Financial Valuation of AGL Energy Limited - Case Study Example

Executive Summary

AGL Energy Limited is listed on the Australian Securities Exchange and it is an S&P/ASX 50 company. The company has been operating in Australia since 1837 and it was one of the first companies to be listed on the Australian Securities Exchange. This report provides a review of valuation done on the company based on two models namely: Method of comparables and discount rate model. The results of the two valuations were compared and recommendation made on whether to buy, sell or hold the stock.

Introduction

AGL Energy Limited is one of the leading energy companies in Australia. It is considered as one of the largest developer, generator and operator of renewable energy in Australia (AGL Energy Limited, 2016). In addition, AGL is the largest ASX listed company. The company has taken the responsibility of reducing greenhouse gases while at the same time providing its customers with affordable and secure energy. The company’s power generation portfolio includes renewable energy sources such as wind, landfill gas, hydro, biomass and solar. The portfolio also includes peaking, base and intermediate thermal power generation plants. The company also participates in natural gas exploration and development. AGL Energy limited also operates a number of natural gas storage facilities.

AGL Energy Limited is listed on the Australian Securities Exchange and it is an S&P/ASX 50 company (ASX, 2016). The company has been operating in Australia since 1837 and it was one of the first companies to be listed on the Australian Securities Exchange (AGL Energy Limited, 2016). Being a publicly listed company, potential investors and existing shareholders need to evaluate the financial performance of the company. This way, investors or stock analysts may be able to make informed financial decisions on whether to invest on the company’s shares or not. It is, therefore, important that stock analyst or investors evaluate a company in terms of its financial performance in the stock market. This paper, thus, provides a report on financial valuation of the company. The financial valuation included: calculations of the company’s beta, discount rate, forecasting of dividend growth rate, application of method of comparables, and so on.

Question 2: Calculation of AGL Energy Limited Beta

Ways of calculating Beta

Beta is a measure of how volatile or risky a particular stock is risky to invest in relation to the entire stock market volatility. It is normally used as an indicator of how a particular stock is risky, and is used to evaluate the stock’s expected return rate (rate of return) (Clayman, et al., 2012). It is considered as one of the most important factors that stock analyst (investors) consider when selecting stocks for their investment or portfolios. Other factors that stock analysts may consider include: shareholder's equity, price-to-earnings ratio, debt-to-equity ratio, and so on (Ehrhardt & Brigham, 2014). It (beta) can be calculated by using regression in excel or some simple formula. The simple formula and excel procedures are shown below.

• Beta calculation using simple formula

The following steps are followed when calculating beta using the simple formula.

• Value for risk free rate is determined.
• Market rate of return and stock rate of return are determined.
• The next step is subtracting risk free rate from each of the above two mentioned factors (Market rate of return and stock rate of return).
• Dividing the difference between stock rate of return and risk free rate by the difference between Market rate of return and risk free rate. This shown in the equation below

Beta = (stock rate of return - risk free rate)/( Market rate of return - risk free rate)

(Hitchner, 2011)

• Beta calculation using excel

Other than the above mentioned formula excel may also be used to calculate beta for a company by employing regression.

Meaning of Beta values

If the value of beta is less than 1 (one) it means that as compared to market index (as a whole), stock is less volatile. On the other hand, if the value of beta is greater than 1 (one), company’s stock is more volatile as compared to market stock as a whole (Hitchner, 2011). It is also important to note that the value of beta can be less than 0 (zero). This means that either company stock is gaining money while the market index as a whole is losing money or company stock is losing money while the market index as a whole is gaining money; the former is usually less likely (Correia, 2010).

AGL Energy Limited Beta

This was calculated by excel. First, 6 month (November 2015 to April 2016) historical stock values and market indices were downloaded from appropriate websites (yahoo finance). These data were then saved in excel file and prepared before beta was calculated. Some of the data were down loaded are shown in the table below.

Table 1: some of historical AGL stock values and AORD market indices (ASX, 2016) (Yahoo Finance, 2016)

Stocks Prices (Adjusted Close)

Date

AGL-ENERGY LIMITED

AORD

24-Nov-15

16.95

5299.24

25-Nov-15

16.76

5276.98

26-Nov-15

16.78

5245.15

27-Nov-15

16.72

5259.75

30-Nov-15

16.55

5255.2

1-Dec-15

16.83

5218.19

2-Dec-15

17.01

5312.62

3-Dec-15

17.02

5304.71

4-Dec-15

16.82

5276.71

7-Dec-15

16.9

5264.4

8-Dec-15

16.86

5205.94

9-Dec-15

16.84

5157.98

10-Dec-15

16.72

5129.86

11-Dec-15

16.82

5087.49

14-Dec-15

16.59

5002.7

15-Dec-15

16.49

4981.87

16-Dec-15

16.57

4963.86

17-Dec-15

17.29

5078.74

18-Dec-15

17.47

5150.59

The rate of turns based on the previous stock price were calculated for both AGL stock and market stock (AORD) as whole for the period of 6 months. The table below shows some of the calculated rate of return of AGL stock and market index. The returns were calculated in excel using the formula below:

