Valuation methods using residual income-model


British American tobacco is one of the world's leading tobacco companies, engaged in selling cigarettes and other tobacco products in more than 180 countries. It has a portfolio of almost 300 brands with some key international drive brands including Dunhill, Kent, Lucky Strike, and Pall Mall. BAT has close 42% stake in Reynolds American group, leading US Tobacco Company and around 32% stake in ITC, India's leading cigarette manufacturer.

Summary of Valuation

By using the Residual Income model we estimate a final equity value of £53,156 million. Our twelve months target share price is set at £28.12, In order to support our estimates we have also used a Discounted Cash Flow model, which yielded a value of £53,571 million. The estimations derived from both the models reflect our favourable view towards the operating conditions in the global tobacco industry and our optimism regarding the sustainability of BAT's competitive advantages.

The results from both the valuation methods lead in the mispricing of the stock, whereas the difference between the actual performance and the estimated value of the company is extremely difficult to identify. Further to this, any assumption about the firm should be limited to the fact and not to the actual level of mispricing.

Residual Income-model

Our core Residual Income assumptions are a cost of equity of 10.8% (incorporating a beta of 0.615, adjusted towards the unit, risk-free rate of 4.7% and a equity risk premium equal to 10%), company's growth rate of 9.10% (incorporating the historical average growth rate of Annual Earnings 4.14%, the consensus analysts forecast 8.00%, the implied growth rate 9.72% and ROE*retention rate 14.56%). The terminal value of the company is estimated at £65,072 mil.

Discounted Cash Flow (DCF)

Our core DCF assumptions are a WACC of 7.25% (incorporating a beta of 0.615, cost of equity of 10.8%, cost of debt 6.51%, a tax rate of 31.26% and Debt / Total value ratio of 56.06%), Terminal FCF Growth equal to 2.41%. The terminal value of the company is estimated at £56,764 millions.

Principal risks of our target price not being achieved:

  • Possible overpayment for the recent acquisitions
  • Sterling strengthening
  • Regulatory pressure (especially US and potentially UK)
  • Increased competition
  • Smuggling
  • Increasing demand elasticity of price due to structural changes
  • Failure of the company to reduce its costs
  • Failure of company's drive brand strategy
  • Diminishing trading volumes due to economic deterioration
  • Red flags (see appendix)

Factors contributing in growth projections

New Perspectives

In July 2008, BAT acquired Skandinavisk Tobakskompagni, a snus[1] maker which is expected to give BAT a strong competitive advantage in a fast growing industry segment.

Smoking bans in public places and increasing health consciousness, although damaging tobacco companies' revenues, also create new opportunities for expansion. BAT appears to be well prepared since it has already taken various initiatives and the acquisition of SkT will probably underpin a leading position for the company in the market.

We believe that the increasing popularity of smokeless tobacco is due to the increasing health consciousness. Nevertheless, no consensus has been achieved on this topic and subsequent health studies may refute this argument. Moreover, snus consumption is currently prohibited in many EU countries and there is no formal proposal for amending the legislation.

Increased Burden

EU agreed on the introduction of a new set of tobacco taxes, starting in 2014 and BAT will found itself under pressure since Europe constitutes its most profitable market.

However we do not expect any further tax increase since it is a double edged sword for governments. It may increase revenues and contribute to the anti-tobacco campaign but at the same time impels individuals to consume illegal products, resulting in revenue losses. The EU should take into consideration tobacco's price elasticity, the revenue loss from Smuggling and Cross border trading before deciding any further increase.

Does the future look ominous?

Mr. Burnham's statements, Secretary of State for Health, painted a bleak picture of the tobacco industry future as he revealed last month that his agenda includes plans to reduce the number of smokers in UK by 2020. What is expected to have the most impact is Government's intention to introduce plain packaging. BAT will have to revise its whole marketing policy and such a restructure will entail short-term sales reduction and restructuring expenditures, as well as the need of devising new ways of product promotion.

A further implication, which threatens the long run profitability of the company, is the encouragement of illicit tobacco trade as it would be remarkably easier to copy the original products

We would prefer to adopt a more balanced approach to the issue. Before any law come into force, any prediction would be casual. Similar laws were considered in Canada some years before but were abandoned. Firstly, there is no formal evidence that such a policy will influence smoking habits. On the contrary, some argue that price will be the only distinctive characteristic of tobacco products causing adults to turn to cheaper or illegal cigarettes. The government already loses tax revenues from illicit trade and we cannot be persuaded that the Prime Minister would choose such a policy right now.

Not Seeing Much of a Change

In August 2009, the company announced the appointment of Richard Burrows as BAT's Chairman. The choice caused eyebrows to raise and group's shares to fall by 1.6% upon the announcement due to his bleak past with the Bank of Ireland.

The choice may have both advocators and dissenters but the market seems to have accepted the choice. During the last three months the share price has gained more than 15%.

Mr Burrows is undoubtedly an experienced man and BAT proved especially resilient during the recent crises, overall we do not expect him to add value to the Group but we would be surprised if he destroyed.

Damaging Reputation

A recently published paper, by academics of Bath and Edinburgh University, revealed that British American Tobacco was engaged in lobbying activities during the 1990's trying to intervening in the development of the EU's impact assessment system.

The news harm BAT's reputation, however what is not clear yet is the extent to which this is going to affect its share price. If litigation arises, prices will be forced to a reduction. However, litigations are not a rare phenomenon for tobacco industries and investors seem to be immune. The probability of legal actions against British American Tobacco, the time horizon of such a venture and the validity of the above research will determine the extent of the damage. With our attention being focused on the short run, we do not expect any substantial adverse implications for investors.

Ethical Considerations

In January, the Norwegian Government announced that it has already excluded 17 tobacco companies from its Government Pension Fund, as they are considered to violate the fund's ethical commitments. The above decision deprived British American Tobacco one of its biggest shareholders, as the Norges Bank held almost 1.3% of BAT's shares. However, a powerful investor like this, with strong ethical and social considerations, might not be as useful as it seems and especially to a tobacco company.

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