In 1980, Michael Porter presented the five forces that shape competition in the industry for any business organization as ‘ Rivalry among existing competitors, threats of new entrants, bargaining power of suppliers, bargaining power of buyers, and threat of substitute products or services. These forces determine the competitive position of organizations in the markets of their operations.
We hereby introduce a brief introduction about this model and then determine the competitive positioning of Ford Motor Company and Tata Motors with the help of this model.
One important observation that Michael E Porter made about these forces is that if these forces are intense then almost no company gains distinct competitive advantages and earns attractive returns on investments.
The threats of new entrants and substitute products and services are prevalent in industries where major innovations are underway that can potentially cause creative destruction of the existing products and services. New entrants always enter the markets with a desire to capture market shares quickly and hence tend to put lot of pressure on product pricing thus capping the profit potential of the market.
Hence, the existing players in the market benefit out of the barriers to entry of new players that essentially comprise of ‘ supply and demand economies of scale, supplier switching costs to customers (especially when the customers have invested heavily in solutions compliant with supplier’s technology or are very much used to the same), capital requirements, access to distribution channels, restrictive government policies, etc.
The other two balancing forces are bargaining power of suppliers and buyers. The bargaining power of buyers shall be lesser if competition is less given that customers will not have many choices for purchasing products. However, the bargaining power of suppliers is higher in case of lesser competition given that lesser competition will not develop the supplier network (and their mutual competition) and hence they will tend to have more bargaining power.
4.2)Ansoff Analysis of Ford Motor Company and Tata Motors
Ansoff developed a matrix to analyze the product marketing strategy of an organization when designing a model for diversification. Following is the image of original sketch of the matrix drawn by Ansoff himself:
Ansoff Matrix
A simpler form of Ansoff product marketing strategy is presented below
:
‘ Existing products to be marketed in existing markets ‘ market penetration strategy
‘ New products to be marketed in existing markets ‘ product development strategy
‘ Existing products to be marketed in new markets ‘ market development strategy
‘ New products to be marketed in new markets ‘ diversification strategy
Ford Motor Company
Ford Motor Company possesses the empirically tested primary competitive advantage of flexible assembly lines with interchangeable parts that has worked very well in the past. They have developed a globally centralized supply chain system that has supported their primary competitive advantage effectively.
The current market downturn has definitely affected their revenues and the higher cost of supply chain is hurting them. But with the relatively safer strategy of targeting new markets for existing product lines has kept the interest of their investors alive irrespective of their dismal financial performance. Moreover they have sold off the non-performing assets like Jaguar and Land Rover companies to reduce the burden of operating costs. It is due to their confidence on their low risk strategies that they have refused to avail aid from government and are expecting to break even by 2011.
Tata Motors
Tata Motors is currently implementing high risk strategies given that they have attempted to enter two new markets where they do not possess any expertise ‘ UK and European premium car markets with the help of Jaguar and Land Rover and the $2500 Nano car that may altogether develop a new car market globally. If things favor them, they have the potential to become the next Ford of the world but if the happenings do not favor them (like the Singur crisis witnessed by them), then they can suffer losses that will take decades for them to repair.
4.3)Balanced Score Card Analysis of Ford Motor Company and Tata
Motors
Kaplan and Norton developed the balanced score card strategy to assess the performance of businesses by virtue of their internal competencies measured through key performance indicators (KPIs). The balanced scorecard is presented in the figure below
The Balanced Score Card System for Vision and Strategy
The strategy is based on four primary factors that balance each other in a strategic framework ‘ Customer, Financial, Internal Business Process and Learning and Growth. The Customer and Financial perspective is the way the company appears to the customers and the Stake Holders whereas the Internal Business Processes and Learning and Growth perspective is the way the company appears to the internal employees and managers.
The internal business processes and learning and growth perspective has been quite sound in both Ford Motor Company and Tata Motors but the perspectives have been entirely different. Ford Motor Company has focused on localization of products at a global platter whereby they keep their parts supply chain centralized and assemble cars as per the local requirements of a region after studying the needs.
This has resulted in they able to deliver different variants of cars as per the requirements of different countries using the same spares supplied by their centralized supply chain vendor. Hence, the internal learning and growth of Ford Motors has been very comprehensive with localized knowledge captured from various countries and the benefits of global knowledge and experience effectively mixed with the localized knowledge.
Tata Motors appear to be far behind this strategy as compared to Ford Motors but they appear to be taking the same path towards globalization. They have developed Nano as per Indian conditions to start with but are ready to match the localized conditions required at the global level ‘ like the stringent emission norms of Europe.
They already have their small trucks (Tata Sierra) operating in UK which must have
developed their knowledge on UK and European market requirements. Moreover, after the
acquisition of Jaguar and Land Rover their knowledge will be strengthened further. They
already have the basics in place to apply the knowledge in Nano and it may be just a matter
of time that they will be able to achieve compliance for Nano against the regulations of
Europe .
