Estimating the Cost of Capital Executive Summary This thesis is motivated by the challenges of contemporary finance in appraising companies according to their underlying, intrinsic value Scholars and practitioners within the field of financial analysis have searched in futility for an efficient and accurate valuation technique; a single, magic wand that could estimate companies’ intrinsic value accurately Instead, several competing contemporary valuation methods occupy the literature today The purpose of the thesis is to find the intrinsic value of Vestas To so, this thesis will evaluate and discuss contemporary valuation models in order to choose the most appropriate models Vestas is of particular interest being a Danish market leader within a major growth industry Under the current momentum that wind power enjoys, it is relevant to examine if the intrinsic value of the company deviates from the current market price In order to answer the thesis statement, the environmental, competitive, and internal situation of Vestas will be addressed The strategic analyses reveal the profitable prospects for the industry, but also disclose an enormous dependence on political support Vestas also faces an increasingly tougher competition A historical financial analysis reveals that Vestas’ has increased profitability, mainly due to low working capital and an improved gross margin By synthesising the strategic and financial analyses, the intrinsic value of Vestas is then derived under three different scenarios The estimates are then examined via a sensitivity analysis, which is supplemented by a simulation and a peer group analysis The thesis finds an intrinsic value estimate of 53.91 EUR but also note significant, theoretical issues within the employed financial theory This thesis therefore stresses that estimates, share price targets, buy/sell recommendations, and so forth should be treated extremely critically and one must not be seduced by precise formulas with imprecise assumptions (Graham 1974) Bachelor Thesis © Emad Sharghbin 2009 ii Estimating the Cost of Capital The concept of future prospects and particularly of continued growth in the future invites the application of formulas out of higher mathematics to establish the present value of the favored issue But the combination of precise formulas with highly imprecise assumptions can be used to establish, or rather justify, practically any value one wishes Benjamin Graham 1973, “The Intelligent Investor”, 4th ed., Harper and Row, New York, pp 315-316 Bachelor Thesis © Emad Sharghbin 2009 iii Estimating the Cost of Capital Brief Table of Contents I EXECUTIVE SUMMARY II PART I – THESIS INTRODUCTION PART II - CRITICAL REVIEW OF VALUATION MODELS PART III – STRATEGIC ANALYSIS OF VESTAS 20 3.COMPANY PROFILE 20 4.EXTERNAL STRATEGIC ANALYSIS 21 5.INTERNAL STRATEGIC ANALYSIS 35 PART IV – FINANCIAL STATEMENT ANALYSIS OF VESTAS 41 6.HISTORICAL FINANCIAL ANALYSIS 41 PART V – VALUATION OF VESTAS 47 7.ESTIMATING THE COST OF CAPITAL 47 8.VALUATION 53 9.CONCLUSION 68 10 BIBLIOGRAPHY 70 11 APPENDICES 76 Bachelor Thesis © Emad Sharghbin 2009 iv Estimating the Cost of Capital COMPREHENSIVE TABLE OF CONTENTS I EXECUTIVE SUMMARY II PART I – THESIS INTRODUCTION 1.1 INTRODUCTION .1 1.2 THESIS STATEMENT .1 1.3 SOURCES AND LITERATURE 1.4 DELIMITATION .3 PART II - CRITICAL REVIEW OF VALUATION MODELS 2.1 INTRODUCING THE VALUATION CONUNDRUM .5 2.2 THE TECHNICAL VERSUS FUNDAMENTAL CONUNDRUM .5 2.3 FOUR CATEGORIES OF MODELS WITHIN FUNDAMENTAL VALUATION 2.4 THEORETICAL FOUNDATION .7 2.4.1.Asset-based Valuation Models 