Operating profit which is less open to manipulation compared to P/E ratio and is driven by cash flow, which empirical evidence suggests that stock market deems cash flow to be important than earnings (Mauboussin and Johnson, 1997). Mauboussin (1997) characterizes this as NOPAT; it is unlevered and by making it cash it is more comparable with other companies even across boundaries. DCF major strength that no other model shows is the inclusion and measure of the risk aspect which no other model seems to show, this is called the cost of capital which uses several variables (risk free rate, beta and risk premium) and is calculated by using CAPM (Section C of the report). It is important for investors to recognize the risk because only then can you expect a higher return. This allows an investor to identify the present value of future cash flows by discounting them by the cost of capital (Mauboussin, 2006). Thus, allowing the investor to consider the Time Value of Money. The benefit of using such a model than the others is the ability to apply sensitivity analysis when valuing a company. By altering a few of the variables an investor is capable of identifying a better valuation. However its main downfall is the same thing that makes it unique and that is the multiple components. The ability to estimate the figures is majorly based on assumptions after all it is basing it on future cash flows. To estimate the risk and the cost of equity can be quite demanding, even more demanding is estimating the beta and the risk premium. It is hard for any investor to adopt the ability to point of the cost of capital even with the use of CAPM, which has faced several criticisms recently.

Looking at fosters you can see there has been a lot of changes in structure since 2010/2011, this creates noise and make it extremely difficult to capture a trend of some of the number such as growth and ROIC which has been inconsistent due to these changes. Another negative of this model that can be mentioned is depending on the firm if it produces negative numbers the horizon period must be extended to come up with a positive number thus manipulating the real figure.

(v)

CONCLUSION OF VALUATION METHODS

In conclusion the methods (1-3) have shown to be quicker and easier to calculate and more comparable to other companies however, are they really giving an accurate interpretation of the companies value? In this case we would disagree I decide to use the FCF/DCF model, the theory has shown to be the models success. Its theory accounts for all future risk, cost of capital, a likely return, growth rate and a present value of the firms valuation. The strength of this model clearly dependent upon the user; more analysis and time spent on acquiring variables will lead to a stronger and more robust model (Welter, 1970).

SECTION C
(i) COST OF CAPITAL (CAPM)

The selected model to estimate the cost of capital is The CAPM, the theory of this model relies on certain assumptions; it assumes that the market are dominated by rational, diversified and risk averse investors who seek a return for their systematic risk on an investment (Mullins Jr, 1982). CAPM presumes that all securities are correctly valued and that there are no transaction costs and tax. Al these assumptions are based on single period model in order to make comparable returns on different securities. CAPM has shown to have several advantages over other models to calculate the required return. Firstly, it assumes that investors have a diversified portfolio, only considering systematic risk, which is called undiversifiable since its associated with financial risk. The attraction of the CAPM model is that it offers powerful and intuitively pleasing predictions how to measure risk and return ( Fama and French, 2004) and captures the theoretically derived relationship between risk and return and systematic risk. However the assumptions reflect the weaknesses of the model, it makes unrealistic assumptions and simplification of reality. The components of this model cannot be estimated precisely, they are constantly changing on a daily basis and are difficult to predict for the future thus, making it very problematic. However CAPM has shown to withstand is many critics and limitations, it has survived as the default model for risk in equity valuation and corporate finance. It is seen as a much better method of calculating the cost of equity then the Dividend Growth Model and is clearly superior to the WACC in providing discount rates for use in investment appraisal (student accountant, 2008). The other models such as the Arbitrage pricing theory and the Multifactor model have made inroads in performance evaluation but not in perspective analysis. The alternative models do a much better job in explaining past return, but their effectiveness drops off when it comes to estimating future returns. Also the alternative models are much more complicated and require more information than the CAPM. For most companies, the expected return you get with the alternative models is not different enough to be worth the extra trouble of estimating four additional betas.

(ii)

CAPM Components
1) THE RISK FREE RATE

The risk free rate is the minimum return an investor expects for an investment, it is determined by using government bonds as an acceptable substitute for the risk free asset. The risk free rate on changes depending on which countries capital market is being considered in this case Australia and is also not fixed which is the problem faced in using it in a long horizon period where it subject to change. The risk free rate was taken from Bloomberg and Australianbonds.com for a 10 year horizon period.

(2) RISK PREMIUM

This is seen as the excess return required for investing in equity (Student Accountant, 2008). This was the most difficult figure to calculate depending on the approach adopted (historical, survey, implied) it was likely to get a different figure each time. Premium can depend on two major factors the risk aversion of the investor and the economic risk. The survey approach was to adopted to estimate the risk premium, Damodaran (2011) states If the equity risk premium is what investors demand for investing in risky assets today the most logical way to estimate it is to ask these investors what they require as expected returns. A survey conducted by Fernandez et al (2011) asked professors, analysts and Companies on their market risk premium used, the survey showed the market risk premium for 56 countries. By arithmetically averaging the figures given by the three we were given a risk premium of 6%.

(3) BETA
Beta measures the part of the asset's statistical variance that cannot be removed by the diversification provided by the portfolio of many risky assets, because of the correlation of its returns with the returns of the other assets that are in the portfolio (Fama and French, 2004). Although risk can have very negative consequences for those who are exposed to it, risk is also the reason for higher returns to those who use it to their advantage (Damodaran, 2005). After looking at several sources as seen in appendix C the beta that has been used to calculate the cost of capital is 0.19. However this is always subject to change.

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