4.4)Budgets and Forecasts
The future of an organization is carried out by carrying out capital budgeting and discounted cash flow forecasts. Capital budgeting is carried out to analyze the returns on investments within a specified time period from a project such that the same can be accepted or rejected by the stakeholders. Capital Budgeting decisions have always been a major challenge for corporate management and investors from the perspective of the most appropriate method for carrying out the ROI forecasting and measurements.
In fact the widely accepted decision criteria use an old empirical generalization of
‘Accept-Reject’ criteria established whereby the project is either accepted or rejected based on its value addition to the firm, the investors and to the shareholder wealth.
Beranek showed that the cost of capital of a project is marginalized to maximize the investors’ money and shareholders’ wealth by including rate of interest, the required rate of return to stock holders, corporate marginal income tax rate, debt to equity ratio and lifetime of the proposed project and the weighted average cost of capital.
In another paper written by Beranek , he claimed that the Net Present Value rankings of the investment opportunities do not match equity market value unless the projects are of one period duration or are solely financed by equity only. He established the widely used criteria by financial analysts that a project should be accepted only if its Present Value is greater than zero and recommended that the project among multiple mutually exclusive projects having highest Present Value should be chosen for best ROI. Overall, the Net Present Value has remained the most trusted method to evaluate capital budgeting decisions due to its advantage of evolving the time value of money (the fluctuations in value of money as time passes).
4.5)Systematic and Unsystematic Risks
The capital budgeting technique is largely influenced by systematic risks in the markets. Systematic risks are related to factors that are prevalent in a country, region or at global level and are external to the control of an organization. Examples of Systematic risks are ‘ market risks, political risks, currency fluctuation risks, oil prices fluctuation risks, etc.
Systematic risk assessment is important for the listed companies to effectively price the equities, determining the cost of capital and effective evaluation returns from projects. Unsystematic risks are related to internal threats and vulnerabilities of a company ‘ like attrition, loss of major customers, frauds and scams (like inflated accounting statements), agency issues, sudden obsolescence, fire/special perils, etc. . The following presents a brief on valuation of Systematic Risks when evaluating the return on investments.
The systematic risks of common stocks of an organization can be evaluated using variance in multiple factors that are closely observed by market experts. Thompson (1976) enumerated the variance in the following factors that market experts observe to evaluate the systematic risks pertaining to the common stocks of a firm:
(a) variance in Dividends
(b) variance in Earnings
(c) variance in Earnings Multiple
(d) variance in Earnings Yield
(e) variance in Operating Income
(f) variance in Sales
(g) variance in Total Debt to Total Assets ratio
(h) variance in Cash Flow to Total Debt ratio
(i) variance in Pretax interest coverage
(j) variance in Current ratio
(k) variance in Working Capital to Total Assets ratio
(l) variance in Cash and Receivables to Expenditures ratio
These Variances are measured as systematic relationships between accounting values of the firm and the aggregated corresponding accounting values of all firms put together. The management of an organization try to smoothen different inputs and outputs to reduce environmental risks which are reflected in these variance analysis and hence they can be logical indicators of systematic risks pertaining to the common stocks of an organization.
To analyze the systematic risks more analytically, Thompson presented the following mean and trend forms to explain the Systematic Risks to Common Stocks:
(a) Dividend payout by companies ‘ measured as mean of annual dividends to earnings ratios
(b) Dividend payout by companies ‘ measured as the ratio of nine year sum of dividends to the nine year sum of earnings
(c) Analyzing growth in assets
(d) Analyzing growth in earnings
(e) Analyzing growth in Sales
(f) Growth measured as the mean of the asset growth, earnings growth and sales growth
(g) Investments to Earnings ratio ‘ measured as the ratio of the nine year change in assets to the nine year sum of earnings
(h) Return on Investments ‘ measured as the ratio of the nine year change in earnings to the nine year change in assets
Market Volume that is measured as the mean of the natural logs of the market value of annual traded common stocks (in Million US Dollars)
(j) Mean of Annual Ratios of the total debts to the total assets
(k) Mean of Annual Ratios to the cash flow to the total debt
(l) Mean of Annual pretax interest coverage ratios
(m) Mean of Annual current ratios
(n) Mean of annual ratios of the Working Capital to Total Assets
(o) Mean of annual ratios of the Cash and Receivables to the Expenditures for operations
(p) The size measured as mean of natural logs of the total assets (in multiple of $10 Millions)
(q) The size measured as mean of natural logs of the total earnings (in multiple of $10 Millions)
(r) The size measured as mean of natural logs of the total sales (in multiple of $10 Millions)
The unsystematic risks are normally termed as residual risks which are kept out of the modeling but are reported in internal financial analytics. These risks are hard to predict because they depend upon the factors that are internal to the organization and are not linked with the market risks.
