Introduction
The bank of Queensland was instituted in 1874 as the first permanent building society in Queensland, Australia. Initially, it was being operated as Brisbane Permanent Benefit Building and Investment Society. This society was later incorporated in 1887 and then got amalgamated with the City and Suburban Building Society in 1921. Later on in 1931, it was again amalgamated with Queensland Deposit Bank. It received a license to operate as a trading bank in 1942. The bank computerized its operations in 1970 and then underwent a series of transformations that included changing its name to bank of Queensland. The bank was first listed in the Australian Stock Exchange in 1971 when it became a publicly traded company. The bank has also had a series of mergers and acquisitions in the recent past that has helped it in boosting its operations thus improving its efficiency hence improved profitability. It acquired ATM solutions in 2003 which made it the owner of the second largest ATM networks in Australia. Prior to it merging with the Western-Australia home building society in 2007, the bank acquired debtor financing division of the ORIX Australia. This helped in strengthening its position in th debtor finance industry. The bank later on acquired the Australian and New Zealand Division of the CIT Group Inc. This bank is one of the oldest financial institutions in Australia. It has more than 270 branches and has more than 650,000 customers. The bank rolled out a national branch expansion program in 2002 so as to expand its customer base. This has helped in popularizing the bank thus making it more popular with the local population. The bank allows individuals to own and operate the branches of the bank on contracts as franchise. This has also helped in boosting its customer base since the sub-branches can be established anywhere in the country thus increasing the bank’s presence with the local communities. This bank mainly offers core banking services and it used its unique concept of the Owner Managed Branch to provide banking services to a large number of customers who are spread across the country. This bank also provides quite a variety of financial services to individuals and different Australian companies which include: personal banking services (everyday banking accounts, savings and investments accounts, credit cards, personal loans, home loans, private banking services, foreign cash), property finance and insurance products. The company also provides its customers with business banking services, cash flow services and international services which include foreign exchange payment options. In addition to the above mentioned services provided by the bank, it also offers internet banking and mobile banking options. The interstate Owner Management Branches of the bank has helped in boosting the bank’s growth and popularity with the local citizens and various financial institutions in the country.
This bank has shown tremendous improvements and the trend is likely to rise even further as the bank continues to consolidate smaller financial services firms which are funded by a mixture of cash and scrip. The company is however being faced with several challenges of bad debts. Competition is also one of the challenges facing the bank but the management has been able to reduce competition through the provision of extra-ordinary services that attract more customers hence always putting the bank ahead of all their competitors. The bank reported a drop in NPAT to $ 50.4 million which was equivalent to a 45% decrease of NPAT for the 1st half of the financial year 2011. There was also a significant drop in profits which was attributed to the momentous mutilation charges in the current half of the last financial year. The revenue for the ordinary activities however, on the other hand rose to $390.7 which is equivalent to a 14% increase. The increase has been propagated by the growth in balance sheet and the impacts caused by the mergers and acquisitions which had taken place in the recent past. This bank provides a high level of professional services to its customers through the employment of highly qualified staff in different fields of specialization. The quality services provided have attracted more customers thus improving the bank’s profitability.
Capital structure and debt/equity funding
The bank has had a consistent Net Interest Margin in the recent past. From the year 2005 – 2007, the NIM rose by about 1.8% but later on in 2008, it declined to 1.67%. The fall was attributed to the lower credit rating which resulted into a higher cost of wholesale funding. In September 2010, the bank managed to boost its balance sheet through a capital raising plan of $340 million. This further helped the bank to lift its bank tier ratio to more than 9.5%. The Bank of Queensland had a bad debt cycle which lagged behind most of the other majors in the industry. The management of the bank therefore increased the retail deposit of the bank that resulted into an expansion from $9.2 billion to $16.2 billion. The share price of the bank also has a similar story in terms of the bank’s progress in the recent past. The stock of the bank has also been on the increase in the recent past. However, in 2009, there was a significant decline in the share price of the bank when it hit a record low of $6.5 from the initial value of $19.00. This has however changed and the price returned to about $12.00 at the close of 2011.
