Valuation of fin ist ass 4 PDF

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A. Introduction The primary purpose of this assignment is to illustrate the ability to prepare the valuation of a large financial institution, including methods of Dividend Discount Model (DDM) valuation, Comparative Valuation, and Excess Return Model (ERM) Valuation. According to Aswath Damodaran, the valuation of financial service firms is difficult from the standpoint of cash flow and regulatory issues. The first reclines in the difficulty estimating the cash flows to the firm, since “items like capital expenditures, working capital and debt are not clearly defined (2009)”. The second is that most financial service companies operate under strict policy that regulates the capitalization, limits the investment strategy and determines how fast they can grow on of the usage of FCFF (2009). Thereby, analysts may find DD and ER models to be more handy than the DCF models in valuation of an Investment Bank, Brokerage or a large Hedge Fund companies, which BlackRock (NYSE:BLK), the investment management firm with the largest amount of assets under management as of now, most definitely is (BlackRock Inc Corporate Profile, 2018);the relative valuation of a company based on the utilization of different metrics of BlackRock and its closest competition, including, but not limited to State Street Corp (NYSE:STT)., JPMorgan Chase Co. (NYSE:JPM), Invesco Ltd. (NYSE:IVZ), and Goldman Sachs (NYSE:GS)1 is then supposed to bring more precise results (Damodaran, 2011). Valuation, regarded as a strategy is especially crucial in corporate finance whether it is the study of market efficiency, analysis of stock returns, or evaluation of different investments in process of capital budgeting (Damodaran, 2011). With this being noticed, the several methods mentioned above will be utilized for the sake of BlackRock’s valuation. In this regard, the paper will provide an explanation of principal assumptions used in the DDM of Constant and Variable Growth and discussion of its results, which will then be followed by discussion of ERM and 1 According to Willis Tower Watson The World’s 500 Largest Asset Managers ranking, BlackRock Incorporated maintains the largest amount of assets worldwide (2017). Based on this criterion, its primary competitors are Vanguard Group, State Street Corporation, Fidelity Investments, and Allianz Group; however, three out of four mentioned companies are private, which creates several difficulties in estimation of the firms’ financial multiples and further use in relative valuation for the sake of this paper. Thereby, STT, JPM, GS, and IVZ mentioned earlier were used for comparison in the paper as closest ones to BLK in amount of assets under management.

VALUATION OF FINANCIAL INSTITUTION 2 Comparative valuation outcomes. Also the measures’ consistency across the analysis will be determined and the It also should be noted, that the entire information is based entirely on the opinion, views, and calculations of the author, and in no way represents an actual call to action. Eventually, the issues and challenges met in analysis assessment will be presented and the results of BLK’s valuation will be outlined. Analysis Section In this section the findings of DDM, ERM and Relative Valuation as well the models’ principal assumptions will be discussed, a comparison between the estimated intrinsic values and the current market value will be carried out and a discussion of the consistency of the approaches will be put under consideration. 1. Findings and Principal Assumptions of Dividend Discount Models The basic principle of dividend discount model is simple stocks trade from which investors expect future cash flows or dividends and expected price in case the stock is being sold (Harris, Eades, and Chaplinsky, 2008). In practice, the DDM appears in many forms (Damodaran, 2011); yet, regarding this assignment the main focus is put on estimating the intrinsic value of an equity security and the required return on equity. Hereby, the findings and principal assumptions of the DDM Stock Valuation model provided by Professor Steven will be presented, followed by a thorough discussion of them. The estimated results are as presented below as follows: EPS

$30,23

Last Cash Dividend & Stock Repurchase

$18,75

Payment Per Share Expected Annual Growth Rate (Dividends &

3,66%

Stock Repurchase); geometric mean Required Rate of Return (k); CAPM Required Rate of Return (k); DDM Required Rate of Return (k); Average

11,85% 8,64% 10,25%

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DISCOUNTED CASH FLOW MODEL VALUATION

3 Sustainable Rate of Growth

5,82%

Stock Value – Constant Growth Model

$266,51

(CGM) Stock Value – Variable Growth Model

$320,93

(VGM) Current Market Value as of of

$390,07

12/12/2018 4:02PM EST (Finviz.com,2018)