The market beta analysis is not a static one time analysis but is a continuous process because the variance in current means compared to the means of past few weeks changes continuously. The market beta analysis requires very complex beta analysis tools for data capturing and analysis. The authors, being students are keeping the process of in-depth analysis out of the scope of this dissertation. However, the authors hereby present forecast reports by money analysis sites pertaining to Ford Motor Company and Tata Motors.
4.6)Forecast of Ford Motors
The chart in figure 11 shows the estimates of Ford Motor Company as on 24th April 2009. The Earning Per Share estimate continues to be in negative in 2010 but the company outlook looks positive as the growth projections are moving in positive direction as can be seen from the EPS trends in past 90 days.
It appears that the 2010 estimates of EPS are gradually moving in the positive direction which is a good sign for Ford Motor Company. Year 2010 may witness a sales growth in positive as indicated herewith. The next five year industry growth is estimated as more than 10% PA although Ford Motor Company may witness 3% growth PA given dismal performance in the past.
Market Analysis of Ford Motor Company
Ford Motor Company EPS may break even in 2011
The EPS estimates by moneycentral.msn.com also predicts similar results projecting Ford EPS to breakeven by end of FY2010
4.6)Forecast of Tata Motors
The Market analysis of Tata Motors is not as in-depth as Ford Motors because they are new to the NYSE. The Beta is also not yet published due to lack of adequate historical data. Hence, the estimates do not show too much of variations as such. For example, the EPS for last 60 days is consistently projected as 0.11 for 2009 and 0.2 for 2010. On the NYSE, the company opened with a huge big bang with PE ratio about 160 but has crashed substantially after that. Tata Motors was one such stock that crashed heavily due to the economic turmoil largely because of lack of information about its systematic risks. However, at a global level and especially in the stock markets of India, they have been performing well. Hence, the overall projection of Tata Motors is presented on a positive side with growth projected at 81.8% next year and overall 10% in the next five years.
Market Analysis of Tata Motor
The figure below presents the CAPM analysis of Tata Motors by Thomson One retrieved from the CBS Library
Please note that Thomson One has not used the data of New York Stock Exchange but rather has used the data of Bombay Stock Exchange. The stocks of Tata Motors in India have been consistently performing with high EPS rating. The overall EPS rating has never gone into negative irrespective of the financial crisis which did hit India as well. Compared to the performance of Tata Motors stocks on the New York Stock Exchange, the performance has been substantially better on their domestic stock exchange in India.
Hence, referring to Michael Porter’s competitive advantages theory (presented earlier), Tata Motors do have sound fundamentals for the future because they are strong in their home country unlike Ford Motor Company that has lost ground in their domestic country as well. Tata Motors EPS from 2008 to 2009, however, reduced drastically as shown in the figure below:
Tata Motors has been consistently ensuring positive EPS against trading at the Bombay Stock Exchange
projection, however, reveals that Tata Motors may reach about 50% of the levels of EPS that it
MSN Money is again very optimistic about the future of Tata Motors in 2010 projecting the growth of EPS to about 28%.
4.7)Cash Flow Analysis
In an old empirical theory, Bodenhorn established the importance of cash flow in valuation of stock. He took three primary factors in analyzing cash flows ‘ cash transactions involving goods and services, financial obligations and cash balances. The transactions of goods and services are recorded as capital expenses and recurring expenses when purchasing them and revenues are recorded if the same are sold against cash transactions.
If a credit is extended, and cash has not been received or disbursed against the transaction as on the date of financial statement, the transactions are recorded in the form of obligations. These obligations include receivables and payables pending as on the date of statement. In the firm’s own obligation, the debt and equity obligations are considered whereby due to uncertainties in the cash flow.
In the world of certainty a company would like to lend all cash balances to earn interest rates. However, the uncertainties always haunt the businesses in many forms and hence they hold cash balances o provide liquidity in crisis situations. Bodenhorn defined an increase in cash balance as ‘purchase of liquidity’ and reduction in cash balance as ‘sale of liquidity’. The management of a firm should project the future cash receivables and payables, subtract payables from receivables to find out the cash flow and then apply the discount level that keeps the present value of the net cash flows greater than zero.
The net cash flows evaluated during the period valuation is the difference between the cash received by the firm from the banks, debtors, customers, etc. and the cash used by the firm to increase the cash balances, make payments for goods/services, pay interests, repay debt, or lend. Bodenhorn established that such flows should be associated with equity obligations
‘ a positive net cash flow representing the cash payments to stockholders by the firm in the form of dividend payments or stock repurchase and a negative cash flow representing the cash payments to the firm by the stockholders in the form of new stock subscription.