2.4.2.Multiple Valuation Models .8 2.4.3.Accounting-based Valuation Models 10 2.4.3.1.Dividend Discount Models 11 2.4.3.2 Cash-Flow Valuation Models .11 2.4.3.3 Economic Profit Valuation Models .12 2.4.3.4 Residual Income Valuation Models 13 2.4.3.5 Abnormal Earnings Growth Valuation Models 14 2.4.4.Real Options Valuation 15 2.5 CONCLUDING DISCUSSION OF THE FOUR GROUPS OF VALUATION MODELS 16 2.6.THE AUTHOR’S SYNTHESISING CONCLUSION .17 2.7.SUMMARISING THE CRITICAL REVIEW OF VALUATION MODELS 18 2.8 APPLICABILITY OF VALUATION MODELS TO A VALUATION OF VESTAS 18 PART III – STRATEGIC ANALYSIS OF VESTAS 20 Bachelor Thesis © Emad Sharghbin 2009 v Estimating the Cost of Capital 3.COMPANY PROFILE 20 4.EXTERNAL STRATEGIC ANALYSIS 21 4.1 ENVIRONMENTAL ANALYSIS – USING THE PESTED FRAMEWORK 21 4.2.INDUSTRY ANALYSIS - USING PORTER’S FIVE FORCES FRAMEWORK 25 4.2.1.Foundation - Static Analysis 25 4.2.1.1.Threat of substitutes .26 4.2.1.2.Rivalry among competing firms 28 4.2.1.3.Threat of new entrants 28 4.2.1.4.Bargaining power of customers 29 4.2.1.5.Bargaining power of suppliers .29 4.2.2.Putting Porter into Perspective – Dynamic Analysis .30 4.3 COMPETITOR AND DEMAND ANALYSIS – A WORLD MARKET UPDATE FROM VESTAS’ PERSPECTIVE .31 5.INTERNAL STRATEGIC ANALYSIS 35 5.1 VALUE CHAIN ANALYSIS – USING BARNEY’S VRIO FRAMEWORK .35 5.1.1.Primary Activities 36 5.1.2.Supportive Activities 38 5.2 SUMMARISING SWOT TABLE 39 PART IV – FINANCIAL STATEMENT ANALYSIS OF VESTAS 41 6.HISTORICAL FINANCIAL ANALYSIS 41 6.1.INTRODUCTION 41 6.2 GROWTH .42 6.3 ROIC 43 6.4.CREDIT RISK .45 PART V – VALUATION OF VESTAS 47 7.ESTIMATING THE COST OF CAPITAL 47 Bachelor Thesis © Emad Sharghbin 2009 vi Estimating the Cost of Capital 7.1 INTRODUCTION 47 7.2.ESTIMATING THE COST OF EQUITY 47 7.3 ESTIMATING BETA .49 7.4 WACC 51 8.VALUATION 53 8.1 INTRODUCTION 53 8.2 FORECAST-DRIVERS AND CONSTANT VARIABLES .53 8.3 BASE, BEARISH, AND BULLISH SCENARIO-ANALYSES 55 8.3.1.Base case scenario 55 8.3.2.Bearish scenario 57 8.3.3.Bullish scenario 59 8.3.4.Conclusion on scenario analyses .60 8.4 SENSITIVITY ANALYSIS 60 8.5 SIMULATION OF FORECAST-DRIVERS 63 8.6 PEER GROUP ANALYSIS .64 8.7 COMPARING PRICE TARGETS AND ESTIMATES 66 9.CONCLUSION 68 10 BIBLIOGRAPHY 70 10.1 ACADEMIC BOOKS AND ARTICLES 70 10.2 REPORTS AND OTHER SOURCES 74 NEWS PAPER ARTICLES 75 11 APPENDICES 76 11.1.MARKET PREMIUM CALCULATIONS 76 11.2.MARKET WEIGHT REPORT CSE 15/04-09 77 11.3.LUNDHOLM’S CREDIT RISK FRAMEWORK 78 11.4.GUIDE TO THE VALUATION MODEL 79 11.5.BASE SCENARIO – VALUATION SUMMARY 80 11.6 BEARISH SCENARIO – VALUATION SUMMARY .82 11.7 BULLISH SCENARIO – VALUATION SUMMARY 84 Bachelor Thesis © Emad Sharghbin 2009 vii Estimating the Cost of Capital 11.8 CONSTANTLY HELD VARIABLES IN THE FORECAST .86 11.9 PRICE TARGETS FROM LEADING INVESTMENT BANKS 88 11.10 THREE PEER GROUP ANALYSES: WIND, SOLAR, INDUSTRIALS 90 Bachelor Thesis © Emad Sharghbin 2009 viii Estimating the Cost of Capital LIST OF FIGURES FIGURE 1: DISPLAYING THE TWO MAIN GROUPS OF VALUATION APPROACHES FIGURE 2: DISPLAYING THE FOUR MAIN CATEGORIES OF VALUATION MODELS FIGURE 3: PESTED-ANALYSIS - OVERVIEW 22 FIGURE 4: IMPACT OF PTC EXPIRATION ON ANNUAL INSTALLATION OF WIND CAPACITY ON US MARKET 23 FIGURE 5: SELF-REINFORCING RELATION: GOVERNMENT SUPPORT, DEMAND, AND COST REDUCTIONS 23 FIGURE 6: INDUSTRY ANALYSIS USING THE FIVE FORCES FRAMEWORK – OVERVIEW 26 FIGURE IN-DEPTH PRESENTATION OF THREAT OF SUBSTITUTES ANALYSIS 27 FIGURE 8: RELATIVE ENERGY PRICES FOR DIFFERENT ENERGY SOURCES 28 FIGURE 9: FIVE FORCES FRAMEWORK IN A TIME-ORIENTED PERSPECTIVE 30 FIGURE 10: BTM