Cfm assignment 1

Corporate Financial Management ASSIGNMENT 1

FINANCIAL ANALYSIS OF PADDY POWER BETFAIR PLC

AUTHOR: Gabriele Calabrò STUDENT NUMBER: 21319823 SUBMISSION DEADLINE: Tuesday 14th November 2017 LECTURER: Dr Masar Hadla

Table of Contents: 1 INTRODUCTION.................................................................................................................................3 2 SHAREHOLDER WEALTH MAXIMISATION..........................................................................................3 2.1 CAPITAL GAIN..............................................................................................................................4 2.2 DIVIDENDS..................................................................................................................................5 3 SOURCES OF FINANCE.......................................................................................................................7 3.1 CAPITAL GEARING RATIO (CGR)..................................................................................................8 3.2 DEBT TO EQUITY RATIO...............................................................................................................9 3.3 INTEREST COVERAGE RATIO (ICR)...............................................................................................9 4 CURRENT VALUATION......................................................................................................................10 4.1 NET ASSET VALUE (NAV)...........................................................................................................10 4.2 PRICE TO EARNING RATIO (P/E)................................................................................................12 5 CONCLUSIONS.................................................................................................................................13 APPENDIX...........................................................................................................................................14 REFERENCES…………………………………………………………………………………………………………………………………15

1

“Equity is soft; Debt is hard.

Equity is forgiving; Debt is insistent.

Equity is a pillow; Debt is a dagger.”

(Bennett Steweart, 1990)

1 INTRODUCTION 2

Paddy Power Betfair is among the world’s largest betting and gambling operators, created from the merger on 2 February 2016 with Paddy Power plc and Betfair plc. (Annual Report, 2016).

Today, the group involve four distinct brands: Paddy Power, Betfair, Sports bet and TGV. The company’s revenue has been £ 1,551m in 2016 with an increase of 18% compared to 2015 £1,318m (Financial Review PDYPLC, 2016).

Moreover, the full-year dividend per share amount to 165p composed by 2 interim dividend 12p and 40p respectively and one final dividend of 113p1.

This company has been chosen because of the possibility to analyze a merger effect. 2 This report aims to clarify the shareholder wealth maximization, source of finance and current valuation of the group in the light of appropriate benchmarks such as FTSE 100 and gambling.

2 SHAREHOLDER WEALTH MAXIMISATION SWM is the main corporate objective for companies (Arnold, 2013).

It can be defined as maximising purchasing power, thus maximising the flow of dividends through time (Examples: Microsoft, Philips etc.) (Arnold, 2013).

A more detailed definition of (SWM) is that short-term goal and long-term purpose of an enterprise is to maximize return on equity capital (Windsor and Boatright, 2010).

The way firms achieve this objective is through dividend (short-term) and capital gain 3 (long-term) (Watson and Head, 2013).

2.1 CAPITAL GAIN

1 still subject to shareholder approval

2 Precisely, it is interesting try to understand to what extend its shareholder wealth maximization depends on the merge or is there any macroeconomic factors that influenced it.

3 Although an investor buying a share is buying a future group of dividends to infinity, he needs capital gain because he will not hold the share to an infinite horizon but to sell it to another investor (Arnold, 2013)

3

Capital Gain yield =

Current market price per share−original market price per share ∗100 original market price per share (1)

CGY consist of the gap among the current market value and the purchase price (Watson and Head, 2013).

Furthermore, it clarifies volatility and return of companies’ stocks, thus facilitating comparison and analysis. By contrast, it does not specify the provenience of the “gain” (Leverage or equity), and it include tangible and intangible assets.

Table 1:

CAPITAL GAIN PP

2012

2013

2014

2015

2016

2017

(P1-P0)/P0

0%

21%

-10%

44%

31%

-10%

CAPITAL GAIN LB (P1-P0)/P0

2012 0%

2013 19%

2014 -31%

2015 -18%

2016 14%

2017 -5%

Source: www.paddypowerbetfair.com, 2017

Table 1 witness that PPB.L. had perform better than Ladbroke Plc, although it underperform its benchmark since the FTSE 100 growth rate has been +0.30% while PPB.L growth rate achieved merely +0.19% (Yahoo Finance, 2017).