Thus, the value of stock is represented by the present value of the future net cash flows which represents the projected wealth of the stock holders during the period in which the present value has been calculated. However, the actual wealth can differ from projected wealth if the cash flow of the period is different from what has been projected, cash flows projections have changed from the ones that were carried out at the beginning of the period, or if the discount rate has changed from the what was assessed at the beginning of the period. What Bodenhorn didn’t explain was the impact of depreciation and amortization on the cash flows.
The Discounted Cash Flow (DCF) is already introduced earlier in this dissertation. Dulman in 1989 presented that Discounted Cash Flow is the sole technique for Capital Budgeting that is adopted by US. However the researchers predicted that the Present Value technique (already introduced earlier) .
The discounted cash flow technique is very useful when the cash flow is expected to be uneven, and the project may not behave like a single duration project. For projects anticipating even flow of cash and exhibiting behavior of project in the mode of a single duration project, the present value technique is more suitable.
The discounted cash flow depends upon the cash flow forecasts (that relate directly to the firm being valued) and the historical systematic risks associated with the firm and its entire industry as determined by market analysts. Hence the discounted cash flow method largely depends upon the accuracy of risk assessments, cash flow projections, and the overall assumptions incorporated in calculating the cost of capital. Hence, this methodology largely depends upon the accuracy of the perceptions by analysts which unfortunately is prone to inherent estimation errors . The industry experts, actually, use comparable firm statistics to make their perceptions as accurate as possible.
This is the primary reason that Net Present Value analysis became more popular for cash flow forecasts because it correlates money with time more effectively and is dependent upon the expected return and interest rate. The investment in a project is feasible if the Net Present Value is greater than zero otherwise it can be a loss making affair.
We shall carry out the future outlook for the next ten years for both the companies. To begin with, we first look at the cash flow statistics of Ford Motor Company from their capital financing activities assuming it to be a single duration project of next ten years
We shall carry out the future outlook for the next ten years for both the companies. To begin with, we first look at the cash flow statistics of Ford Motor Company from their capital financing activities assuming it to be a single duration project of next ten years:
We shall carry out the future outlook for the next ten years for both the companies. To begin with, we first look at the cash flow statistics of Ford Motor Company from their capital financing activities assuming it to be a single duration project of next ten years:
Cash Flow Data of Ford Motor Company with values in Million Dollar
2008 2007 2006 2005
Cash at Beginning
of Period 35283 28896 28391 22806
Cash at End of
Period 22049 35283 28896 28391
Net Change in
Cash and Cash -13234 6387 505 5585
Equivalents
4.8)Capital Structure Analysis
A firm’s capital structure primarily comprises of two components, the Debt and the
Equity. The overall valuation of the firm is a function of these two components of capital structure. The decision of how much a firm should be financed by debt or equities is very complex whereby an optimal choice depends upon many factors specific to the internal and external environment of the firm.
The overall value of the firm is defined by Ross, et al as the sum of the overall market value of equities and the overall market value of debt. Most companies have maximization of shareholder wealth as one of their primary goals. To achieve this, the firm management tries to decide on the most appropriate debt to equity ratio such that the overall value becomes as large as possible ‘ a company may be totally financed by equity or totally by debt or somewhere in between. Managers are accountable to choose the optimal capital structure that they believe will have the highest firm value and shall be most beneficial to the firm stakeholders.
An old theory on Capital Financing developed by Modigilani and Miller is that the cost of the capital of a firm is independent of its dept to equity ratio commonly known as leverage ratio .
Kochar related agency theory with capital structure and argued that agency costs keep a control on the capital structure. If a firm is completely financed by debt and controlled by shareholders, they will tend to take high risks given lower liabilities for maximization of their wealth and hence even may risk the net present value becoming negative.
On the other hand, the managers are bound to take cautious steps to save their jobs and enhance the value of the firm and hence they shall tend to use debts only in case of contingencies. Whether the same is true for this reason or another, it is widely found that firms controlled by shareholders tend to rely more on debt whereas firms controlled by managers rely more on equities.
Sharp argued that it is more to do with optimal agency control rather than optimal capital structure. From his perspective, a practical generalized model of optimal capital structure may not be feasible; however, existence of more equity may indicate more power to the managers as they tend to use debts more for contingencies during crisis situation to mitigate solvency risks.
In a recent theory Brav added a new dimension to debt-equity optimization proving that the sensitivity of the controllers of the firm defines how much they allow equity finance compared to debt finance. Traditionally, debt financing has been considered to be safe but curtailing the growth of the firm. Brav argued that private companies tend to stay away from equity markets and prefer to be more debt financed than equity financed due to high sensitivity to fluctuations in performance. They also argued that the structure of management plays a major role in choosing debt versus equity. Shareholders in family owned businesses that do not like too many fluctuations in performance tend to select debt financing whereas high risk averse managers tend to select equity financing.