Dividends
The bank of Queensland pays out dividends to its shareholders and has different packages from which the customers can choose from. The options include:
i. Direct Credit – this is available to the Australian share holders while the cheque option is available to non-Australian resident holders.
ii. Dividend Reinvestment Plan (DRP) – the shareholders can decide to increase their stake at the company by choosing reinvest all or part of the shares that they hold for the company.
iii. Dividend donation- the shareholders can decide to donate part or the whole of their shares to the less fortunate members of the society.
Dividend Discounted Model
The Dividend Discounted Model (DDM) can be used when the dividend stream of the company can be reasonably forecasted. This is a situation that generally applies to most banks. We have assumed that the Bank of Queensland will continue to pay rich dividends in the year 2012 and we are also expecting a dividend payout ratio of about 80% as it has been the case for the last two years. The Bank of Queensland’s very high capitalization will be very beneficial towards enabling the bank to maintain a rich dividend paying policy.
Error Analysis
Errors in the DDM Model
The most common types of errors that occur when using this method lie in the assumptions about the fruition of the payout ratio as the rate of growth of the firm changes. There are very many high growth firms that pay low dividends while others do not pay any dividend at all. As the rate of growth changes, the dividend should also rise. However, if this doesn’t take place, these firms will not be worth much especially when using this model to value them.
Errors in the FCF Model
When using the FCFE/FCFF models of valuation, the assumptions about the net expenditures and the growths are strongly linked. When one of the variables changes the other one should also change. There are two types of errors that occur when using this type of model. The high growth firms which have high net capital expenditures are assumed to keep reinvesting at the current rates even if the growth drops. This results into errors since the firms cannot register a progressive increase in the amount of capital. At some point, the capital may significantly reduce which needs to be registered but this method does not have that provision. Such firms are actually not valued very highly using these models thus resulting into errors due to the misrepresentation. On the other hand, the net capital expenditures are reduced to zero in the stable and progressive growth. The valuations in this case tend to be very high thus resulting into the eruption of even more errors. In order to avoid the occurrence of these errors, there is need to make the assumptions about the reinvestment as a function of the growth and the return on the capital. As the growth rate of the firm changes, the reinvestment rate will also change.
The Capital Asset pricing model (CAPM) analysis
The CAPM is used to determine the required rate of return of an asset. The model takes into account the asset’s non-diversifiable risk. The asset’s non-diversifiable risk can also be referred to as the market risk of the asset and is represented the symbol, β. This model typically describes the relationship between the risk and the expected return. The following formula can be used to find the value of the CAPM.
The model also shows the possible ways that the investors can be compensated on:
i. The time value of money
This is the risk-free rate, which is abbreviated by rf in the above formula. It compensates investors for the insertion of money in any kind of investment for some given period of time.
ii. Risk
This is represented by the other half of the formula βa (rm - rf). This is calculated by taking a risk measure that compares the returns of the asset of the market over a given period of time to the market premium (Craig, 2003).
The CAPM model therefore asserts that the value of the expected return of a security or a given portfolio is equal to the rate of a risk free security and the premium. If the expected return is not the same or higher than the required return, then this kind of investment should be avoided. This model can also be used in the computation of the expected return of a given stock. In the case of the Bank of Queensland,
Risk free rate = 4.75%
The beta (risk measure) of the stock = 1
Expected market return over the period = 19%
Therefore the stock is expected to return 19%
The figures above obtained from 2011 Annual report: Available at http://www.boq.com.au
Using the formula
CAPM error analysis
A random error in identifying the value of the Beta leads to some downward biased slope and an upward biased intercept in the second pass regression model that is used to test the CAPM
The formula for defining the correct model for the second pass regression can be given by:
Whereby β1 is the true observed value of the Beta for security i. β1 also on the other hand has a cross sectional mean of 1 and a variance of δ2(β1).
Assuming that the estimate of β1 from the first-pass regression has an error that is independent of β1 and e1
Allow b1 to be equal to the value of β1, therefore we can obtain the following equation:
This can further be simplified as shown in the equation shown below:
The value of γ0 is an upward-biased estimate of the true intercept. When using the cross-sectional variance of b1 and the square of the standard error of b1, we can conclude that plim γ1 = 0.64 γ0. The value of the error obtained can be even bigger if more assumptions are made on the variables being used for the estimation.