The situation become slightly better by comparing PPB.L with its narrower benchmark of travel and leisure section where the group is at the sixth position out of nine by growing rate (London Stock Exchange, 2017).

However, the most streaking feature is the -10% Capital loss in 2014. This was due to a drastic change in the capital composition as showed in table 2: Table 2: PADDY PLC 2012 2013 2014 2015 2016

PWR LIABILITES/EQUITY 84,32% 75,87% 63,70% 70,49% 15,65%

Source: www.paddypowerbetfair.com, 2017

The consolidated financial statement 2014 shows indeed that Total liabilities almost doubled from 246,571,000 in 2013 to 488,834,000 in 2014. While, the total equity attributable to equity holders of the company decreased from 386,981,000 in 2013 to 69,288,000 in 2014 (Financial Statement, 2014).

2.2 DIVIDENDS

4

Dividend=π∗pay out ratio Dividend per share=

(2)

dividend number of outstanding shares

(3)

Dividends are the portion of profit payed regularly to shareholders and signaling tool for a firm (Miller and Modigliani, 1961).

Indeed, the dividend policy of a firm is extremely important to corporate officials, investors and every stakeholder interested in the firm.

It is interesting to note that although Paddy Power plc faced some losses through last five years its dividend always increased as shown in the following table: Table 3: DESCRIPTION FINAL 2016 INTERIM 2016 SPECIAL DIVIDEND 2016 INTERIM 2016 FINAL 2015 INTERIM 2015 FINAL 2014 INTERIM 2014 FINAL 2013 INTERIM 2013 FINAL 2012 INTERIM 2012

DIVIDEND PER PERIOD (PENCE PER SHARE) GBP 1,13 GBP 0,40 GBP 1,41 0,12 EUR 1,20 € 0,60 € 1,02 € 0,50 € 0,90 € 0,45 € 0,81 € 0,39

TOT. PER YEAR GBP 1,53

€ 1,80 € 1,52 € 1,35 € 1,20

Source: www.paddypowerbetfair.com, 2017

This is due to a clear dividend policy growth i, which is possible because of the retained earnings such as €421,009,000 in 2013 and €136,470,000 in 2014 (Financial Statement, 2014/13).

Another streaking feature is the dividend yield, which return the investors’ gain coming from a security purchase without taking in consideration capital gain figures.

Dividend yield=

dividend per share∗100 Share price

Table 4: PADDY POWER PLC

DIVIDEND YIELD 5

(4)

FINAL 2016 INTERIM 2016 SPECIAL DIVIDEND 2016 INTERIM 2016 FINAL 2015 INTERIM 2015 FINAL 2014 INTERIM 2014 FINAL 2013 INTERIM 2013 FINAL 2012 INTERIM 2012

0,0189%

0,0199% 0,0221% 0,0283% 0,0227%

Source: www.paddypowerbetfair.com, 2017

LADBROKE As the tables above witness PPB.L.’s yield of FINAL 2016

is significantly lower than its competitor Ladbroke. In fact, it does not even cover the INTERIM 2016 inflation rate in the UK: Table 5:

2012 2.8%

2013 2.6%

2014 1.5%

Source: rateinflation, 2017

FINAL 2015 INTERIM 2015 FINAL 2014 2015 INTERIM 2014 FINAL 2013 0% INTERIM 2013 FINAL 2012 INTERIM 2012

According to the dividend yield figures Ladbroke should be a more attractive security to invest in since it generates higher percentages.

DIVIDEND YIELD 2,3362% return

2,6701% 6,5113%

2016 0.7% 4,4627% 5,3023%

However, the obviously question is if firms with generous distribution policies sell at a premium compared to those with less frequent payouts and particularly if the increase in cash payments to the current shareholders is enough to compensate the future lower share value (Miller and Modigliani, 1961).

