Assume that you are an equity analyst and you have been asked to generate a twelve month forward price target for ShopSmart Plc, a retail company. You decide to use the discounted Free Cash Flow to Firm (FCFF) valuation model. For the year just ended you have collected the following information on ShopSmart PLC:
Net Income: £260 m
Sales: £2,600 m
Depreciation: £100 m
Investment in fixed capital: £180 m
Interest expense: £110 m
The working capital has increased from £55m at the beginning of the year to £95m at the year-end
Effective tax rate: 30%
Current market value of the outstanding debt: £1,800 m
Number of shares outstanding: 10 m
Current P/E (price-to-earnings): 25
The company’s target capital structure is 30% debt, and 70% equity.
Before-tax cost of debt: 6%
Risk free rate: 5%
Market risk premium: 5%
The stock’s beta: 1.3
You forecast that the FCFF and Net Income will grow at 7% per annum over the next three years. Due to uncertainty beyond this three-year forecast horizon, you decide to estimate the terminal value (at the forecast horizon) by using the sector’s historic-average EV/Sales (Enterprise Value-to-Sales) multiple of 4. You also forecast that future years’ net profit margin will remain constant, and will be equal to the margin of the year just ended.
Reminder of the FCFF formula:
FCFF = Net Income + Net Noncash Charges + Interest Expense x (1- tax rate) – Fixed Capital Investment – Working Capital Investment
Required:
Generate the twelve month forward price target for ShopSmart Plc using the FCFF valuation approach, and state and justify your investment recommendation for the stock. Please show your workings.