O’Brien proved an empirical generalization that firms having higher emphasis on innovations (R&D investments) possess lower debt to equity ratios. This is because Research and Development creates substantial amount of intangible assets that cannot serve as an effective collateral in debt financing and hence do not support high levels of debt. Their research proved that all listed companies investing heavily in R&D tend to be more equity financed than debt financed.
In fact, companies having high initial costs of plant and machineries may also try to avoid debt due to large burden of long term interests. Typical examples may be telecommunications industry where global companies are heavily investing in large infrastructures in developing countries. The recent example of Vodafone taking over Essar in India proves this fact that such global giants are seriously interested in large capital investments in developing countries (Vodafone Annual Report. 2008).
However, most of the big giants in telecom industry (like Vodafone, Essar, Verizon, etc) are largely equity financed as evident from their reports on CNN money. This might be because of two major reasons ‘ the limits set by creditors are much lesser than the overall capital structure of such companies or the company management doesn’t wish to take long term interest rate burden given the huge capital investments in developing countries.
Shareholders and Creditors normally have conflict of interest pertaining to management policies in capital structure. High performing firms that are able to exceed the value of initial capital by adding earnings pay dividends to shareholders from the excess earning over the initial capital. Hence, Shareholders will try to maximize this ‘excess earning’ to get dividend payments as fast as possible.
4.9)Now let us compare the capital structures of both Ford Motor
Company and Tata Motors
Ford Motor Company
Debt to equity ratio of Ford Motor Company
Year 2008 2007 2006 2005
Equity 17311 5628 3465 13442
Debt 154196 168530 171832 153278
Debt to Equity Ratio 8.91 29.94 49.59 11.40
Tata Motors
Debt to equity ratio of Tata Motors
Year 2008 2007 2006 2005
Equity 2630.3 2119.9 1821.5 1293.1
Debt 3193.6 1836.1 823.8 653.3
Debt to Equity Ratio 1.21 0.87 0.45 0.51
Ford Motor Company
The company has been under financial distress for quite some time as it has faced huge bottom line losses in the past. Moreover, the automobile sector doesn’t seem to be promising as has been detailed in the systematic risk assessment in the dissertation. Hence, in such circumstances, the investors in equity have lost their interest in the company equities. Moreover, the company has not paid cash dividends in 2007 and 2008 as reported by CNN Money.
Hence, the company had to bend towards debt financing to run their operating expenses. In fact, the sale of Jaguar and Land Rover again has been used to generate cash to run operations. The company has not invested in new ventures for a long time and has been busy closing manufacturing units and firing people. Hence, the company will not be stuck with large amount of mortgaged assets as such. Hence, overall by choice or by circumstances, the company has been bent towards debt financing.
Tata Motors
Tata Motors have been consistently paying dividends and hence keeping shareholder interests alive. Moreover, they have been busy establishing new plants to meet their commitment of Nano. The development of Nano itself must have forced them to incur heavy expenses in R&D.
Hence, overall the situation for Tata Motors is not in favor of Debt financing given that mortgage charges against such huge plant and machinery equipment plus the long term interest rates may add large burdens on their already ‘not so promising’ fundamentals. But, Purchase of
Jaguar and Land Rover again has happened at more than 20% of their annual revenues which already must have put them into liquidity troubles. Hence, they may end up bending towards debt financing if they undergo financial distress in the near future. Also, interest rates of debt financing from 2006 onwards have not been attractive.
4.10) Different Valuation Methods
In this section we present details of various valuation techniques and their merits under different scenarios of valuation. The valuation of a company is not absolute such that every market expert may arrive at identical results. It depends upon the perceptions of risks, the opportunities that the company can avail, the nature of financials of the company, the overall organizational strategy for running operations and doing business, the time horizon in which the analytics is being carried out, comparison with other companies, etc.
Hence, the valuations largely differs with the purpose of valuation ‘ tax calculations, raise capital from investors, management buyout, parting ways among shareholders, estate planning, merger or acquisition, financial reporting, employee stock holder ship, etc. An industry expert says ‘ ‘Change the question and you change the value of the company’. Example, the valuation is lower for the purpose of parting ways or tax planning but is higher for the purpose of raising additional capital from investors or selling the company.
Hence, the valuations largely differs with the purpose of valuation ‘ tax calculations, raise capital from investors, management buyout, parting ways among shareholders, estate planning, merger or acquisition, financial reporting, employee stock holder ship, etc. An industry expert says ‘ ‘Change the question and you change the value of the company’ . Example, the valuation is lower for the purpose of parting ways or tax planning but is higher for the purpose of raising additional capital from investors or selling the company.