The answer change depending on external factor such as: tax, economic growth, inflation etc.

Thus, although dividends represent a crucial sign of company wealth not always a growth dividend policy maximize the shareholder wealth.

Indeed, depending on the valuation method of share used 4 the answer will change quite sharply.

Finally, it is possible to conclude this chapter by saying that a firm should adjust its dividend policy to what extent a further increase in dividends will not offset the advantage of an increase in capital gain (Miller and Modigliani, 1961).

4 Discounted cash flow, current earnings plus future investment opportunities, the stream of dividends or the stream of earnings

6

3 SOURCES OF FINANCE There are two main sources of finance: pure debt instruments and pure equity issues (Myers, 2001).

In a world of certainty, the cost of capital was identified simply as the rate of interest of bonds, thus companies will follow a rational behavior and will invest to what extent the marginal yield on physical assets is the same as the market rate of interest (F. Modigliani and H. Miller, 1958).

Following this approach, it would be equivalent to maximize profits or maximize the market value.

However, since the real world allow existence of uncertainty the cost of capital from equity is the required rate of return (Arnold, 2013).

Expected return=Risk free rate+beta+ the averagerisk premium for shares

5

(5)

As regard with the cost of capital coming from debt it is obviously a sum of the rate of interest on the borrowing capital plus the drawbacks of a financial distress and reduced market credibility (Myers, 2001).

Having clarified the costs of the two Sources of finance the following issue is to decide the right mix of debt and equity in the capital structure.6 Although, there are a considerable number of different ideas regarding this choice it is possible to summarize three macro theories:   

The tradeoff theory7 The pecking order theory8 (Market timing theory)ii The free cash flow theory9

 

Risk-free rate is the risk coming from a secure investment such as a Bond Beta is the covariance among the return in a specific asset and the return of the whole market such as index or other Benchmarks. (Arnold, 2013) The average risk premium for shares is the expected return on the market – the risk-free rate

5 Where:



6 WACC (Weighted Average Cost of Capital) = Ke We + Kd (1-t) Wd

7 The tradeoff theory which says that more debt will be allowed to what extent the benefits of taxation will offset the cost of financial distress. (S.C. Myers, 2001)

8 The pecking order theory states that companies will borrow when their liquidity is not enough to fund capital expenditure because Equity has an Adverse selection problem. Thus, issuing more debt will lower the share price (S.C. Myers, 1984).

9 The free cash flow theory says that increasing debt will increase firm’s value to the point in which their operating cash flow offset their investment opportunities. (S.C. Myers, 2001)

7

The different conclusions of the three theories showed above are caused by the differences regarding the weight that each theory gives to the factors.

For instance, the first theory focuses on the tax advantages, while the second one underline the inequalities in information and the last one emphasizes the agency cost iii (S.C. Myers, 2001).

3.1 CAPITAL GEARING RATIO (CGR) Capital Gearing Ratio=

long−term debt capital∗100 total assets−current liabilities

10

(6) Another streaking feature of the analysis regards the CGR which is the percentage of firm’s capital coming from debt (Watson and Head, 2013).

This ratio indicates the firm’s capability to sell assets to repay its debt (Arnold, 2013) Usually, the limit of this finance indicator is 50% but it can change slightly depending on the industry sector.

Overall, higher level of business risk sectors such as luxury good have a lower level of ratio compared to companies included in a low level of risk such as utilities (Elliot and Elliot, 2011).

For instance, the leisure and sports sector are an intermediate risk industry since it has a moderate high cyclical risk and intermediate competitive risk and growth (McGraw Hill Financial, 2014).