The intrinsic values of BLK vary from model to model. According to the constant growth model, BLK has an estimated underlying value per share of $266,51; therefore, BLK has market value is $266,51* 164,42M shares outstanding = $43 817,48M. BLK’s intrinsic value according to the variable growth model is $320,93. Thus, according to the variable growth model, BLK’s market value by now is $320,93* 164,42M shares outstanding =$52 765,92M. Thus, the stock is currently trading at 46,36% (as per CGM) and 21,54% (as per VGM) premiums as opposed to the present market value of the stock ($390,07 per share as of 12/12/2018 4:02PM EST, Market Closed conditions (Finviz.com, 2018)). Some of the principal assumptions for the DDM are the growth rate and required rate of return (used as the discount rate). The growth rates entered for the variable growth rate valuation were based on the Zacks Investment Research Analysts’ estimates (NASDAQ, 2018), the changes in which and expected payment to shareholders (cash dividend and stock buyback combined) are outlined on the chart below:

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VALUATION OF FINANCIAL INSTITUTION 4 $ 30.00

13.18%

$ 25.00

10.84%

$ 20.00 $ 15.00 $ 10.00 3.00% $ 5.00 0.14% $ 0.00

1

2 10.96%

3

4

5

EXPECTED ANNUAL GROWTH RATE (DIVIDENDS + STOCK REPURCHASES) EXPECTED ANNUAL CASH & STOCK REPURCHASE PAYMENT PER SHARE

BlackRock is expected to have a terminal shareholder payment growth rate of 3, which ultimately cannot be higher than the GDP growth. During the past 12 months, 3 years, 5 years and 10 years, BlackRock's average Dividends Per Share Growth Rates were 16.30%, 9.00%, 10.90%, and 15.10% per year with the median of 13,30% (Gurufocus, 2018). Current dividend yield of 2,92% is also close to its 6-year high of 3,46%, meaning the company is creating above its historic average value for the shareholders, whilst it still has room for growth. Given the estimated TTM dividend growth rate of 10,96% and its historic growth rates mentioned earlier, each calculated via compound annual growth rate model (CAGR), combined with stock repurchase amounts increasing on the YoY basis (+6,76% by now since 2016), a terminal growth rate of 3% seems quite fair. The discount rate for BLK was calculated via Capital Asset Pricing Model (CAPM) as equal to the required rate of return; the output is illustrated below: Required Rate of Return = Risk-free rate + Beta * Market Risk Premium Required Rate of Return of MBT = 2.85% + 1.50 * 6% = 11.85% As have been mentioned earlier, BLK is considered significantly overvalued as of 12/12/2018 by both Constant Growth and Variable Growth Models. The difference between both models’ estimated values is determined by the significant discrepancy between the dividend

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DISCOUNTED CASH FLOW MODEL VALUATION

5 growth rates (Damodaran, 2011). CGM assumes the dividends and buybacks are to increase by 3% each year, which equals to compound growth of 15% by the end of the given period, while VGM has more optimistic sight based on the forecasted compound growth of 43,37% over the five year period. 2. Findings and Underlying Assumptions of the Excess Returns Valuation Model The Excess Returns Model estimates the value of a firm as the amount of invested capital and the present value of excess returns that the firm expects to make in the future combined (Damodaran, 2009). The complete ERM calculations may be found in the attached Excel File or the Appendix Section. The key elements of the ERM output in Millions of US Dollars are listed below as follows: Book Value of Equity Invested Currently $32 470,0 Present Value of Excess Return (Next 5 $5 368,0 Years) Present Value of Terminal Value of Excess $29 606,1 Returns Value of Equity $67 444,2 Number of Shares 164,42 Value per Share $410,19 Current discount 5,16% To complete the ERM valuation the following assumptions were made:  The book value of equity Invested are $31 825M, as per BLK’s 2018 form 10K for the fiscal year (FY) 2017; and $32 470M as per BLK’s form 10Q dated September 2018.  The annual net income of BLK is $5007M, as per BLK’s 2018 form 10K for the FY2017.  The dividend payout ratio, calculated as per BLK’s Form 10Q dated September 2018 was calculated as:

Dividend Payout Ratio = Dividends per Share / EPS Dividend Payout Ratio = $3,13 / $7.54 = 42%

