Prospective Analysis and its Application
In the present analysis prospective analysis is done. The analysis aims to forecast Origin Energy Ltd’ future financial performance by using the valuation models and provides the investment recommendations. The valuation models used are: Dividend discount model, Residual income model, Residual operating income model, free cash flow model and Sensitivity analysis. The prospective analysis found a good potential for future performance of the company. Still while using the recommendations provided in the present study need to taken with some limitations such as advance techniques of analysis also need to be applied to verify the results of basic valuation models.(Gordon,1959)
(1) Dividend Discount Model
The dividend discount model is a model of arriving at present value of share by discounting the expected future dividends back at present. This model works for only those companies that dividends, the companies who do not pay the dividends cannot use this model to value the share price. The formula for valuing a stock with dividend discount model is as follows:
J.W. Williams (1938) provided the theoretical background in his “The Theory of Investment Value” but the complete dividend discount model was developed by M.Y. Gordon (1959), hence dividend discount model is also called Gordon Growth Model also. The main problem while using the dividend discount model is of finding the appropriate growth rate. This problem is solved by calculating the growth rate by multiplying retention ratio with Return on Equity (ROE).
| Origin Energy Limited | |||||||
| Dvidend Paid | |||||||
| Date Paid | Cents per share | Dividend Payout Ratio | Retention ratio | PAT | Equity | ROE | Growth rate |
| 40998.00 | 25.00 | ||||||
| 40634.00 | 25.00 | 0.04 | 0.96 | 79.00 | 13516.00 | 0.01 | 0.01 |
| 40269.00 | 25.00 | 0.05 | 0.95 | 606.00 | 11438.00 | 0.05 | 0.05 |
| 39897.00 | 25.00 | 0.07 | 0.93 | 606.00 | 11144.00 | 0.05 | 0.05 |
| 39542.00 | 12.00 | 0.02 | 0.98 | -1674146.00 | 517558.00 | -3.23 | -3.16 |
| 39171.00 | 10.00 | 0.02 | 0.98 | 2819507.00 | 6969256.00 | 0.40 | 0.39 |
Data Source : http://www.originenergy.com.au/1380/Dividends
| Dividend Discount Model | ||||
| MPS on 18-05-2012 = $12.72 | ||||
| Dividend =$12.72*.25 =3.18 | ||||
| Share worth as per dividend discount model =3.18/.07 -.0056= 45.42 | ||||
On the basis of above calculation it can be said that the present market price is lower than what share is worth that is $45.42. It is share undervaluation. Undervaluation of shares in the stock market means buying position for the investors because they can reap the benefits by selling these shares in the market when prices rise. The undervaluation of the above share may be due to poor performance in the past and some risk in the company at present, though company’s financial performance may remain good.
(2) Residual Income Model
Residual Income Model is an alternative to dividend discount flow or discounted cash flow technique. In this method residual income is discounted back to the present. Here, residual income refers to the income above to the expected return on equity. The information of a company used in this method is extracted from the balance sheet and income statement of the company.
In other words residual income is above cost of capital. In residual income method first step is to determine Equity charge of the firm. Equity charge is firm’s total equity multiplied by cost of capital or the required rate of return.
| Equity Charge =
Equity Capital x Cost of Equity |
After getting the Equity charge of the firm for a particular year then subtract it from the net income of the firm for that particular year. Then the remaining amount after subtraction is called the residual income.(Bloomberg,2012)
This method helps in determining the actual returns to the shareholders. On its equity the firm may earn a higher profit but that all amounts is not an actual profit shareholders get, the required rate of return needs to be subtracted from it then only the firm gets residual income.
Now the information of residual income will be used for estimating the true value of the firm. The intrinsic value of a firm using its residual income can be categorised in two parts: its present value and the book value. The formula for calculating the present value of the residual income is given below:
The main difference in discounted cash flow technique (DCF) and residual income method is that DCF uses weighted average cost of capital (WACC) while residual method uses the cost of equity as discount factor.
The merit of residual method is that it can be used for the firms who do not pay the dividends and the data are always readily available in the financial statements of the firm. It looks at economic profitability of the firm rather just looking at accounting profitability that is profit after tax. The major demerit of the residual income method is that it is completely based on the company forecasting about future therefore forecasting biases or manipulation in financial statement may not provide the true value of the firm based on the residual income method.