Table: 6

PADDY PLC 2012 2013 2014 2015 2016

PWR GEARING RATIOiv 9,79% 5,17% 62,06% 74,75% 6,55%

LADBROKE PLC 2012 2013 2014 2015 2016

GEARING RATIOv 54,00% 55,85% 58,44% 48,24% 40,76%

Source: www.paddypowerbetfair.com, 2017

The tables above show that Paddy power plc has an acceptable ratio (less than 50%) in 2012, 2013 and 2016 while it jumps over 50% in 2014 and 2015.

However, the sample company shows a much higher gearing ratio with less than 50% just during last couple of years, whereas the first three years are above the limit.

10 Capital gearing: there usually four types of Capital gearing:  Long-term debt/shareholders’ funds  Long-term debt/ (long-term debt + shareholders’ funds)  Long-term debt/Tot. market capitalization  All borrowing/ (All borrowing + Shareholders’ funds)

8

Therefore, by focusing on the CGR, PPB.L. would be a better investment, although its values have a wider dispersion (higher fluctuation) compared to its competitor. 11 3.2 DEBT TO EQUITY RATIO

Debt ¿ Equity Ratio=

long−term debt capital share capital +reserves

(7)

This financial indicator is like the last one analyzed, although, from the debt to equity ratio point of view the up limit is 100% (Watson and Head, 2013).

Table: 7

PADDY PWR PLC DEBT/EQUITYvi 2012 84,32% 2013 75,87% 2014 63,70% 2015 70,49% 2016 15,65%

LADBROKE PLC DEBT/EQUITY 2012 60,27% 2013 38,58% 2014 66,36% 2015 60,05% 2016 57,69%

Source: www.paddypowerbetfair.com, 2017

Both firms have a reasonable under 100% Debt to Equity Ratio.

However, for PPB.L. the outliers are 84.32% in 2012 and 15.65% in 2016. While Ladbroke plc outliers are 66.36% in 2014 and 38.58% in 2013.

Therefore, this indicator shows also a less dispersion but higher average in Ladbroke plc’s values.

3.3 INTEREST COVERAGE RATIO (ICR) Interest Coverage Ratio=

profit before interest ∧tax interest charges

(8)

Table: 8

PADDY PWR PLC INTEREST COVERAGE RATIO 2012 48,83 2013 77,92 2014 100,34 2015 62,25 2016 23,80

LADBROKE PLC INTEREST COVERAGE RATIO 2012 68,27 2013 27,04 2014 13,23 2015 16,43 2016 54,00

Source: www.paddypowerbetfair.com, 2017

11 However, it might unconscious to value merely the assets when evaluating a firm’s capacity to repay debts. Often, the INCOME GEARING (operating cash flow/interest charges) is used as well (Arnold, 2013).

9

This ratio witness how many times a firm can afford to cover its current interest payment without considering the current profit.

Thus, is an important feature to understand if the outstanding debt can be an issue.

Usually, a value above 7 is taken as safe while above 3 is the limit under which the firm will be considered a risky one (Watson and Head, 2013).

In this case the tables above indicate values over 7 which means that both firms are safe investments.

However, by focusing on this indicator Paddy power plc should be preferred to Ladbroke since on average has a higher ICR than its competitor.

4 CURRENT VALUATION 4.1 NET ASSET VALUE (NAV) Net Asset Value=Totalassets−Total liabilities

(9)

This indicator is usually used for the task of company valuation.

All its components are taken from the balance sheet and the firm’s worth is considered as sum of its net assets’ value (Arnold, 2013).

In the balance sheet obligations to creditors are considered, thus with the deduction of long and short-term liabilities we obtain the NAV (Arnold, 2013).

Moreover, this valuation approach is considered useful when:   

Firms are in Financial difficulty Takeover bids Discounted income flow techniques are difficult to apply

Although In this case the MCV is used as comparison to the NAV, there are other valuation models that can be used.12 The MCV consist of the sum of total outstanding shares market value of a company (Arnold, 2013).

Market Capitalization Value=current share price∗number of shares

(10)

12 Income-flow models, Dividend valuation models (to infinity model, growth model), The Price-Earnings Ratio model (PER) and Cash-flow-based models (owner earnings, EBITDA)

10

By comparing these two indicators (NAV and MCV) is possible to understand whether the shares are over/under valued in the market and therefore make important investments decisions.

