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William Valentine is a junior analyst for Morganfield Trust, a regional brokerage firm based in Toronto, Canada. Valentine has recently been assigned to initiate coverage on Laboutin Group, a publicly traded company on the Toronto Stock Exchange with financial statements expressed in Canadian currency (CDN$). Laboutin owns two businesses that include a property & casualty (P&C) insurer and an energy firm that owns a fleet of deep-sea drilling rigs.Before Valentine starts his analysis, Sarah Norman, Chief Equity Analyst and Valentine's boss, explains to him the different equity valuation and security selection approaches. Valentine makes the following conclusions based on his understanding of Norman's explanations:Conclusion 1: A company’s sustainable growth rate assumes growth through internally generated funds, and it approximates the average rate at which dividends can grow over a long horizon.Conclusion 2: Both free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) are impacted by changes in the firm’s financial leverage.Conclusion 3: For an active security selection to be consistently successful and achieve positive alphas, the analyst must combine accurate forecasts with an appropriate valuation model. Further, her expectations must differ from consensus expectations and be, on average, correct as well.Valentine begins his research for valuing Laboutin by looking at its two separate business units. He determines that the P&C insurer business has an industry-leading return on equity (ROE) and holds the largest market share in Canada. However, he finds that the energy operations business is in a less advantageous position, but Laboutin’s management is considering the acquisition of a rival firm, Frontier Energy Co., to improve its competitive edge. The rival is privately held with no publicly traded common equity. The founder owns 100% of the business, and his asking price is $100 million for the entire company. Valentine believes that if Laboutin pursues this acquisition, it should consider adjustments for such factors as control premium, liquidity, and lack of marketability, as appropriate, in order to negotiate a lower and more appealing purchase price.Valentine compiles the data in Exhibit 1 to conduct a P/E analysis to assess Laboutin’s stock by comparing its justified (fundamental) P/E and trailing P/E ratios. Next, Valentine sets out to determine the stock’s predicted P/E applying the data in Exhibit 1 to a crosssectional regression equation that was estimated for a group of stocks with characteristics similar to Laboutin. The estimated regression is as follows:Predicted P/E = 5.65 + (6.25 × DPR) – (0.70 × β) + (15.48 × DGR), where DPR is the dividend payout ratio and DGR is the expected dividend growth rate.Upon reviewing Valentine’s P/E analysis, Norman makes the following two suggestions to Valentine:1. The P/E analysis by itself is incomplete, and you should consider the free cash flow to equity model to evaluate Laboutin’s stock. The company fits the constant growth assumptions, and you should use the firm’s sustainable growth rate as a proxy for the constant growth rate.2. Review Laboutin’s financial statements and footnotes to ensure its earnings are of high quality. Per Norman’s suggestion (2) above, Valentine reads through Laboutin’s financial statements and accompanying notes and makes the following three notes:Note 1: Given the increased volatility of capital markets and to be prudent, it has been decided to increase the discount rate for pension liabilities by 150 basis points.Note 2: The depreciation period on Laboutin’s capital equipment is significantly shorter than that of its competitors.Note 3: Laboutin has had a number of material non-audit services performed by a consulting firm that recently went bankrupt. |
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