Valuation Method: FCFF Model
In this section, we will now compute the intrinsic valuation of Air Canada using Discounted Cash Flow Valuation using FCFF method. Referring to the annual report of the company for the latest years, 2011, 2012 and 2013, we found that the company had never paid dividend, hence, it was clear that we cannot go ahead with dividend payments to value the firm. Moreover, FCFF valuation is suitable for firm-wide valuation which is the very essence of our report. Here are some of the rations as why we selected FCFF for valuation of the firm:
- As discussed above, Air Canada do not pay dividends, hence the valuation is only possible through free cash flows.
- Assuming that if we are valuing the company with the objective of acquisition, free cash flows are more appropriate measure as the new owners will have discretion over its distribution.
- Free cash flows are well related to the long-run profitability of the firm than the dividend payments.
- Free Cash Flow valuation is more realistic involving set of rational assumptions than the dividend payments.
Assumptions for FCFF Model
FCFF model is based on multiple assumptions which are not only derived from firm-specific historic events but also the factors that are largely affecting the industry. Below are the assumptions relating to FCFF valuation:
FCFF Valuation & 2-Stage Growth period
In order to compute the value of the stock, we will be relying on number of assumptions related to growth rate in operating income, capital expenditure and working capital investment. Important to note, in order to calculate the FCFF we will be following Cash flow approach, where Free Cash Flow to the firm will be calculated as:
FCFF= CFO- Fixed Capital Investment
However, it will be an abnormal assumption to assume a stable growth rate in the upcoming future or even an average growth rate based on past 5 years as the airline industry is heading high with significant growth in the global economy, Moreover, post the economic recovery, the company has been doing well as the same is indicted through its revenue and operating income figures. For Instance, post the economic downturn of 2008, the company witnessed loss of ($316) Million while an year later, the company recorded a profit of $361 Million. It was during 2010, the company in their statement declared that they are now more cautious of their growth strategy in adding more seat capacity as the global economy indicated signs of recovery and aims to focus on mid-2013 period, which seems to be achieved as per the financial results of 2013. As per the latest financial reporting, where the company registered growth in its operating income for third consecutive year amid, we can believe the operating income of the company to grow for a rational 25% every year as not only the company continues to add more economy seating and increased stage length. Below is the operating statistics of the company which shows the through combination of economic seating and increased stage length, the company managed to decreased yields in various markets, thus head high with strong growth prospects:
Hence, we will assume that the operating income of the company will increase by 25% for next 7 years and then become stable at 15%, hence accounting for 2 stage model.
Other assumptions
Depreciation Expenditure: This will be calculated for past 5 years in proportion to the revenue of the company.
Capital Expenditure: This will be calculated for past 5 years in proportion to the revenue of the company.
Working Capital Investment: This will be calculated for past 5 years in proportion to the revenue of the company.
Conclusion
Since the FCFF calculation provided us with significantly high value of $33.27/share, we decided to conduct the valuation using two more methods, Earnings Power and PE valuation. Finally, on the basis of margin of safety of 15%, we found the stock to be undervalued as the weighted intrinsic value is $24.28.
Works Cited
Air Canada’s favourable top-line 2Q2014 results but 7% capacity growth provokes reduced yields. (n.d.). Retrieved November 30, 2014, from http://centreforaviation.com/analysis/air-canadas-favourable-top-line-2q2014-results-but-7-capcity-growth-provkes-reduced-yields-181449
Jang, B. (2010, September 7). Air Canada cautious in its growth strategy. Retrieved November 30, 2014, from http://www.theglobeandmail.com/globe-investor/air-canada-cautious-in-its-growth-strategy/article1357231/