Table: 9

PADDY PWR PLC NET ASSET V. 2012

€ 277.560.000

2013

€ 311.002.000

2014

GBP 301.400.000

2015

GBP 373.820.000

2016

GBP 431.660.000

MARKET CAP. EUR 209.680.515.408 EUR 254.253.720.232 GBP 215.112.303.779 GBP 550.275.169.556 GBP 765.384.297.139

LADBROKE PLC NET ASSET V. MARKET CAP. 2012 GBP 30.622.000,00 GBP 15.252.202.635,83 GBP 2013 GBP 7.480.000,00 183.358.333.599,16 GBP 2014 GBP 10.860.000,00 126.142.207.889,79 GBP 2015 GBP 45.650.000,00 114.405.573.373,81 2016 GBP 14.352.000,00 GBP 24.970.415.254,37 Source: www.paddypowerbetfair.com, 2017

According to the tables above both firms seem to be overvalued from the market but unluckily the confrontation between MCV and NAV does not return the proper outcome since the data diverge wrongly13 (Table 9).

It would be possible to compare the NAV per share with the market share price, but since this is the inverse of the (10) it would lead to the same issue.

Therefore, it can be assumed that, in this case, the NAV must be interpreted carefully and decisions cannot be based merely on this indicator.

The main issue of the NAV is that the firm is considered as sum of the value of its net assets (Arnold, 2013) However, companies’ value relies on assets impossible to quantify (unique skills of the workforce, relationship with customer suppliers, brands etc.).

13 This makes clear that shareholders do not value the company based on balance sheet net asset figures (Arnold, 2013)

11

To sum up, it is possible to state that accounts documents are not designed to respect market values and the tot. value of a company is given by the sum of asset in balance sheet plus assets which cannot be measured (Arnold, 2013)

4.2 PRICE TO EARNING RATIO (P/E) P Market Value of theCompany ' share price ratio= E Earnings per share

(11)

This is a valuation method which considers the target firm’s distributable earnings. (Watson and Head, 2013) However, there are different shades of this method14

Table:10

PADDY PWR PLC P/E 15 2012 3271,26 2013 7325,10 2014 2593,58 2015 715,55 2016 2591,33

LADBROKE PLC P/E 2012 15,28 2013 2,91 2014 3,77 2015 11,50 2016 17,08

Source: www.paddypowerbetfair.com, 2017

The tables above show that PPB.L. has a higher P/E Ratio compared to Ladbroke.

Thus, investors are ready to pay 2591,33 £ to receive 1£ and this means that they value PPB.L. as a more reliable and profitable company than Ladbroke plc.

However, this valuation method although straight forward form the calculation point of view has some drawbacks.

Indeed, the outcomes vary significantly and there are issues in utilizing distributable earnings which make harder to calculate the P/E ratio after a merge (Watson and Head, 2013).

14 Bidder’s P/E ratio or Target company’s P/E ratio

15 P/E: The PPB.L. high values are justified because of an average share price much higher than Ladbroke’s one £ 8.385,00 and £136,40 respectively (LSE, 2017).

Moreover, the two firms have a different approach to dividend policy and this influence the EPS which is used in the P/E ratio calculation.

Indeed, past retained earnings increase the current value share price, thus the P/E ratio.

12

Therefore, the Forward P/E16 could be a better indicator to evaluate an investment, although the challenge related to the estimation of future earnings17 (Gordon and Shapiro, 1956).

5 CONCLUSIONS In the end, is possible to state that PPB.L. is a better investment although its sector of game and leisure underperform the FTSE 100.

Indeed, PPB.L. has a more stable capital gain compared to Ladbroke’s one.

As regard with dividends although lower than Ladbrokes’ one, PPB.L. offer a growing dividend policy which gives stability and reliability to its investors.