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VALUATION OF FINANCIAL INSTITUTION 6  The 3 month average Beta estimate of BLK is 1,50 based on Yahoo!Finance data (2018).  The Constant Maturity 10 Year US Treasury Bond Rate is 2,85% as of 12.12.2018 (Gurufocus, 2018); Market Risk premium was assumed to be 6% based on historic data.  The assumed growth rate estimate for net income in 2024 was equal to its historic 5Year average of 8% based on the Company SEC Fillings data (BlackRock, 2014; 2017; 2018).  The assumed ROE for BLK in 2024 was calculated based on two assumptions: net income estimate by 8% more than the 2023 estimate; and book value of equity increasing at not less than 5-Year average forecasted annual growth of shareholders payment including cash dividends and stock buyback equal to 10,86% as was mentioned in the previous section of the present paper; all factors combined, the 2024 ROE was estimated to be equal 15,33%. The cost of equity based on the assumed risk-free rate of 3%, constant beta of 1,50 and market premium of 6% was in its turn estimated to be equal 12%. As per the present analysis of ERM, BLK is currently undervalued and is currently trading at 5,16% discount. Notably, the Excess Equity Returns are expected to grow steadily until 2023 and decrease by 5,01% in 2024, yet if that the book value of equity continue outperforming the growth rate of payment to shareholders, the company will continue creating excess capital attributable to it. 3. Relative Valuation of BlackRock Incorporated For the relative valuation four comparable firms have been selected to estimate BLK's relative value. Its main competitors by Global Money Managers market are State Street Corp (NYSE:STT), JPMorgan Chase Co. (NYSE:JPM), Invesco Ltd. (NYSE:IVZ), and Goldman Sachs (NYSE:GS). In the relative valuation PE, P/B, P/S, P/CF multiples have been used to determine whether BLK is over- or undervalued compared to its competition. Price/Earnings reflects how many investors are willing to pay per one dollar of the company's earnings. Price/Sales and 6

DISCOUNTED CASH FLOW MODEL VALUATION

7 Price/Cash Flow, following the same analogy represent the amount of money shareholders is likely to pay per each dollar of the company sales and cash flows; however, the former is better in valuation of the startups, which are yet to be profitable; the latter, in its turn, represents a more sophisticated variation of PE and is believed to reflect the company's value better and more fair than PE, as long as cash flows' data is harder to manipulate. Price/Books reflects its current price of equity compared to its books. It also should be noted that the multiples have to be defined uniformly across the entire number of firms in the given group (Damodaran, 2011). Thereby, it is important to mention that multiples represent 2018 estimates based on the data from companies' 10K 2018 reports found on the web resource last10k.com (2018); the results are listed below. COMP ANY Pr i c e / Ea r ni n g s Pr i c e / Boo kVa l u e Pr i c e / Sa l e s Pr i c e / Ca s hFl o w Pr i c e / Fr e eCa s hFl o w PEG Ma r k e t Ca p En t e r p r i s eVa l ue EV/ EBI TDA

BLK

STT

JPM

IVZ

GS

Industry Mean

14,09 1,93 4,40 16,50 34,74 1,30 62,63 60406,00 9,89

9,13 1,14 7,00 1,70 1,95 0,97 24,39 30049,00 -

11,72 1,48 4,66 10,10 19,22 1,21 342,11 279359,00 6,43

6,96 0,81 1,36 5,60 24,76 1,53 7,39 12664,00 7,74

7,06 0,90 1,32 0,29 67,34 487770,00 -

3,48 1,25 3,75 8,48 20,17 1,06 100,77 174049,60 8,02

The following was observed based on the findings:  BLK has the third largest market and enterprise value, conceding to large investment banks (GS and JPM) only. Yet notably, while the company has a limited benefit it can receive from the economy of scale and thus carry more risk as an investment, it still operates better than GS, which may be clearly seen in the enterprise multiple comparison.  Based on the vast majority of the used multiples, BLK looks significantly overpriced compared to its peers. The company’s stock is traded at the price 14 times the earnings it generates and almost 2 times its book value, which are the highest multiple values in the given sector. Its fair value per operating profit looks a bit better though, making it the third least attractive among its peers. 7

VALUATION OF FINANCIAL INSTITUTION 8  The company’s P/S is above the industry average by .75 meaning the company is significantly overvalued;  BlackRock Incorporated creates much less free cash flows per its price than its peers on average. Even though unlike GS it at least is able to create profit, its competitors look a lot more attractive from that perspective than BLK;  The company has the second highest Price to earnings to growth ratio, which is still . 24 more than the industry average. It means the company’s stock is trading at premium to its earnings’ growth rate and is not as attractive as its competitors based on this criterion. Overall, BLK’s ratios and multiples look good, however the company’s stock is less attractive than its peers’ from the investor’s perspective. Even though the stock price of the company has been correcting for almost ten months, the company is still significantly overpriced as of now, and is believed to be not worthy as an investment relative to the competition (Finviz.com, 2018). 4. The Consistency of the Valuation Models The stock intrinsic values were found to vary from model to model. The results are presented in the table below as follows: Valuation Model Constant Growth DDM Variable Growth DDM Excess Returns Model Current Market price

Stock Value $266,51 $320,93 $410,19 $390,07

Each model has calculated different underlying stock values with the standard deviation of $65,84 meaning the valuations are not consistent. The difference between each model’s estimated intrinsic values is determined by the significant discrepancy between the input data and the methods used. Both constant and variable growth models alongside with the relative valuation point at the significant premium the company’s stock is trading at. Though, however, the Damodaran’s ERM suggests that BlackRock is able to generate surprisingly large excess

