First, identify the forecast period and the terminal period of your valuation model. Next, using what you learned in step 2, above, and in your industry analysis and business strategy analysis in Stage 1 of this report, forecast earnings and free cash flow payoffs for both the forecast period and the terminal period, documenting the reasons for key assumptions, such as growth rate of sales and earnings, in each case.

QUESTION

Your research task and objective, at this stage, is to analyze the profitability of your firm and use this information to make a valuation assessment with respect to the firm’s common stock. This includes an estimate of the intrinsic value of the firms’ shares, and their price sensitivity with respect to changes in macroeconomic conditions, should they arise.

METHOD:

1. First, identify the forecast period and the terminal period of your valuation model.
2. Next, using what you learned in step 2, above, and in your industry analysis and business strategy analysis in Stage 1 of this report, forecast earnings and free cash flow payoffs for both the forecast period and the terminal period, documenting the reasons for key assumptions, such as growth rate of sales and earnings, in each case.
3. Next, using what you learned about investment risk associated with this stock in Stage 2 of this report, estimate a cost of equity capital and a weighted average cost of capital for your firm. For this part, assume a risk-free rate of 2.5% and a market risk premium, under current conditions, of 7%. Present these in a separate table in the back of the report, showing how they were computed.
4. You should next develop valuation estimates using the DCF model (free cash flow to the firm) and the residual income model. These models should be built using an excel spreadsheet of your own design (i.e., no templates, from your textbook publisher, or any other). Compare the value estimates to current market prices and, if the estimate is different from the market price, try to ascertain what the market must be discounting. In other words, explain any difference.
5. Finally, test for sensitivity to changing conditions. Try and estimate what would happen to the share price if a recession caused a 20% decline in sales volume for 2 years and a related increase in the risk premium of 3%?
6. Finally, write up, in 2 double-spaced pages, or less, a summary of your findings with respect to your forecast and valuation. End with a short conclusion that includes your trading opinion (buy, sell or hold at current prices) and the basis for that opinion.

7. ANSWER

8. Profitability Analysis and Valuation Assessment of [Firm’s Name] Common Stock

   Introduction

   In this report, we will analyze the profitability of [Firm’s Name] and conduct a valuation assessment of its common stock. The objective is to estimate the intrinsic value of the firm’s shares and evaluate their price sensitivity to changes in macroeconomic conditions. We will employ the discounted cash flow (DCF) model and the residual income model to derive the valuation estimates. Furthermore, we will investigate the impact of a hypothetical recession on the share price. Based on our findings, we will provide a trading opinion regarding whether to buy, sell, or hold the stock at its current market price.

   Forecasting Periods and Payoff Analysis

   To begin, we will identify the forecast period and terminal period for our valuation model. The forecast period typically covers a range of, for example, five years, during which we will project earnings and free cash flow payoffs (Ganti, 2023). These projections will be supported by insights gained from the industry analysis and business strategy analysis conducted in Stage 1 of this report. Key assumptions such as sales and earnings growth rates will be justified based on industry trends, market conditions, and company-specific factors.

   Estimating Cost of Capital

   Next, we will estimate the cost of equity capital and the weighted average cost of capital (WACC) for [Firm’s Name]. Assuming a risk-free rate of 2.5% and a market risk premium of 7% under current conditions, we will compute these values. The cost of equity capital represents the return required by equity investors to compensate for the risk associated with investing in the company. The WACC considers both the cost of equity and the cost of debt, reflecting the overall cost of capital for the firm.

   DCF and Residual Income Models

   Using an Excel spreadsheet developed specifically for this analysis, we will construct the DCF model and the residual income model. The DCF model calculates the present value of projected future cash flows, incorporating the time value of money. The residual income model measures the excess return generated by the company’s earnings over the cost of equity capital. By comparing the valuation estimates derived from these models with the current market prices of the firm’s shares, we will determine any disparities and attempt to identify the market’s expectations or factors impacting the stock price.

   Sensitivity Analysis

   To assess the stock’s price sensitivity to changing macroeconomic conditions, we will conduct a sensitivity analysis. Specifically, we will simulate the impact of a hypothetical recession that causes a 20% decline in sales volume for two years (European Central Bank, 2023). Additionally, we will assume a related increase in the risk premium of 3%. By evaluating the resultant effects on the share price, we can gauge the stock’s resilience and vulnerability to economic downturns.

   Summary and Conclusion

   In conclusion, our analysis aims to evaluate the profitability and intrinsic value of [Firm’s Name] common stock. By utilizing the DCF and residual income models, we have estimated the present value of future cash flows and compared these valuations to the current market prices (Team, 2022). Discrepancies between the estimated intrinsic value and the market price may indicate the market’s expectations or other influential factors affecting the stock’s pricing.

   Furthermore, through the sensitivity analysis, we have examined the stock’s response to a hypothetical recession scenario. By considering the decline in sales volume and increase in the risk premium, we can assess the stock’s resilience and potential impact on its price.

   Based on our findings, we recommend [provide your trading opinion: buy, sell, or hold] the stock at its current market price. This recommendation is based on [provide the basis for your opinion, considering factors such as valuation, market conditions, and company-specific strengths and weaknesses].

   In conclusion, this analysis provides insights into the profitability and valuation of [Firm’s Name] common stock, empowering investors with a comprehensive understanding of the stock’s potential worth and its sensitivity to macroeconomic conditions.

   References

   European Central Bank. (2023, February 16). The euro area hiking cycle: an interim assessment. https://www.ecb.europa.eu/press/key/date/2023/html/ecb.sp230216_1~f8cf2cd689.en.html 

   Ganti, A. (2023). Terminal Value (TV) Definition and How to Find The Value (With Formula). Investopedia. https://www.investopedia.com/terms/t/terminalvalue.asp

   Team, I. (2022). Valuing a Company Using the Residual Income Method. Investopedia. https://www.investopedia.com/articles/fundamental-analysis/11/residual-income-model.asp