Valuation of Kia Motors

1. Introduction

Kia motors is one of top 10 carmakers in the world. As this Korean automobil company is showing an impressive performance in such a highly competitive global market, even by newly included into the Best Global Brands 2012 Top 100, valuating this company will be an interesting subject. Kia is a new addition to Best Global Brands Top 100 along with facebook, Prada, Ralph Lauren and Pampers. For the past few years, Kia has been one of fastest-moving global automotive brands. One of only three auto brands to increase US sales each of the past three years, sales are on the rise, even in a difficult market like Europe.

Although the lineup is attractive to many cost-conscious consumers, the brand has built a particularly strong connection with Millennials and Gen Y audiences. A more aggressive front end design with the brand’s trademark tiger nose grille helps give Kia an edge that attracts younger drivers and also differentiates it from sister brand, Hyundai. When it comes to valuating companies for a going concern company like Kia motors, DCF method will be suitable. However, Due to the complexity of projecting future cash flow, Terminal Value method will be used to estimate the value of Kia motors based on its 2011 annual report. In Terminal Value technique, cost of debt and cost of equity is required as the basis for assessing the value of those cash flows (Discount rate).

Therefore finding out cost of equity, which is derived from riskfree returen rate plus market risk premium multiplied by beta factor, is the key research subject which is crucial to conclude Weighted Average Cost of Capital(WACC) which determines the scale of the value of our target company. Key informations such as dept to equity ratio, the amount of total debt, tax rate, interest rate for borrowings, free cash flows(Net Cash Provided by Operating Activities minus Net Cash Used in Investing Activities), share price and the number of issued shares can be found from the annual report 2011.

2. Valuation Methodology

To introduce Terminal Value method, Discounted cash flow (DCF) method is necessary to discuss in the report.

2.1. Discounted Cash Flow

Discounted cash flow (DCF) analysis is a method of valuing the intrinsic value of a company. In simple terms, discounted cash flow tries to work out the value today, based on projections of all of the cash that it could make available to investors in the future. It is described as “discounted” cash flow because of the principle of “time value of money” (i.e. cash in the future is worth less than cash today). The advantage of DCF analysis is that it produces the closest thing to an intrinsic stock value – relative valuation metrics such as price-earnings (P/E) or EV/EBITDA ratios aren’t very useful if an entire sector or market is overvalued. In addition, the DCF method is forward-looking and depends more on future expectations than historical results.

The method is also based on free cash flow (FCF), which is less subject to manipulate than some other figures and ratios calculated out of the income statement or balance sheet. DCF does however have its weaknesses as an approach. As it is a mechanical valuation tool, it is subject to the principle of “garbage in, garbage out”.

In particular, small changes in inputs can result in large changes in the value of a company, given the need to project cash-flow to infinity. James Montier argues that, “while the algebra of DCF is simple, neat and compelling, the implementation becomes a minefield of problems”. He cites, in particular, problems with estimating cash flows and estimating discount rates. Despite the issues, DCF analysis is very widely used and is perhaps the primary valuation tool amongst the financial analyst community.

2.2. Terminal Value

Terminal Value, in simple term, is the value of a company with an infinite row of constant future cash flows. To arrive at a total company value, or enterprise value, we simply have to take the present value of the cash flows and the Terminal value, divide them by the discount rate and, finally, add up the results. If we are discounting free cash flow of the firm at the weighted average cost of capital, this would give the value of the firm, so it would be necessary to deduct net debt in order to arrive at the equity value. In this report, simply use FCF in the year of 2011 to compare the value of the firm to the stock price in the year end of 2011.

2.3. Weighted Average Cost of Capital

The Weighted Average Cost of Capital (WACC) is the discount rate used in a Discounted Cash Flow (DCF) analysis to present value projected free cash flows and terminal value. Conceptually, the WACC represents the blended opportunity cost to lenders and investors of a company. The WACC reflects the cost of each type of capital (debt (“D”), equity (“E”)) weighted by the respective percentage of each type of capital assumed for the company’s optimal capital structure. Specifically the formula for WACC is: Cost of Debt times % of Debt (D/E+D) times (1-tax rate) + Cost of Equity times % of Equity (E/E+D).

2.3.1 Cost of Equity

Equity shareholders expect to obtain a certain return on their equity investment in a company. From the company’s perspective, the equity holders’ required rate of return is a cost. However, unlike the cost of debt which is relatively easy to determine from observation of interest rates in the capital markets, a company’s current cost of equity is unobservable and must be estimated. To calculate a company’s cost of equity, we need an formula which states both of the risk side and an expected return rate of equity holders. The cost of equity equals the risk free nominal interest rate plus the multiplication of Beta times the market risk premium.

The risk free rate is generally considered to be a return rate of bonds of an AAA-rated country. Beta should be levered and represents the riskiness (equivalently, expected return) of the company’s equity relative to the overall equity markets. The equity risk premium is the amount that stocks are expected to outperform the risk free rate over the long-term. Prior to the credit crises, most banks tend to use an equity risk premium of between 4% and 5%. However, today is assumed that the equity risk premium is higher.

