CSL Limited and Cochlear Ltd. Case study report

The purpose of this report is to guide the clients of G.S. Klyne, in making investment decisions. The clients are interested in the Australian Biotechnology sector and have asked us to do a comparative study between two companies. The two companies’ understudies are CSL Ltd and Cochlear Ltd. Both companies are listed on the Australian stock exchange. In order to accomplish the projects along the stated lines, a top-down approach is used. In this, we studied the present condition of the Australian economy and the sector in which the company is present. Further, we analyze the Balance Sheets and P/L Account of both the companies over the period and estimate future Balance sheet and profit and loss statement. For this detailed research about the company is done. Apart from the Percentage of Sales method, past ratios and assumptions are also used to forecast future financials. Trends analysis of all the items in the profit & loss statement and balance sheet is done to give us any indication of the future potential. These notes to accounts have been studied in detail to know the impact of these items in estimating the intrinsic value of the share. A lot of assumptions have been taken into consideration for doing the analysis.
After that risk analysis is done for both the companies. This helps us understand what necessary steps has the company taken to handle adverse scenarios and cases. For e.g.  Has the company kept sufficient reserves to handle a recessionary situation that occurred last year? Accounting analysis and adjustment of journal entries help us to find out the adjustments which the company has made. These adjustments have been thoroughly examined and deciphered so that it gives us a clear picture of what this entry actually leads too. Then Discounted Cash Flow valuation method is used to determine the free cash flow. Various variables like cost of equity, cost of debt, beta, etc are determined to calculate WACC. Finally, we find out the intrinsic value of the share. Based on the DCF valuation method used we found out the Intrinsic value of Cochlear Limited to be 71 AUD and for CSL to be 33.75. Both stocks are trading around their intrinsic values on 11th May 2010. Based on accounting analysis and ratios it was found that CSL’s ratio was better as compared to Cochlear. The company’s fundamentals are strong and are also financially well managed. Trend analysis also gives us a positive picture of the company. So we would suggest our clients invest in CSL Ltd.
Introduction

From an investor’s perspective, a company must generate returns that not only allow it to stay in business but also give its investors an adequate reward for their investment. Any long term and thoughtful investment decision should be preceded by a thorough study and research about the prospective company. So to find out the right investment option proper valuation of the company needs to be done which will lead to better returns.
Valuation
Valuation is the estimation of an asset’s value based either on variables perceived to be related to future investment returns or on comparisons with similar assets. Skill in valuation is one very important element of success in investing. The valuation of a business is not as simple as someone buying the business for an amount equal to its net worth. Business valuation usually takes into account the net worth reported in its balance sheet, but many other factors play a role in putting a value on a business.
Valuation process
We have seen that the valuation of a particular company is a task within the context of the portfolio management process. Each individual valuation that an analyst undertakes can be viewed as a process with the following five steps: Understanding the business: This involves evaluating industry prospects, competitive position, and corporate strategies. Analysts use this information together with financial statement analysis to forecast performance.  Forecasting company performance: Forecasts of sales, earnings, and financial position (pro forma analysis) are the immediate inputs to estimating value. Selecting the appropriate valuation model. Converting forecasts to a valuation.
Making an investment decision (recommendation).
Analysts may consider qualitative as well as quantitative factors in financial forecasting and valuation. For example, some analysts may modify their overall valuation judgments and recommendations based on qualitative factors. These may include the analyst’s viewpoint on the business acumen and integrity of management as well as the transparency and quality of a company’s accounting practices. Although analysts may attempt to reflect the expected direction of such considerations in their financial forecasts or to otherwise quantify such factors, no formal valuation expression can fully capture these factors.” Equity analysts study financial results and disclosures for information bearing on the company’s current and future ability to create economic value.
Investment analysts play a critical role in collecting, organizing, analyzing, and communicating corporate information, and in recommending appropriate investment actions based on sound analysis.
Some analysts use discounted cash flow models to value firms, while others use multiples such as the price-earnings and price-book value ratios. Since investors using this approach hold a large number of ‘undervalued’ stocks in their portfolios, their hope is that, on average, these portfolios will do better than the market. (Investopedia 2010)
Discounted cash flows
In a famous article Pearson Hunt came back from a visit to Ireland with Professor Finagle’s three laws of information:
1) The information we have is not what we want,
2) The information we want is not what we need,
3) The information we need is not available.
Professor Hunt discusses Finagle’s laws in the context of what investment analysts want from a firm’s financial statements. What they have are the financial statements with “accounting earnings” the bottom line. However, what analysts need for their valuations are not accounting earnings, but cash flow, the actual cash generated from the firm’s operations.
Discounted cash flow tries to work out the value of a company today, based on Projections of how much money it’s going to make in the future. In discounted cash flows valuation, the value of an asset is the present value of the expected cash flows on the asset, discounted back at a rate that reflects the riskiness of these cash flows. Target prices (from which recommendations are derived) are based on the sum of the present value of future earnings based on a discount rate incorporating an equity risk premium. This approach comes with the best theoretical credentials.
There are several tried and true approaches to discounted cash flow analysis, including the dividend discount model (DDM) approach and the cash flow to a firm approach. We will use the free cash flow to equity approach to determine the “fair value” of companies.
Steps in DCF valuation