Overview of Valuation Techniques
Dagiliene and Kovaliov carried out an investigation into the correlations between accounting data and company valuation to discover that they are getting more and more distant with the increased complexity of modern valuation techniques. The traditional method of company valuation is to look into the size of earnings. However, in the modern context there are many factors that contribute to the insufficiency of accounting information in deciding the value of a company.
Some of the factors are:’
‘ R&D expenditures: The R&D expenditures directly reduce the size of profit although the company’s overall value might be increasing.
‘ Valuation of intangible assets: A substantial part of intangible assets of a company cannot be accounted for and included in the balanced sheet due to limitations or lack of accounting rules and principles pertaining to them.
‘ Recognition of expenditures: many expenditures like reorganization and restructuring during mergers and acquisitions have many non-quantifiable components (like the efforts of executives, special task forces, etc.) that cannot be taken in the overall valuation. One may like to call them ‘ cost to process an acquisition.
‘ Analysis of profitability factors: Accounting information is static and depends upon history; complex calculations like time value of cash cannot be incorporated in the profitability factors of accounting statements.
External Environment: Legal environment, compliance, technological
developments, industry forecasts, etc. going in the favor of the organization
are also included in the valuation.
There are four broad methodologies of company valuation:’ Asset valuation, Income based valuation, Cash Flow based valuation and Market based valuation. Following are the techniques that are used under these valuation methodologies
(a) Asset Based Valuation:
i. Adjusted Book Value
ii. Book Value
iii. Liquidation Value
iv. Substantial Value
v. Intellectual Property Valuation
(b) Income Based Valuation:
i. Value of Earnings
ii. Value of Dividends
iii. Sales Multiples
iv. Other Miscellaneous Multiples
(c) Cash Flow Based Valuation:
i. Free Cash Flow
ii. Equity Cash Flow
iii. Capital Cash Flow
iv. Net Present Value
v. Economic Value Added
vi. Market Value Added
(d) Market Based Valuation:
i. Dividend Paying Capacity
ii. Price to Earning Ratios
iii. Earning Per Share
iv. Price to Book Value
A) Asset Based Valuation
Asset based approach is also called cost based approach in which the valuation of the company is carried out by accumulating the costs that would be required for replacing or selling off the assets. The fundamental approach to this approach is that an investor would not like to pay the cost price of the asset but would rather like to pay the replacement cost of the asset as per the market valuation.
This approach is not a seller friendly approach because certain assets devaluate in the market very rapidly due to technological changes, currency fluctuations or reduction of inflation. Examples of such assets are computers, cars, mobile phones, etc. However buyers do like this valuation because asset based valuation may end up achieving the lowest value of a company assuming that it is a startup. Some assets like buildings and land do result in larger valuations. The primary advantages of asset based valuation are:
a. Measure of security in valuation of company shares
b. Measure of added value when comparing with other similar firms
c. Measure of the baseline cost of a company before outcomes of other valuations are added
The primary disadvantages of asset based valuation are:
(a) Lack of professional valuation experts that specialize in a particular asset type
(b) Very much speculation driven
(c) Realization of true value of assets is a difficult task
(d) No definite market for assets that can guide on their market valuation ‘ example,
commercial land, buildings, cars, etc. are all driven by availability of interested
buyers which may not happen during the valuation process.
The primary methods of asset valuation are ‘ Book Value, Adjusted Book Value, Liquidation Value and Substantial Value; these values are defined below
Book Value:
Book Value is also called Net Worth. It is defined as the value of shareholders’ equities stated in the balanced sheet that includes capital and reserves. This is purely based on accounting statements and hence is unlikely to be realistic.
Adjusted Book Value:
This is the Book Value on the balanced sheet of a company that includes the values of assets and liabilities adjusted to market values.
Liquidation Value:
The term liquidation is directly related to cash. The liquidation value is thus the immediate cash that can be generated after all assets on the balanced sheet is sold quickly and the debts and liquidation expenses (like layoff compensation to employees, taxes, duties, etc.) are paid off. Such a valuation is carried out to plan for an unforeseen event of bankruptcy.
Substantial Value:
Substantial valuation can be carried out to establish an investment required to form an identical company to the one being valued. It is also called ‘Asset Replacement Valuation’.
Intellectual Property Valuation:
This section shall be presented in considerable depth given the complexity of the subject. Intellectual Property Valuation can result in higher market valuation of a company if the tangibility factor can be assessed, demonstrated, documented and approved by experts. Intangible assets are of two types ‘ Identifiable intangible assets and Unidentifiable intangible assets.