Weight Average Cost of Capital
When WACC involves the calculation of the firm’s cost of capital whereby each of the category of the capital is weighted proportionately. The following needs to be taken into consideration when calculating the weighted Average cost of capital.
i. Common stock
ii. Preferred stock
iii. Bounds
iv. Long-term debt
The assets of a company can be financed by either the debt or the equity of the firm. The weighted average cost of capital can on the other hand be said to be the average of the financing costs. The WACC is also the capital constituent multiplied by its proportional weight and then added up together. This can be obtained using the formula shown below:
Where:
Re is the cost of equity
Rd = cost of debt
E= Equity of the firm
D = debt of the firm
V = Equity + the Debt
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate
In the case of the Bank of Queensland, according to the annual report of 2011, the following values were found:
Re = cost of equity = $ 108 million
Rd = cost of debt = $ 44.6 million
E = market value of the firm's equity = $ 63 million
D = market value of the firm's debt = $ 475million
V = E + D = $ 538 million
E/V = percentage of financing that is equity = 0.11
D/V = percentage of financing that is debt = 0.88
Tc = corporate tax rate = 30%
Therefore the WACC for the company was
Substituting the values we get 0.11* 108m + 0.88*44.6m (1-0.3)
When the WACC is discounted, we can then obtain the Net Present Value of the company using the following formula:
NPV = Present Value (PV) of the Cash Flows discounted at WACC.
(This information available on Wealth creators report page 10)
The value = Earnings * P/E multiple
The P/E multiples is assumed to remain constant
The figure below shows the NPV report of the company available in the Wealth Creators report on page 10
Source: Wealth Creators Report – Bank of Queensland page 10
In the company’s website, using the Discounted Cash Flow Method, the value of WACC = 11.0%, beta=1.0, ERP = 5.0% and the RFR = 7.0%.
The valuation error is the absolute value of the difference between the calculated value of the WACC and the actual value of the WACC
Valuation error = |actual value-calculated value|
|11.0% - 39.27%|
Therefore the valuation error is 28.27%
Residual Earnings model
This model values securities using a combination of the book value of the company and the NPV of the company. The company’s value is the book value of the company at the time of the valuation and the present value of the residual income.
The residual earnings can be obtained using the formula:
(R - r) × B
Where by:
B is the book value of the company
R is the return earning of the company which can be calculated by dividing the net profit of the company by the book Value of the company.
Abnormal Earnings growth Model (AEG)
This method there has one constant discount rate and there are no personal or company taxes. This model focuses mainly on the bottom-line earnings and growth in the abnormal bottom-line earnings and can therefore be viewed as an equity level model. Ignoring the taxes, we first extend the model to a firm level model based on the operating earnings and the growth in the abnormal operating earnings thus allowing for two exogenous discount rates thus allowing required rate of return under all the equity financing and the borrowing rate. The Dividend policy irrelevance also holds for this model. When using the firm-level model as the avenue, a new equity level model is then developed whereby the dividends are discounted at a leverage dependent fluctuating cost of capital. Once all these have been established, the firm-level and the equity level models are then extended to a situation with the company and personal taxes incorporated. At this stage, the dividend policy irrelevance no longer holds.
This method can be used to determine a company’s worth based on the book value and the earnings of the company. it is also known as the residual income model and looks at whether the management of the company is worth what is based on the book value. This model states that the investors should pay more than what is stated in the book value.
G is the cum-divided earnings growth rate
(G-C) * FEPSt-1 represents the abnormal earnings growth. When using the AEG model, the normal earnings represents the growth in earnings. It should be noted that when G is equal to the cost of capital, then there is no abnormal earning. This model also allows the anlyst to use forecasted earnings and not the individual adjustments. The AEG valuation model will yield the same value as the RE model thus making the error in both cases to be the same.When valuing a company using this model, we start with the initial balance sheet in the first year (year 0) this model then follows a decaying pattern and then levels at 12% in the fourth year. The NOA reach a value of 4% growth rate by the 5th year with a constant obtained from year five onwards. The Residual Earning from operation grows at an average rate of 4% and the subsequent value is calculated progressively. The dividend payout here is such as to maintain the constant market leverage of 46% so that the cost of equity is a constant. Both the residual earnings and the residual operating methods give the same values of the valuation process.
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