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DISCOUNTED CASH FLOW MODEL VALUATION

9 returns on the equity, based on the relative comparison of BLK and its main rivals’ P/FCF ratio there are still better options in the financial sector. It should be noted that valuation itself involves a lot of uncertainties due to the different input data and methods used and its results should be viewed as a result of subjective estimation (Le Anh, 2017). Thus, the primary challenges met in the valuation of the BlackRock Incorporated were linked to the difficulty of making assumptions towards the growth rates and actually defining whether the company is over or undervalued. Most large financial service firms’ market values tend to reflect the real book value of the company’s assets, as long as the most financial companies’ assets are highly liquid and kept traded most of the time (Damodaran, 2009). Thereby, it was quite hard to determine what model produces the results closest to fair; yet the variable growth DDM is considered to be relatively close to the real intrinsic value. Conclusion In an attempt to calculate the intrinsic stock value of BlackRock Incorporated, the several models were used, including constant and variable growth DDMs, ERM, and relative valuation each presenting a different result. Overall, the stock was found overvalued, with many better options for investing in the financial industry. Though quite effective in most cases, utilization of comparables approach have resulted in quite skewed outcomes, with the BLK trading with severe premium at its underlying stock value. The only model to consider BLK being traded at a discount was the excess returns model, yet it was given less weight in the discussion as long as the company looks less attractive relative to its peers anyway; the variable growth DDM is considered to show the closest to real fair value of the stock, which accordingly trades at around 21,54% premium. Thus, BLK is considered to be not worthy as an investment as a bottom line of the present analysis.

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VALUATION OF FINANCIAL INSTITUTION 10 References Anh, L. (2017). Equity Valuation Using Discounted Cash Flow Method - A case study: Viking Line Ltd, Degree thesis. Arcada. Retrieved from: https://www.theseus.fi/bitstream/handle/10024/132515/Le_Anh.pdf?sequence=1 ; Damodaran, A. (2011). Investment Valuation (3rd ed.). Wiley. Retrieved from: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/inv2E/inv2edquesanswrs.htm#ch1 q; Damodaran, A. (2009). Valuing Financial Service Firms. Retrieved from: http://people.stern.nyu.edu/adamodar/pdfiles/papers/finfirm09.pdf ; Harris, S., Kenneth, M., Chaplinsky, J. (1998). The dividend discount model. Darden Business Publishing, University of Virginia. Retrieved from: http://ssrn.com/abstract=909419; BlackRock Inc. (2018). SEC 10 K Annual Report. Retrieved from: https://www.last10k.com/sec-filings/blk ; BlackRock Inc. (2017). SEC 10 K Annual Report. Retrieved from: https://www.last10k.com/sec-filings/blk ; BlackRock Inc. (2014). SEC 10 K Annual Report. Retrieved from: https://www.last10k.com/sec-filings/blk ; Blackrock, Inc. (2016). Hoover’s Company Profiles. Retrieved from http://ezproxy.umuc.edu/login?url=http://search.ebscohost.com.ezproxy.umuc.edu/login.aspx? direct=true&db=edshvr&AN=HVRD1F1195D8FCAEB9D&site=eds-live&scope=site; BlackRock, Inc (2018). BlackRock Inc SWOT Analysis. Market line. Retrieved from: http://eds.b.ebscohost.com.ezproxy.umuc.edu/eds/pdfviewer/pdfviewer?vid=7&sid=d5227f877d82-42ac-98a8-09709d31eeab%40pdc-v-sessmgr02 ; Finviz.com. (2018) BLK BlackRock Inc Stock Quote. Retrieved from: https://finviz.com/quote.ashx?t=BLK;

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11 Gurufocus.com. (2018). BlackRock Inc (NYSE:BLK) Dividend Payout Ratio. Retrieved from: https://www.gurufocus.com/term/payout/NYSE:BLK/Dividend-Payout-Ratio/BlackRock %20Inc ; Willis Towers Watson (2017). 500 Largest Asset Managers Year End 2016. Retrieved from: https://www.willistowerswatson.com/-/media/WTW/PDF/Insights/2017/10/The-worlds500-largest-asset-managers-year-end-2016.pdf ; Yahoo! Finance. (2018). Summary for BlackRock Inc. Retrieved from: https://finance.yahoo.com/quote/BLK/profile?p=BLK.

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VALUATION OF FINANCIAL INSTITUTION 12 Appendix BlackRock, Inc. Excess Returns Model

12...