A) Income Based Valuation
Income based earnings are essentially based on the income statements of the firm. The valuation carried out here is based on sales, earnings and such other performance indicators. The primary factors that this valuation technique takes into account are ‘ Status of the Industry, Status of the firm in the said industry, Marketability, Asset backing and liquidity and dividends paid. The primary advantages of asset based valuation are:
(a) Provides perfect information of valuation
(b) Perfect valuation method for the sellers
(c) Value of Dividends is known to the shareholders
(d) Companies consistently paying dividends achieve higher values
(e) Company’s true market standing is visualized in the said industry
Future of the industry (where the company is operating) is also visible
The primary disadvantages of this valuation technique are:
(a) Companies not paying dividends are not necessarily at lower values ‘ it can be due to certain invisible impending factors like terms of the creditors
(b) Companies need to tangibly demonstrate enough profitable projects to claim that they can maintain the dividends (sometimes, companies increase debt to pay outstanding dividends)
(c) Dividend policies can be changed after takeover in case the valuation is carried out for an M&A thus giving wrong picture to the investors
(d) Taxation and Issuance expenses do not get exposed adequately
Value of Earnings:
In this method, the value of the equity is calculated by multiplying the net annual income with the PE ratio (introduced before in this dissertation).
Value of Dividends:
As introduced earlier, dividends are parts of the earnings that are paid out to the shareholders.
Sales Multiple:
In this valuation method, the company’s value is calculated by multiplying its sales by a number. The number is determined by market analysis of an industry and is normally fixed for certain industries in an year
4.11)Cash Flow Based Valuation
This is the most widely used valuation technique from seller’s perspective and normally gives seller friendly results when carried out in conjunction with income based valuations. In fact, given the shear complexity of the methods, the sellers can achieve higher valuation if they play with the numbers smartly.
In this method, the company valuation is carried out first estimating the future cash flows and then discounting the same at a discounted rate commensurate with the risks. There are not too many advantages of this method because it is largely based on speculations and some kind of
‘numbers’ (like market beta, discount rates, etc) that come out very complex systems that are hardly understood by vanilla investors. The primary advantages of cash flow based valuation are:
(a) If done properly, the real underlying picture of the company can be exposed
(b) It is completely seller friendly because the buyer shall hardly have strong arguments against the forecasts. At the most they can increase the discounting rates but will have to justify them.
(c) The method is friendly to accountants who can use the inputs from the accounting statements.
(d) Although outcomes may not be reliable, it is the only conceptually correct valuation method.
The primary disadvantages of this method are:
(a) Largely based on market driven speculations
(b) It is very difficult to select appropriate cost and structure of the Capital
(c) Estimates of future cash flows are largely unreliable when the company is largely equity financed; however it is more reliable when the company is largely debt financed
(d) Not best understood by minority investors
(e) Valuations can be volatile that are subject to market beta fluctuations due to impending factors like interest rate fluctuations, inflation fluctuations, currency conversion fluctuations, etc.
Not reliable to assess return on investment for the investors; hence projects having NPVs marginally above zero should not be considered
The primary techniques for cash flow based valuations are ‘ Free Cash Flow, Capital Cash Flow, Net Present Value, Economic Value Added, and Market Value Added.
Free Cash Flow:
The free cash flow projection of a company is the after tax operating cash flow projection of a company without taking into account the debt. The free cash flow can be used to calculate projections in debt cash flow and equity cash flow. The debt cash flow is very easy to calculate; it is the sum of principal repayments and interest payments. In case of fully debt financed companies (like private firms) the debt’s market value is equal to the book value. The equity cash flow however is complex and is normally treated separately.
Equity Cash Flow:
The equity cash flow projection is normally calculated from given free cash flow and debt cash flow. This is the easiest way of its calculation given its complexity as such. The formula for Equity cash Flow is as presented below:
The cash flow projections assume that the capital structure will remain unchanged during the valuation period. Change in capital structure may change in internal components of the cash flow keeping the overall cash flow projection constant.
Capital Cash Flow: Capital cash flow projection is the sum of the debt cash flow projection and the equity cash flow projection.
Net Present Value: Already introduced earlier
Economic Value Added: Commonly known as EVA, it is presented by the following simple equation:
EVA = Net Operating Profit After Tax (NOPAT) ‘ Weighted Average Cost of Capital (WACC)
Market Value Added (MVA):
The market value added is equal to the market value of the firm
(value of firm’s debt and equity) subtracted by the capital invested in the firm. Essentially, MVA is equivalent to PV for all the future expected EVAs.
D)Market Based Valuation
Market based valuation is an external perspective of valuation of a company. The ratios are already discussed earlier in this dissertation. This valuation technique essentially requires the values to be compared with comparable companies operating in the market.
4.12)Which Valuation methods are most suitable for Ford Motor
Company and Tata Motors?
After carrying out a comprehensive assessments of the popular company valuation techniques and analyzing their advantages and disadvantages, the following conclusions can be drawn:
Ford Motor Company
As we have seen that Ford Motor Company has been largely debt financed in the past. Hence, the cash flow technique shall have minimal errors because debt forecasts are relatively easier due to clarity in their market values.