Cost of Equity = Risk Free Rate + Equity Risk Premium* Beta. Beta is a measure of the riskiness of a stock relative to the broader market such as S&P500, DAX etc. By definition the “market” has a Beta of one (1.0). So a stock with a Beta above 1 is perceived to be more risky than the market and a stock with a Beta of less than 1 is perceived to be less risky. Beta is calculated as the covariance between a stock’s return and the market return divided by the variance of the market return.

2.3.2 Cost of Debt

Debt is less expensive for two main reasons. First, interest on debt is tax deductible i.e. the tax shield. Second, debt is senior to equity in a firm’s capital structure. That is, in a liquidation or bankruptcy, the debt holders get paid first before the equity holders receive anything.

2.4. Free Cash Flow

Free cash flow equals EBIT less taxes plus D&A less capital expenditures less the change in working capital. This measure of free cash flow is unlevered or debt-free. This is because it does not include interest and so is independent of debt and capital structure. Free Cash Flow also can be gained by Net Cash Flows from Operating Activities less Net Cash Flows from Investing Activities.

3. Calculation of WACC for Kia motors

Figures for cost of debt were studied from the annual report; cost of debt -3.41%- , % of Debt – 41.5%-, tax rate -25%-. Figures for cost of equity were researched through analists’ reports for automobile industry such as Morgan Stanley; risk free rate 4%, market risk premium 5.5% and beta factor was selected from KOSPI, the Korean stock exchange website; Beta 0.96 and % of Equity is 58.5%. When applying these figures into the formula, WACC equals 6.49%.

3.41%(1-0.25)41.5%+(4+5.5*0.96)*58.5%
Cost of debt 1.06 + Cost of equity 5.43 = 6.49%

For detailed total debt from Consolidated Statement of Financial Posiotion in page 57 of annual report as below; Short-term borrowings 1,588,410
Current portion of long-term debt and bonds 1,509,886
Finance lease liabilities – current 5,775
Bonds 1,696,312
Long-term debt 783,898
Finance lease liabilities 23,020
Total Debt 5,607,300

4. Calculation of Free Cash Flow for Kia motors

Free cash flow can be calculated by Cash Flows from Operating Activities less Cash Flows from Investing Activities. Free cash flow is as below; Net Cash Provided by Operating Activities 4,745,189

Net Cash Used in Investing Activities (2,630,548)

Free cash flow is 4,745,188 minus 2,630,548 equals 2,114,641.

5. Estimation of the value for Kia motors at the end of 2011

Learned from Terminal Value technique, we can estimate the Value of Kia motors in an approach like this, FCF divided by WACC. Termial Value=FCF/WACC=2,114,641/0.0649=32,583,066 Once we have the figure by Terminal Value technique, we can estimate shareholder value of the firm by subtracting market value of debt from it. Terminal Value – Market value of debt = Shareholder value

32,583,066-5,607,300 =26,975,766
Shareholdler value is 26,975,766 KRW in miilions.
Number of issued share at the end of 2011 was 403,990,456.

When the shareholder value (26,975,766 KRW in miilions) divided by the number of shares issued as of December, 31st, 2011, we can come up with the value of one share. The result is 66,773.27 KRW per share, which is fairly close to the market value (66,700/share) of December 29th, whcih is the last day of stock market KOSPI in 2011. The value of Kia motors in euro will be around 19 billion € and 46 € per share.

6. Conclusion

Estimating the value of the firm, from the shareholders’ perspective, requires different insights from the kind of approach i.e. earnings ratio. Valuation begins with having in mind of the capacity of internal financing, which is Free Cash Flow. If we were able to project up-coming 5 or 10 years of cash flow, we could have reached at the virtual Terminal Value.

But in this report, we could have been only assured how closely this approach is able to estimate the value of the firm by comparing figures between from Terminal Value technique and from the actual stock market price. In Kia motors case, the stock price was well reflecting the firm’s value at the year-end of 2011, seen from shareholder’s perspective. Further research about the actual Terminal Value and comparing the actual firm’s performance will be an interesting subject.

References

Fernandez, P. and J. del Campo (2010a) “Market Risk Premium used in 2010 by analysts and companies: a survey with 2,400 answers,” downloadable in http://ssrn.com/abstract=1609563 Fernandez, P. and J. del Campo (2010b) “Market Risk Premium used in 2010 by professors: a survey with 1,500 answers,” downloadable in http://ssrn.com/abstract=1606563 Adam Jonas, Morgan Stanley, Global Autos: A Wall Street View, Automotive News World Congress, Detroit, January 10th, 2012 Michael Annin, Equity Risk Premium Article, January/February 1998 issue of Valuation Strategies

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[ 5 ]. www.wikiwealth.com, November 10, 2012
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[ 9 ]. Morgan Stanley Research, Appendix: Valuation Methodology, Global Autos: A Wall Street View Automotive News World Congress Detroit: January 10th, 2012, [ 10 ]. Debt-to-Equity Ratio, Financial Highlights, page 4, annual report 2011 [ 11 ]. Consolidated Statement of Cash Flows For the years ended December 31, 2011 in page 62 of annual report says; (In millions of won) [ 12 ]. 23,Dividends, Number of shares issued, Notes to Consolidated Financial Statement, page 91, annual report 2011 [ 13 ]. http://finance.naver.com/item/main.nhn?code=000270