Equity valuation and acquisition opportunities at Conglomerato

Conglomerato is a holding company which currently has a significant amount (well over a billion dollars) of cash available to invest in equities. Conglomerato is willing to buy shares of companies, or the entire company itself, depending on how much of a bargain it can get. If need be, it is willing to hold its investments long-term. Conglomerato regularly analyzes and estimates the value of firms (and by extension, fair share price). You are to advise Conglomerato by valuing shares of four firms of interest to Conglomerato. The analysis is based on certain financial ratios, whose details are given helow.

This case has the following simplifications. No firm in this case has any working capital. No firm has any debt. There is zero price inflation. lO% is the appropriate annual discount rate for all cash flows of all firms.

Z-Candy

The first firm of interest is Z-Candy. It has a return on book equity of 40%. (The return on book equity is defined as the ratio of annual earnings, or after-tax income, divided by book equity. (This can be thought of as a profitability measure.)
Z-Candy has annual depreciation of 2% of book equity. (The reciprocal of this can be thought of as measuring the effective lifespan of corporate assets.) Suppose that the 2% number represents depreciation for accounting purposes, depreciation for tax purposes, and actual economic depreciation.

It is common to break up earnings into the "payout ratio" (the fraction paid out to shareholders; for example, dividends) and the "plowback ratio" (the fraction reinvested back into the firm; for example, capital expenditures). Although commonly done. this is not necessarily sensible since earnings are not necessarily cash flow. Consider instead operating cash flow (earnings with depreciation "added back-, and appropriately adjusted for working capital). Although Z-Candy is quite profitable (as measured by its return on book equity), it has few reinvestment opportunities: it only reinvests 10% of its operating cash flow back into the firm in the form of capital expenditures. The remaining 90% ("free cash How") is paid out to shareholders.

7-Candy has (as of the end of last year, which just concluded) $1000 million (or $1 billion) in book equity, and 200 million shares outstanding.

Koka Kola

The second firm of interest is Koka Kola (a soft drink maker). Its return on book equity is 27%. Its depreciation is 3% of book equity. 30% of operating cash flow is reinvested into the firm (in the form of capital expenditures). Koka Kola has $20 billion book value of equity (as of the end of last year), and 2.2 billion shares outstanding.

The third firm of interest is Missouri Pacific Railway. Its return on book equity is 15%. Its depreciation is 10% of book equity. 60% of operating cash flow is reinvested into the firm (in the form of capital expenditures). Missouri Pacific has $20 billion book value of equity (as of the end of last year), and 500 million shares outstanding.

BHO

The fourth firm of interest is 13110, a clothier. Its return on book equity is 8%. Its depreciation is 4% of book equity. 85% of operating cash flow is reinvested into the firm (in the form of capital expenditures). 131-10 has $500 million book value of equity (as of the end of last year), and 10 million shares outstanding.

Issues to consider:

I. For this year, for Z-Candy: What are its expected earnings? operating cash flow? reinvestment (capital expenditures)? At this year's end, what will be its book equity? How much will Z-Candy pay to its shareholders this year?

For next year. for 1-Candy: What arc the corresponding dollar amounts (earnings, operating cash flow, reinvestment, year-end book equity, payout to shareholders)?

What is a fair value (today) for Z-Candy (the firm)? What is a fair share price for Z-Candy? What is then its price/earnings ratio?

If Conglomcrato bought the entirety of Z-Candy today, what is the most they should pay?

2. What is Koka Kola's fair share price? What is its price/earnings ratio?

3. What is Missouri Pacific's fair share price? What is its price/earnings ratio?

4. What is 131-10's fair share price? (Assume this number is also its current market price.) What is its price/earnings ratio?

For this year. what does BI-10 earn? How much does 131-10 re-invest (capital expenditures)? What fraction of earnings are reinvested, and does this make sense?

Suppose that capital expenditures at 13110 were lowered (from 85%) to 80% of operating cash flow. What should that do to the growth rate and value of 131.10?