However, in valuation of Net Present value, the applicable discount rates shall be higher because the company has been doing pretty bad in the past few years and also have not paid dividends in 2007 and 2008. For this reason, the income valuation of Ford Motor company shall fair very badly. It would not be easy to predict the dividend payouts of the company in coming years. The forecasts on EPS have already been predicted earlier in this dissertation which states that Ford Motor Company may break even in 2011 (partially in 2010).
As we have seen that Ford Motor Company has been largely debt financed in the past. Hence, the cash flow technique shall have minimal errors because debt forecasts are relatively easier due to clarity in their market values.
However, in valuation of Net Present value, the applicable discount rates shall be higher because the company has been doing pretty bad in the past few years and also have not paid dividends in 2007 and 2008. For this reason, the income valuation of Ford Motor company shall fair very badly. It would not be easy to predict the dividend payouts of the company in coming years. The forecasts on EPS have already been predicted earlier in this dissertation which states that Ford Motor Company may break even in 2011 .
Tata Motors:
Tata Motors have completely different capital structure compared with Ford Motor Company. They have been largely equity financed in the past four years. Hence, the cash flow analysis for Tata Motors will require more of market valuation of equity than market value of debt thus making the valuation relatively more difficult.
Moreover, Tata Motors is not very old on the NYSE and hence the market largely lacks historical data about them to evaluate correct market beta. Combining data from Bombay Stock Exchange and NYSE is not feasible due to different mode of operations and numerous technical
difficulties. This has been seen in the market valuation of Tata Motors earlier in this dissertation. Hence, arriving at the right discount level for Tata Motors is difficult given these scenarios.
It may be more feasible to carry out Income based valuation of Tata Motors than cash flow based valuation at least in 2009. If cash flow analysis is preferred, they should be discounted at higher rates currently to play safe in their net present value calculations.
Income based valuation of Tata Motors have many positive signs ‘ they have been paying dividends, they have remained profitable in past four years, they have developed a sizeable market capital on NYSE and hence overall, Tata Motors appears to be a good investment opportunity for investors.
However, the investors should be cautious about there current systematic risks ‘ their purchase of Jaguar and Land Rover at a cost that is more than 20% of their net revenues and the recent Singur crisis that reeled them into a $400 million losses and more importantly opportunity losses because they shall be more than an year late in the delivery of Tata Nano .
Conclusion
5.1)Balanced Score Carding of Tata Motors
To conclude the dissertation, following are the outcomes about Ford Motor Company and Tata Motors:
Ford Motor Company:
Ford Motor Company has been the King of innovations in the automobile industry. Ford
R&D and their all time proven innovation of interchangeable parts in moving assembly lines
resulted in phenomenal global expansion for them. They are an old heritage that once ruled
the global automobile markets of the world. In fact some of the most prestigious motor
brands of the world have been owned by Ford Motor Compan
They have witnessed some of the best times in terms of revenues and profitability and enjoy a large customer base even today. However, some of the mistakes like the Ford 2000 initiative caused irreparable damages for which Ford Motor Company is still paying the price and in this context they completely went the wrong way and hence could not withstand Japanese competitors that were quick to grab Ford’s own home market in USA.
As presented earlier in terms of mapping with Michael Porter’s five forces theory, For
Motor Company was badly hit by new entrants in the market. They indulged deep into debt
financing due to financial crisis and hence have today become largely debt financed
company. They had to sell Jaguar and Land Rover companies to Tata Motors to build some
cash which, however are peanuts because bad times are continuing. Moreover, they haven’t
paid dividends for past two years and hence are losing shareholder confidence.
They have not been able to manage their cash flows and have lost substantial cash in 2008 and are rapidly closing extra plant capacities and laying off people to downsize as per their current market standing. We carried out net present value analysis and concluded that to keep NPV positive for next five years for Ford Motor Company is challenging task given that they would be discounted at higher rates. However, the current financial outlook by expert analysts project that they shall break even in 2011.
Tata Motors:
Currently they are at least one year late in meeting commitment of delivery of Tata Nano and hence have already opened room for new entrants in this business which may prove to be disastrous for them. Their financial outlook is appearing to be strong with profits made every year and dividend payments made regularly.
However, their cash flow forecast places them at slightly riskier position even at nominal discount rates although they are bound to be discounted at higher rates for time being due to lesser information available on their market beta analysis. Overall, they are largely equity financed but 2009 needs to be watched closely to analyze changes in their Capital Structure.
One of their major challenges is to meet European safety & emission standards on Tata Nano because they have already failed once in the European market and are not yet known for developing global cars and hence have not yet built a sound global brand equity. Hence, currently they appear to be an overambitious company whereby an effective market campaigning of Tata Nano has brought them at a global platter but it appears that end of the day they may just end up capturing their local Indian market.