CONSULT’S FIGURE SHOWING THE TOP TEN SUPPLIERS’ MARKET SHARE AND PRESENCE IN 2008 32 FIGURE 11: THE LEADING SUPPLIERS IN THE TOP 10 MARKETS IN 2008 33 FIGURE 12: VALUE CHAIN ACTIVITIES AS WELL AS THEIR COMPETITIVE AND FINANCIAL IMPLICATIONS 36 FIGURE 13 SUMMARISING SWOT-ANALYSIS 40 FIGURE 14: HISTORICAL GROWTH RATES – GEOGRAPHICAL SEGMENTS 42 Bachelor Thesis © Emad Sharghbin 2009 ix Estimating the Cost of Capital FIGURE 15: DECOMPOSING ROIC-TREE FOR VESTAS BASED ON 2005-2008 ANNUAL REPORTS 43 FIGURE 16 EXPENSE GROUPS IN VESTAS IN PERCENT OF TOTAL REVENUE 2005-2008 44 FIGURE 17: VESTAS’ CREDIT RISK IN THE LUNDHOLM FRAMEWORK 46 FIGURE 18: ESTIMATED MARKET PREMIUMS IN RECENT RESEARCH - S&P 500 48 FIGURE 19 ROLLING 2-YEAR BETA REGRESSIONS AGAINST THE MSCI WORLD INDEX 50 FIGURE 20 HISTORICAL AND FUTURE DECOMPOSITION OF VESTAS’ WACC 52 FIGURE 21 OVERVIEW OF FORECAST DRIVERS IN THE DIFFERENT VALUATION PERIODS 54 FIGURE 22 DEVELOPMENT IN GROWTH, ROIC, EBITA AND GROSS MARGIN IN THE BASE CASE SCENARIO 56 FIGURE 23: DEVELOPMENT OF EP AND FCF IN THE DETAILED FORECAST PERIOD .57 FIGURE 24 DEVELOPMENT IN GROWTH, ROIC, EBITA AND GROSS MARGIN IN THE BEARISH SCENARIO 58 FIGURE 25 DEVELOPMENT IN GROWTH, ROIC, EBITA AND GROSS MARGIN IN THE BULLISH SCENARIO 59 FIGURE 26: THE THREE SCENARIO SHARE PRICE ESTIMATES AND THE WEIGHTED SHARE PRICE ESTIMATE 60 FIGURE 27: SENSITIVITY ANALYSIS – EFFECT ON SHARE PRICE, TABLE AND GRAPH 62 FIGURE 28: HISTOGRAM OF SIMULATED SHARE PRICE ESTIMATES 63 FIGURE 29 PEER GROUP ANALYSIS OF VESTAS AGAINST WIND ENERGY PEERS 65 Bachelor Thesis © Emad Sharghbin 2009 x Estimating the Cost of Capital News paper articles Business.dk 20/03/07: “Også i år vil Vestas mangle komponenter” http://www.business.dk/article/20070320/borsnyt/103201015/ Børsen 11/03-09: “Vestas and Boeing to collaborate on technology research projects” http://borsen.dk/?treeid=2614&id=80302&urlpart_firm=vestas_wind_systems Børsen, 6/11-08: ”Vestas/CEO: Kunder ønsker ikke større møller” http://borsen.dk/?treeid=2613&id=55466&urlpart_firm=vestas_wind_systemsA Børsen, 22/04-09: ”Rival vil slå Engel i 2010” http://borsen.dk/investor/nyhed/155904/ Epn, 07/04-09: ”Vindbranchen er dårlig til rekruttering” http://epn.dk/brancher/energi/alternativ/article1657373.ece Finansnyheder, 20/03-09: ”Vestas: Vindekspert forstår ikke tårnfabrik i USA” http://www.finansnyheder.dk/news/shownewsstory.aspx?storyid=10213859 Finansnyheder, 17/03-09: “Vestas/R&D-chef: År til resultater af Boeing-samarbejde” http://www.finansnyheder.dk/news/shownewsstory.aspx?storyid=10207806 Guardian 17/03-09: “Shell dumps wind, solar and hydro power in favour of biofuels” http://www.guardian.co.uk/business/2009/mar/17/royaldutchshell-energy Guardian 20/04-08: Warren Buffett quote, page 6: http://www.guardian.co.uk/world/2008/apr/20/usa.subprimecrisis Ingeniøren, 29/01-08: ”Vinge rev sig løs fra Vestas-mølle og fløj 40 meter væk” http://ing.dk/artikel/85123-vinge-rev-sig-loes-fra-vestas-moelle-og-floej-40-meter-vaek Wall Street Journal 08/10-08: “As rivals stall, Porsche engineers a financial windfall” Bachelor Thesis © Emad Sharghbin 2009 75 Estimating the Cost of Capital 11 Appendices 11.1 Market Premium calculations Source: Datastream 13/03-09 Bachelor Thesis © Emad Sharghbin 2009 76 Estimating the Cost of Capital 11.2 Ticker KFX MAERSKB DC Equity MAERSKA DC Equity CARLB DC Equity COLOB DC Equity DNORD DC Equity DCO DC Equity DANSKE DC Equity DSV DC Equity FLS DC Equity GEN DC Equity LUN DC Equity NKT DC Equity NDA DC Equity NOVOB DC Equity NZYMB DC Equity SYDB DC Equity TOP DC Equity TRYG DC Equity VWS