Residual Income estimation for Origin Energy Limited for year 2012
| (in millions) | |
| Equity Capital |
13516.00 |
| Cost of equity |
0.07 |
| Equity Charge |
946.12 |
| Net Income |
79.00 |
| Residual Income |
12569.88 |
| Book Value of residual income |
12569.88 |
| Present value of residual income |
11747.55 |
Data Source: Financial statements of the company (Originenery.com,2012)
The residual income method shows that Origin Energy ltd. is providing the positive actual income to the shareholders. It is an accurate measure for determining the shareholders residual income rather than just looking at absolute residual income which is generally understood as profit after tax.
(3) Residual Operating Income Model
Residual Operating Income model is an alternative to residual income method. The major difference in two methods is of using cost of equity in residual income method and cost of capital in residual operating income method. The residual operating income method is used to analyze the firm’s future value for the purpose of investment in it. If is shows positive prospects investors will invest in it otherwise they will be reluctant to invest in it.
Origin Energy Limited: Year 2011
| (in millions) | |
| Capital or total assets |
23213.00 |
| Cost of capital |
0.06 |
| Capital Charge |
1485.63 |
| Net Operating Income |
187.5 |
| Residual Income |
21727.37 |
| Book Value of residual income |
21727.37 |
| Present value of residual income |
20497.52 |
Source : Financial statements of the company(Origin Ltd,2011)
The above table shows positive results of the company as it residual operating income is highly positive that is distributable income to creditors and to shareholders.
(4) Free Cash Flow (DCF) Model
In finance free cash flows are the cash flows available for distribution among all the shareholders of the firm. The process of determining free cash flow is very complicated and it interpretation varies widely.
Net Free Cash Flow = Operation Cash flow – Capital Expenses to keep current level of operation – dividends – Current Portion of long term debt – Depreciation
Origin Energy Limited
| Year | FCF |
|
2007 |
4070324 |
|
2008 |
-458935 |
|
2009 |
-8484174 |
|
2010 |
736.8 |
|
2011 |
3390.5 |
Data Source: Financial statements of the company
The free cash flow table of Origin Energy limited shows that the company had negative free cash for consecutive 2 years 2008 and 2009. But after that it has been giving the positive cash flows.
5. Sensitivity Analysis
Sensitivity analysis is the prediction of uncertainty in the output of a model caused by various factors affecting it. In sensitivity analysis it is seen that what will be the impact on output if the particular variable changes to this amount or goes in particular direction.
In other words, the sensitivity analysis is based on two types of variables: dependent variable and independent variables. It looks for impact of changes in independent variable on dependent variable. For example a finance manager would like to see the impact on equity capital with changes in price-earnings multiple.
| Share Price | Dividend(in cents per share) | Dividend in $ |
|
12.72 |
25 |
3.18 |
|
13 |
25 |
3.25 |
|
14 |
25 |
3.5 |
|
15 |
25 |
3.75 |
|
11 |
25 |
2.75 |
|
10 |
25 |
2.5 |
|
9 |
25 |
2.25 |
In the above table sensitivity analysis is done. The dependent variable is dividend amount and the independent variable is the share price. It was seen as the share price goes down dividend will go down but by lesser amount.
Recommendations
Based on the above analysis it can be recommended that the Origin Energy Limited is performing well and future prospects are good. As the Dividend discount model says its share price is undervalued therefore the buying of the share can be recommended. The residual income method also show the positive value of the company’s actual earning to its share holders. The residual operating income also showed positive operating income available for its lenders and shareholders. In free cash flow analysis it was found that its free cash flow has been negative in 2008 and in 2009 then again it started increasing after 2009 and gave a positive free cash flow in 2010. In 2011 its cash flow by more than 3 per cent. Thus taking a decision to invest in Origin Energy Limited would be a positive but modest return driven investment avenue selection.
REFERENCES
Gordon, Myron J. (1959). “Dividends, Earnings and Stock Prices”. Review of Economics and Statistics (The MIT Press) 41 (2): 99–105
Frequently Asked Questions, viewed on 17th may 2012, http://www.originenergy.com.au/18/FAQs
Bloomberg 2012, Origin energy Limited, viewed on 17th may 2012, http://www.bloomberg.com/quote/ORG:AU
Share Prices, viewed on 17th may 2012, http://www.originenergy.com.au/1889/Investor-graphs
Origin 2010, A decade of energy, viewed on 17th may 2012,http://www.originenergy.com.au/files/Origin_US_Roadshow.pdf
Origin energy Ltd 2011, viewed on 17th may 2012, http://www.originenergy.com.au/files/Equity_Raising_Investor_Presentation_150311.pdf
Appendix
Supporting Tables
Annual Financials for Origin Energy Ltd
LC85
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