Monthly yield was then calculated using the following formula:

Table 2: some of the calculated rate of return of AGL stock and market index (Yahoo Finance, 2016) (ASX, 2016)

Stocks Prices (Adjusted Close)

% Return

Date

AGL-ENERGY LIMITED

AORD

AGL

AORD

24-Nov-15

16.95

5299.24

25-Nov-15

16.76

5276.98

-0.01121

-0.0042

26-Nov-15

16.78

5245.15

0.001193

-0.00603

27-Nov-15

16.72

5259.75

-0.00358

0.002784

30-Nov-15

16.55

5255.2

-0.01017

-0.00087

1-Dec-15

16.83

5218.19

0.016918

-0.00704

2-Dec-15

17.01

5312.62

0.010695

0.018096

3-Dec-15

17.02

5304.71

0.000588

-0.00149

4-Dec-15

16.82

5276.71

-0.01175

-0.00528

7-Dec-15

16.9

5264.4

0.004756

-0.00233

8-Dec-15

16.86

5205.94

-0.00237

-0.0111

9-Dec-15

16.84

5157.98

-0.00119

-0.00921

10-Dec-15

16.72

5129.86

-0.00713

-0.00545

11-Dec-15

16.82

5087.49

0.005981

-0.00826

14-Dec-15

16.59

5002.7

-0.01367

-0.01667

15-Dec-15

16.49

4981.87

-0.00603

-0.00416

16-Dec-15

16.57

4963.86

0.004851

-0.00362

17-Dec-15

17.29

5078.74

0.043452

0.023143

The value of beta was then calculated using the regression.

First, Covariance was calculated as using the formula below (Rosa 2014):

Then variance was calculated in excel uing the fomula:

Then beta was calculated in excel using the the formula below,

The formula is expressed in excel as shown

Beta = COVARIANCE.P (E8:E108,F8:F108)/VAR.P(F8:F108)

= 0.03455

Interpretation of AGL Beta Value

The calculated beta value is 0.03455 which is less than 1; and as stated earlier, if the value of beta is less than 1 (one) it means that as compared to market index (as a whole), stock is less volatile.

Question 3: Calculation of AGL Energy Limited Discount rate using CAPM model

Discount Rate

Stock markets are risky to invest in and one needs to do their homework well before deciding to invest in them. It is therefore important that future dividends are discounted. It is important to note that even though expected dividends are discounted, the future dividends are really uncertain(Gensor, 2009). A number of models have been developed to calculate discount rates that are risk adjusted. One such model is Capital asset pricing model (abbreviated as CAPM)(Hitchner, 2011).

CAPM model

Capital asset pricing model (abbreviated as CAPM) is a model used determine rate of return for a risky stock. It is expressed as shown in the equation below.

ra = rrf + Ba (rm-rrf) (Lumby & Jones, 2003)

Where:

rm = expected rate of return for the whole market

rrf = risk free rate of return =

Ba = beta for company’s stock

Ra = discount rate

The term that is enclosed in the brackets (rm-rrf) represents equity premium. This term measures the benefit (excess) an investor gets from investing in stock market than in risk free bond. This means that expected rate of return of stock (Ra) is function of three terms namely: risk free rate, equity premium and, beta of the stock (Hitchner, 2011).

Calculation of AGL Energy Limited Discount rate

Assumption: Rate of return on Australia’s Treasury bond = 2.65%, and is considered as risk free rate of return. This is according to Bloomberg (2016).

ra = rrf + Ba(rm-rrf)

Where:

rm = expected rate of return for the whole market = 0.00012244

rrf = risk free rate of return = 2.65% (Bloomberg, 2016)

Ba = beta for company’s stock = 0.03455 (average rate of the entire period)

Ra = discount rate

ra = rrf + Ba (rm-rrf)

0.0265 + 0.03455(0.00012244-0.0265)

= 0.02559

= 0.02559 X 100 = 2.559%

Therefore;

Discount rate = 2.559%

Question 4: Forecasting AGL Energy dividend growth

AGL Energy Limited’s average growth rate of dividend per share for last 12 months was approximately 3.2%. The dividend growth rate per share for past 3 years was about 4.2% per year, and the growth rate dividend per share for the past 5 years was 6.8% per year. This clearly shows that the future dividend per share growth rate will continue to slow down. (Financial Times, 2016). The figure below shows growth forecast made by Financial Times Europe.