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Determine Free Cashflow

Free cash flow is the cash flow available to all investors in the company – both shareholders and bondholders after consideration for taxes, capital expenditure, and working capital investment.
Free cash flow = NOPAT + Depreciation – Capital Expenditure – (+) Increases
(Decreases) in Working Capital Investment
Where NOPAT = Net Operating Profit after tax = Earnings before Interest But    after Taxes = EBIT (1- Tax rate)
 EBIT = Revenue – the cost of goods sold – operating expenses – depreciation

Estimate a suitable discount rate for the project

The discount rate should reflect the capital structure of the project. To calculate the discount rate:

 Find out the cost of equity

Cost of Equity (Re) = Rf + Beta (Rm-Rf).
Where
Rf – Risk-Free Rate (This is the amount obtained from investing in securities considered free from credit risk, such as government bonds)
Beta – Co-variance (SENSEX return, Stock return)/ Variance (SENSEX return)
This measures how much a company’s share price moves against the market as a whole
Rm – The returns investors expect, over and above the risk-free rate.

Cost of Debt

The cost of debt (Rd) should be the current market rate the company is paying on its debt.

WACC

WACC is the weighted average of costs of debt and equity, the weights being a target, market value debt-to-value and equity-to-value ratios respectively
WACC= Re x E/V + Rd x (1 – corporate tax rate) x D/V.
Where V- Value of firm      E- Equity value         D-Debt value

Calculate the present value of cash flows

Discount the free cash flows using the WACC calculated to get the present value of cash flows.

 Estimate the terminal Value

The terminal value is the present value of cash flows occurring after the forecast period. If we assume that cash flows grow at a constant rate after the forecast period, the terminal value
T.V = [CFt (1+g)] / kg
Where CFt  = cash flow in the last year
            g = constant growth rate
            k = discount rate
·         Add the present value of terminal value
Value of the firm = Present value of future cash flows + Present value of Terminal value
So DCF gives us the Intrinsic Value (real value) of the stock and helps investors in deciding about their investments. (Palepu, Healy, Bernard 2004)
Cochlear limited
Cochlear Limited (Cochlear) operates in the implantable hearing device industry. Its products include a cochlear implant system, Baha system, freedom accessories, speech processor upgrades, and nucleus freedom implant. Nucleus Freedom is the next generation of Cochlear’s technology, including SmartSound 2, which brings clarity to everyday hearing. Its bone conduction implant, the Baha system, helps people with conductive hearing loss, mixed hearing loss, as well as Single Sided Deafness (SSD). The Company has also introduced Nucleus Freedom speech processor technology to all of its Nucleus implant recipients. Cochlear’s Nucleus Freedom implant with Contour Advance electrode and Nucleus Freedom implant with Straight electrode features an electronics platform with a microchip. During the fiscal year ended June 30, 2009, Cochlear acquired Percutis AB, a Swedish company. ( Cochlear official website (2010))
INTRINSIC VALUE
DCF methodology was used to calculate the intrinsic value of the company’s share. Initially, trends were studied of the net operating profit after tax, and then forecasting was done by taking the average of the trends. Then free cash flow to the firm was calculated using the above-explained DCF methodology. (Reuters 2010)
Assumptions

The trend of operating profit has been found out and then the average of it has been taken to forecast future operating profits. In this case, we have found out the average to be 15%.
An increase in capital expenditure has been taken to be 500,000 AUD per year. Even this has been the trend of the last four years.
 The market premium has been taken to be 5.8% which is the average of the last 100 years.
Long term growth has been assumed to be 3.5%. This has been found out taking into consideration the life cycle in which the company is currently present and the sector outlook for the future.

The table below shows the weighted average cost of capital calculations. Risk-free return is got from the yield on 10-year bonds issued by the Australian government. Beta is taken from the Reuters database and market premium is found out by taking average returns for the past years. The cost of debt has been calculated from the interest charges paid by the company divided by the total debt.
COH: WACC Calculation
 

Particulars
%

Risk-Free Return (Rf)
5.4

Market Premium (Rm)
5.8

Calculated Beta
0.64

Cost of Equity (Re)
6.936

Cost of Debt (Pre-tax) %
9

Debt /Equity
0.5178

WACC
1.053

CSL : DCF Calculation
 

Particulars
Rs. Cr

The present value of the explicit phase
630240.8

Terminal value
15599168

Terminal growth rate
3.50%

 

The present value of the terminal value
13361580

(A+B) Total present value
189036.3

Net debt
7244965

Equity Value
6746856

Shares(cr)
95000

Implied DCF value per share (Rs)
71.01954

We arrive at an intrinsic value of 71 AUD. Currently, the stock is trading around 72 AUD which suggests that the markets reflect the correct value of the stock. Data from the income statements and balance sheets were used to arrive at this value.
 