Moreover, although PPB.L.’s sources of finance are more volatile than its competitor, they have a lower average.

Finally, the P/E ratio values are clearly in favor of Paddy Power plc.

16 Forward P/E: It is the stock’s current price divided by the mean EPS estimate for the next fiscal year .

17 Even if this indicator could be derived from the past it is not easy to accept the assumption that the future growth of firm’s earnings will be identical to the past (Arnold, 2013).

13

APPENDIX

14

i Dividend policy consist of the determination of proportion of profit to pat out to shareholders.

There are different theories applied to this decision such as:  Miller and Modigliani, 1961 which under certain circumstances states that it does not make any difference to pay dividend or not because investors can always use homemade dividends by selling a proportion of their shares  According to the Dividend as residual theory, dividends should be distributed only if the retained earnings reinvested in the firm have an IRR smaller than Ke. However, in our world we need to consider other effects such as:  Tax: According to Elton and Gruber, 1970 there is a pattern between countries tax system and dividend payments. Consequentially, if UK government impose more tax on dividends, Uk firms will pay out less dividend and viceversa.  Clientele effects: According to Shefrin and Sstatman, 1984 shareholder have different preferences depending on their wealth. Therefore, a rich investor will buy shares which do not pay any dividend because even if he would receive any he will probably reinvest them.

Whereas, a less wealthy investor will pursue shares with a stable dividend policy.  Signalling: dividends are often perceived as managers’ perception of the future. Thus, a decrease in dividends, from the investors point of view, as bad predictions and this is due to information asymmetry.  Resolution of uncertainty: On the other side Myron and Gordon, 1963 developed the thoughts that market prices high shares that will pay dividends in the near-term because investors perceive this as a resolution of uncertainty.

However, the perception is subjective and therefore it cannot be universally true . Indeed, the Bird-in-the hand fallacy theory states that this risk is already considered in Required rate of return.

The gearing decreases when companies have the possibility to issue share at high price and increases when share price are low because the company buy its shares (Arnold, 2013) According to Alti (2006) this effect disappears in almost two years. ii

Agency Cost: Cost that arise from issues such as conflict of interests between management and shareholders. A solution to this issue is the reinvestment risk which support the idea that high debt obligates managers to make regular payments. Consequentially, it is possible to escape the managers’ temptation to accept investment with low or negative NPV. In fact, if they are not oversupplied with funds their projects appraisal must be reviewed and analysed by the market (Hart, 1995). iii

Low gearing can also help to create a Financial slack which is a borrowing capacity in case the firm need quick liquidity for investment opportunities (Almazan et al., 2012). iv

On the other hand, high gearing means that managers are confident about the future and therefore through signalling high gearing may lead to an increase in share price (Ross, 1977). v

vi There are several topics that influence the decision between debt and equity such as:

Motivation: indeed, by acquiring more debt the firm’s ownership will not be diluted, consequentially the concentrate shareholders will pay more attention to its investment and persuade managers to improve its performance in a more efficient way (Bennett Stewart, 1990).

REFERENCES: Arnold, G., 2007. Essentials of Corporate Financial Management. Pearson Education.

Arnold, G., 2013. Corporate financial management. Pearson Higher Ed. Boatright, J.R., 2010. Finance ethics: Critical issues in theory and practice (Vol. 11). John Wiley & Sons.

Dyson, J.R., 2007. Accounting for non-accounting students. Pearson Education.

Miller, M.H. and Modigliani, F., 1961. Dividend policy, growth, and the valuation of shares. the Journal of Business, 34(4), pp.411-433.

Myers, S.C., 2001. Capital structure. The journal of economic perspectives, Vol. 15(2), pp.81-102.

Ryan, B., 2007. Corporate finance and valuation. Cengage Learning EMEA. Watson, D. and Head, A., 2010. Corporate finance: principles and practice. Pearson Education.

Williams, J., 2014. Financial accounting. McGraw-Hill Higher Education.

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