AGL Energy limited dividend per share growth rate forecast (Financial Times, 2016)

In addition, the company’s revenue has been slowing down for the last 3years; this is shown in the figure below. The figure also shows that the company recorded a negative profit margin in the same period.

AGL Energy limited historical revenue showing slow in revenue for the last 3 years(Financial Times, 2016)

Given that Financial Times forecast dividend per share growth rate of 1.59% and slowing down of the of the company’s revenue growth, a dividend per share growth rate of 1.59% has been forecasted for year ending 2016 and 2017.

Question 5: Determination of AGL Energy Limited Stock Price

A method normally used to determining stock price is dividend discount model (abbreviated as DDM) (Karlson, 2015). The procedure (model) uses predicted dividend growth rate and then discounting them to the current value. It is important to note that if the DDM stock value is high than the current share price, the stock price is devalued (Lumby & Jones, 2003). The value of stock can be calculated using the formula below.

(Ehrhardt & Brigham, 2014)

Using the dividend discount model, stock price was calculated using formula below.

Value of stock = (dividend per share)/(discount rate - dividend growth rate)

This formula can be contracted as shown below:

Given the following:

Current dividend per share = Div1 = $0.32 (according to AGL Energy Limited, 2016)

Discount rate = r = 2.559% = 0.02559

Dividend growth rate = g = 1.59% = 0.0159

Next year’s dividend per share based on the forecasted growth rate = (1+0.0159) X 0.32

= 0.244

Value of Stock = 0.3251/(0.02559 – 0.0159)

= $33.54

Appropriateness of DDM as Valuation Model

This model is not appropriate for valuation of the company’s stock. It predicts that the price of company’s stock next year will be $33.54. That’s more than 150% increase in the company’s share prices. This is opposed to the company’s current and projected financial position, and predicted share price. It has been forecasted by reputable financial firms such as Financial Times that AGL’ s share will grow 1.59% in the next years so a growth rate of more than 150% illogical. Also, DDM model assumes that the company’s past performance would influence its future financial performance. But this is not guaranteed when it comes dividend payouts, especially if the current company’s financial performance persists.

Question 6: Valuing the Company using Method of Comparable

A number of financial factors were compared among the following similar companies. These include: AGL Energy Ltd, Origin Energy Ltd, and Sundance Energy Australia Ltd.

Table 3: Comparison of financial preformance of three similar companies (Morning Star, 2016)

Industry Peers

Market Cap 

Million

Net Income 

Million

Price To Sales Ratio (P/S)

Price to Book Ratio P/B

Price to Earning Ratio (P/E)

Dividend

Yield%

5-Yr Rev

CAGR%

Med Oper.

Margin%

Interest

Coverage

Debt to Equity Ratio D/E

AGL Energy Ltd (AUD)

9,358

-539

1.1

1.5

—

4.9

10.1

6.9

2.3

0.4

Origin Energy Ltd (AUD)

7,104

-887

0.7

0.6

—

1.9

6.2

5.1

-0.4

0.6

Sundance Energy Australia Ltd (AUD)

84

-369

0.9

0.5

—

—

—

-27.8

-38.4

1.1

Industry Average for selected multiples

0.9

0.867

3.4

-5.267

-12.16

0.7

CAGR = compounded annual growth

Of the three companies AGL Energy limited is the biggest. From the above comparables it is seen that other the Debt to Equity ratio, the company’s multiples are above the industry average.

Appropriateness of Method of Comparables as Valuation Model

Of the two valuation models (Method of comparables and discount rate), the comparable method gave the performance of the company based on the industry as a whole. It evaluates the company’s performance relative to industry peers.

This, however, does not mean that it is most the appropriate approach. If stock market get overvalued, the method of comparable may not be appropriate. The discount rate model has a flip side too since it looks solely on the company that being valued. This lead to a number of important market factors getting ignored. Therefore, in order to get real picture of the company’s financial performance in stock market it is important that both the models are employed.

Question 7: Buying or Selling AGL Energy stock

I would recommend BUY the stock. Looking at both methods, the Company is not doing bad it terms dividend. The discount rate model predicted that the price of company’s stock next year will be $33.54. As strange as it may sound, that can be a very good return especially based on current share price of $18.7. The method of comparables has indicated that the company is not doing when compared to its peers in Australia.