DC Equity WDH DC Equity Market Weight Report CSE 15/04-09 Name A P Moller - Maersk A/S A P Moller - Maersk A/S Carlsberg A/S Coloplast A/S D/S Norden Danisco A/S Danske Bank A/S DSV A/S FLSmidth & Co A/S Genmab A/S H Lundbeck A/S NKT Holding A/S Nordea Bank AB Novo Nordisk A/S Novozymes A/S Sydbank A/S Topdanmark A/S TrygVesta AS Vestas Wind Systems A/S William Demant Holding % Weight Shares Last Price in the Index in the Index 11,5 2,2 28300,0 11,3 2,2 27800,0 5,6 118,9 252,5 2,8 42,4 353,0 1,4 44,6 166,0 1,5 48,9 165,0 7,3 698,8 56,3 1,7 190,2 47,2 1,7 53,2 169,5 1,9 44,9 233,5 3,7 196,9 100,8 0,5 23,7 123,3 3,1 457,7 36,0 23,1 526,5 237,3 3,9 54,3 386,0 1,1 67,5 85,3 1,8 16,7 586,0 3,5 68,0 276,5 10,2 185,2 297,5 2,6 59,0 238,8 Source: Bloomberg, 15/04-09 13:34 Bachelor Thesis © Emad Sharghbin 2009 77 Estimating the Cost of Capital 11.3 Lundholm’s Credit Risk Framework Based on their different ratios, industrial firms are grouped into 10 deciles The firms are then assigned historical default probabilities according to their deciles The historical, average sum is % (Lundholm 2007) Bachelor Thesis © Emad Sharghbin 2009 78 Estimating the Cost of Capital 11.4 Guide to the valuation model The following guide will hopefully make it easier to understand the model After several months of work the model may seems simple, but the author has recognises the difficulties in understanding others’ model The two dark blue sheets to the left are the input sheet in which the balance sheet and income statement data has been typed, which result in the third sheet, the historical statements The fourth sheet, the regular blue WACC sheet, depicts both historical and future calculations of the WACC The turquoise fifth and sixth sheets are also input sheets In the Driver sheet, the short-term and long-term drivers are typed in In the Forecast Driver sheet, various, necessary information is typed in, but the sheet also contains financial statement The seventh sheet, Results, is, as the name indicates, the results of both the historical and future forecasts The final four green sheets all contain “end” information The eight sheet, Valuation summary, summarises the valuation, and calculates the share values This is one the most important sheet in the model The ninth sheet, Output, contains, the ROIC tree and various other information, whereas the tenth sheet, Table, only includes a minor table of the development in ROIC and EBITA and so forth in the detailed forecast period The final sheet, Credit risk, is based on Lundholm’s framework and calculated the credit risk of Vestas based on key accounting ratios Bachelor Thesis © Emad Sharghbin 2009 79 Estimating the Cost of Capital 11.5 Base Scenario – Valuation Summary RONIC in the continuing value = 22.9 % Growth in NOPLAT = 3.5 % Bachelor Thesis © Emad Sharghbin 2009 80 Estimating the Cost of Capital Bachelor Thesis © Emad Sharghbin 2009 81 Estimating the Cost of Capital 11.6 Bachelor Thesis © Emad Sharghbin 2009 Bearish Scenario – Valuation Summary 82 Estimating the Cost of Capital RONIC in the continuing value = 14.5 % Growth in NOPLAT = 3.5 % Bachelor Thesis © Emad Sharghbin 2009 83 Estimating the Cost of Capital 11.7 Bullish Scenario – Valuation Summary RONIC in the continuing value = 25.7 % Growth in NOPLAT = 3.5 % Bachelor Thesis © Emad Sharghbin 2009 84 Estimating the Cost of Capital Bachelor Thesis © Emad Sharghbin 2009 85 Estimating the Cost of Capital 11.8 Constantly held variables in the forecast This appendix provides an overview of all variables held constant in all the scenarios and the simulations