Income Statement
Revenue
Cost of sales
Gross profit
Other income
Selling and general expenses
Administration expenses
Research and development expenses
Results from operating activities
Net finance income/(expense)
Profit before income tax
Income tax expense
NET PROFIT

2009
$000’s
694,699
-196,244
498,455
3,081
-185,23
-44,979
-96,682
174,645
1,623
176,268
-45,728
130,54

2008
$000’s
601,725
-169,013
432,712
2,51
-156,487
-36,092
-80,017
162,626
-5,909
156,717
-41,483
115,234

2007
$000’s
559,412
-161,334
398,078
1,133
-141,046
-38,635
-65,949
153,581
-10,1
143,481
-45,805
97,676

2006
$000’s
452,26
-130,962
321,298
884
-124,808
-29,951
-58,926
108,497
338
108,835
-30,61
78,225

 
 

Balance Sheet
Cash and cash equivalents
Trade and other receivables
Inventories
Current tax receivables
Prepayments
Total current assets
Trade and other receivables
Other financial assets
Property, plant, and equipment
Intangible assets

2009
$000’s
80,016
173,256
105,944
3,898
8,205
371,319
31,086
0
46,794
208,275

2008
$000’s
36,687
173,266
99,169
4,157
8,817
322,096
15,963
0
43,219
208,959

2007
$000’s
83,382
143,076
91,89
0
5,39
323,738
6,178
477
40,565
196,268

2006
$000’s
87,073
109,388
76,822
0
5,92
279,203
0
383
30,833
205,238

 

Deferred tax assets
Total non-current assets
TOTAL ASSETS
Trade and other payables
Loans and borrowings
Current tax liabilities
Provisions
Deferred revenue
Total current liabilities
Trade and other payables
Loans and borrowings

2009
21,899
308,054
679,373
64,881
0
5,362
32,222
14,678
117,143
56
188,583

2008
17,679
285,82
607,916
60,83
15,438
2,803
31,516
14,358
124,945
0
154,545

2007
18,511
261,999
585,737
61,923
161,337
7,997
30,953
17,338
279,548
0
37,552

2006
30,267
266,721
545,924
57,345
70,547
24,981
27,058
23,525
203,456
0
125,493

 
 The following are the analysis based on the ratios

There has been no increase in the Gross profit margin. This might mean that either the sales have not increased or costs have increased. The company needs to seriously work on it and find out the reason for it. If its due to a higher cost then it has to reduce its operating cost and if its due to reduced sales then increases the marketing budget.
 There has been a reduction in the net profit margin. This is not a good sign for the company. It might be due to stagnant sales or improper tax planning.
Current Ratio has increased steadily. This leads to an increase in current assets. In the short term, the company is good at handling its operations. This internally affects the net working capital required by the company. This affects the valuation calculation.
 Average receivables haven’t changed significantly. This means that the company is getting the cash from the customers at the same rate as it was used to getting earlier. This leads to poor cash management. Due to this, the company might be required to take additional loans from outside parties leading to the increased cost of capital.
   Inventory turnover had reduced and now it has reached back to the condition what it was 4 years before. The company needs to work on it because higher inventory turnover will mean the goods are moving at a faster rate. The company needs to work on its demand forecasting methods so that only optimum inventory can be kept and this will lead to lower inventory carrying costs.
 The debt to equity ratio is at an optimum level. This means the company is looking for expansion. This is a good sign as the money will get invested in projects and they might generate higher returns leading to better profitability.

Conclusion
So with the help of financial analysis and valuation approach, we come to the conclusion that it will be good for the clients to invest in CSL ltd. The company has better financials based on accounting analysis and ratio analysis. It is currently trading at par with the intrinsic value. If the macroeconomic environment changes it will boost the company’s performance and will generate good returns for the investors.
References

Palepu, Healy, Bernard. (2004) Business Analysis; Valuation, Cengage Learning
Chanda, P. (2008). Risk and Return. Financial Management, Tata McGraw Hill
Cochlear official website (2010), About us (http://www.cochlear.com/) [accessed 11th May 2010]
 CSL Limited official website (2010), About us (http://www.csl.com.au/) [accessed 11th May 2010]
Ninemsn (2010), News and analysis-bond prices (http://money.ninemsn.com.au/news-and-analysis/bond-prices.aspx) [accessed 11th May 2010]
Finfacts Ireland (2010), Australian market returns (http://www.finfacts.ie/Private/curency/historicalstocksreturnsperformance.htm) [accessed 11th May 2010]
 Investopedia (2010), Fundamental Analysis (http://www.investopedia.com) [accessed 11th May 2010]
Reuters Money (2010), Company Profile, (http://in.reuters.com/money/quotes/companyProfile?symbol=CSL.AX), [accessed 12th May 2010]
 Reuters Finance(2010), Company Profile, (http://www.reuters.com/finance/stocks/companyProfile?symbol=CSL.AX), [accessed 12th May 2010]
 Reuters Money (2010), Company Profile, (http://in.reuters.com/money/quotes/companyProfile?symbol=COH.AX), [accessed 12th May 2010]
Reuters Finance(2010), Company Profile, (http://www.reuters.com/finance/stocks/companyProfile?symbol=COH.AX), [accessed 12th May 2010].

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