It refers to the sheet “Forecast Driver” in the scenario models The list is made according to how the sheet is divided For an overview, click on the boxed “1” which is in row with the letters of the columns in Excel This will collapse all the different sections Clicking on the plusses will expand the sections OPERATIONS: S,G&Adm costs: Average of last years to reflect increasing trend R&D R &D is more and more important, and one could argue that it would receive increasing funding The variables is held constant at 3,5 % of revenue, which is above the past funding of 2-2,5 % of revenue Working Capital: All variables are based on the average of the last years However, Accounts receivable, Accounts payable, and other current liabilities have all grown significantly within recent years, therefore these are only based on last years’ average BALANCE SHEET ITEMS: Capex Vestas’ guidance for 2009 includes 1200 mEUR on investments in non-current assets, of which 1000 is in tangibles, both excl dep However, the company has said that they will lower capex depending on Q1, so capex is forecasted around 900 inclusive of depreciation Capex for 2010 and 2013 have both been put at % of revenue, while 2011-2012 is assigned % A slow down is anticipated in 2010, that will be followed by an expansion in 20112012, which will be stabilised again in 2013 Of course, in the different scenarios, capex will be different, but it is outside the scope of this report to estimate exactly how much additional capex a bullish scenario necessitates and so forth Bachelor Thesis © Emad Sharghbin 2009 86 Estimating the Cost of Capital Goodwill: Goodwill is expected not to be amortised, and also, Vestas is not expected to acquire any firms Hence goodwill is kept at OFF-BALANCE SHEET ITEMS: Intangibles: Additions and amortisations are both put at last years average Op leases: Calculated b y finding CAGR for 2004-2008 then using it each year Interest rate is same as interest rate on debt Options: Value of Options Outstanding is put at 12,615 mEUR according to AR 2008: 82 Preferred stock: 0, as there is none in Vestas PROVISIONS & NON-OP- P&L: Long-term debt rate: As mentioned in the section about WACC, it is estimated to be around 6,5 % forward-going TAX: Marginal, effective tax: Vestas’ own guidance forecasts 28 % corporate tax (AR 2008: 11) Although it is possible to estimate effective tax rate based on in which countries Vestas makes its profits, the added complexity outweighs the benefits Deferred tax: Average of last years LONG TERM & CV DRIVERS: Cash tax rate: Average of last years Closing Net PPE & Other IC: Average of last years to reflect decreasing trends Cumulative GW & Intangibles: Written up with average of historical mean in 200408, which was 45 mEUR Bachelor Thesis © Emad Sharghbin 2009 87 Estimating the Cost of Capital 11.9 Bachelor Thesis © Emad Sharghbin 2009 Price targets from leading investment banks 88 Estimating the Cost of Capital Bachelor Thesis © Emad Sharghbin 2009 89 ... although the models are not completely similar Figure 3: Summarising the critical review of valuation models 2.8 Applicability of valuation models to a valuation of Vestas The choice of valuation. .. DISCUSSION OF THE FOUR GROUPS OF VALUATION MODELS 16 2.6 .THE AUTHOR’S SYNTHESISING CONCLUSION .17 2.7.SUMMARISING THE CRITICAL REVIEW OF VALUATION MODELS 18 2.8 APPLICABILITY OF VALUATION. .. contemporary valuation methods occupy the literature today The purpose of the thesis is to find the intrinsic value of Vestas To so, this thesis will evaluate and discuss contemporary valuation