River Island Clothing Limited seeks valuation from Apax Partners

Introduction

Sensing the time to be right, the long serving Managing Director of River Island Clothing Limited has approached Apax Partners, a leading equity valuation firm, with a request to determine the value of River Island.

While valuation of a company’s shares needs to be based on the financial figures, these alone do not provide the full picture. It is also necessary to understand the business conditions and the industry situation.

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Moreover, the financial analyses are made under a set of assumptions, and it is the duty of the valuing consultant to explain the assumptions underlying the valuation, and also examine the impact of any change in any of the assumptions on the overall value of the business.

This paper examines the business and financial situation of River Island Clothing Limited, and makes a financial analysis of the company with a view to determining its value. The valuation is accompanied by a sensitivity analysis involving some of the key factors.

Analysis of business situation

The global economic recession has had its impact on the retail apparel industry as well. Although clothing, being an item of necessity, normally bucks the general trend during a downturn, this has not been true in the case of the current economic recession. The growth in the industry has been sluggish, with negative growths being recorded in individual segments during specific periods.

At the same time, bigger companies have been in a consolidation mode, while smaller companies have found it very difficult to even survive. This presents an opportunity to the bigger companies.

In the past, River Island had always managed to grow even when other companies were facing adverse conditions. However, the 2008 figures for the company show that there was no growth, and business remained static during the year.

Forecast of Future Economic Benefits Stream of River Island

The turnover of River Island grew from £456.58 million in 2004 to £877.36 million in 2008, representing a compound annual growth rate (CAGR) of 17.73%. The growth during 2008 was 2.95%. However this was over a negative growth of -2.1% during the previous year, so that the effective growth during the period 2006-2008 was practically nil.  Profits after tax grew from £60.06 million in 2004 to £110.06 in 2008, representing a CAGR of 16.35%.

The Compound Annual Growth Rate for the Apparel industry, as a whole, during the period 2004-08 was 2.7%. (Datamonitor 2009, p.8) The rate of growth for the year 2008 was 1.8%. (Datamonitor 2009, p.9)

Although the overall CAGR for the period 2004-08 has been much higher in the case of River Island than that of the industry, the growth during 2007-08 has been very close to the industry growth rate of 2.7%. Moreover, River Island had experienced a negative growth rate during the previous year (2006-07).

The industry is expected to slow down to a compounded annual growth rate of 1.6% during the next five years, with negative growth rates in the first one or two years.

Considering all the above facts and forecasts, it is unrealistic to assume a much higher growth rate for River Island during the period 2009-13 than the anticipated industry growth rate. Hence this growth rate (1.6%) has been assumed for the projections of cash flows during this period for River Island.

Although the industry is expected to experience negative growth in the initial years, the growth has been assumed at a uniform rate, throughout the five year period, in the case of River Island.

The above considerations are applicable to the expected growth in the sales turnover. The growth rate in sales turnover only helps in projecting the gross income of the company. In order to arrive at the cash flow projections, the figure of Profit after Tax needs to be computed.

For this purpose the average ratio of profits to turnover during the five year period 2004-08 could be used as the basis.

The ratio of Profit after tax for the five year period 2004-08 works out to 13.59%, with the average for the past three years being 12.45%. For the purpose of the projections of cash flows during the period 2009-13, a rate of 12.5% has been assumed.

With these assumptions, the turnover and profit after tax, projected for the period 2009-13 are shown in Table – 1.

Table – 1

Weighted Average Cost of Capital

Using the Capital Asset Pricing Model (CAPM), the cost of equity capital can be assessed as a function of the risk-free rate, the expected market yield on similar investments, and the beta for the investment representing the volatility associated with it. The expected yield and the beta of the stock together provide the risk premium that needs to be added to the risk free rate to arrive at the cost of capital.

The formula for calculating the expected rate of return from this class of investments (cost of equity capital) is

Expected rate of return = Risk Free Rate + Risk Premium.

The risk free rate in the U.K. is taken as the return on 15 year gilt yields, which was 4.64% as on February, 2010. The U.K. risk premium is 5.00% (Portsmouth Business School 2009, p.3)

Hence the cost of equity capital = 4.64 + 5 = 9.64%.

The debt component in the capital structure is assumed to be zero, since the summary figures for 2008 show only a minimal figure of long-term liabilities, which can be ignored. (Portsmouth Business School 2010) Hence the entire capital is assumed to be made up of only equity capital.

Consequently, the weighted average cost of capital is the same as the cost of equity capital, which is 9.64%.

Quantitative Assessment of the value

The valuation of company shares can be made by employing a number of different approaches such as asset based methods, earnings based methods, dividend valuation models, or discounted cash flow methods. More recently, methods such as market value addition and economic value addition approaches are also being used. (McMenamin 1999, 252-282)

The Discounted Cash Flow methods offer the advantage of taking into consideration the time value of money, and therefore represent a true picture, particularly in cases of variations of cash flows from year to year. The Net present value of projected future cash flows gives a reasonably good idea of the value of the business.

Calculation of Net present Value involves the assumption and use of a particular discounting rate. The Weighted average cost of capital can be used as the discounting rate, as this is the return that is actually required.

Strictly speaking, the entire life of the project should be considered for valuing any project. In this .case we could consider a greater number of years or an infinite stream.

However, this might not provide accurate results because it is difficult to forecast even with a low level of accuracy, the cash flows for such a long period, as we have no idea of what future conditions are likely to prevail.

On the other hand, ignoring the cash flows beyond a certain period, which is 5 years in this case, makes the estimate conservative, and hence does not vitiate the conclusions. The cash flows for a period of five years 2009-2013, have accordingly been considered in these calculations.

With these assumptions, the Net Present Value of the future cash flows works out to £438.88 million. As against this, the total shareholders’ funds as of 2008 were £ 213.74 million. Since the exact number of shares issued is not available, the price per share has not been calculated.

The total value of the business is, consequently, estimated as £438.88 million.

Appraisal of Assumptions and Sensitivity Analysis

Assumptions

The above valuation of the business involves a number of assumptions, some of which are listed below.

• Compounded Annual Growth rate: The rate of growth is assumed from past trends. This may vary substantially in the future years. In particular, the growth rate for the later years may be very different from what is assumed based on present figures. (Harman 2010)
• Discount rate: The discount rate is computed using one of the methods for assessing the cost of capital such as the Capital Asset Pricing Model (CAPM). In this paper, the CAPM has been used. Under this approach, the calculation of the cost of capital makes assumptions regarding the risk free return and the risk premium. The risk free rate can be taken variously as 10-year, 20-year or 30-year bond yields. (Mramor, Joksimovic and Mcgoun 2003, 18)  In this particular case, the 15-year yield has been taken as the risk free rate. Another variable that can affect the discount rate is the risk perception. The calculation of cost of capital is made on certain assumptions regarding the risk premium. This can change with changes in the risk perceptions. (Dayananda, Irons, Harrison, Herbohn & Rowland 2002,  118)
• Cash Flow Projections: Cash flow projections are made on the basis of previous years’ figures. Even minor errors in the assumption of the cash flows in the initial years can magnify the errors over the years and give erroneous results. (Harman 2010)
• Costs: Variation in input costs can affect the cash flow projections by altering the profit to turnover ratio.
• Price variations: The growth rates used in the computation assumes that the prices of the products are constant. Variations in prices can affect the cash flow projections, even though the growth rate remains the same.

Sensitivity Analysis

In order to test the extent to which changes in these assumptions can affect the final conclusions, sensitivity analyses can be done on the data, by varying one or more of the values at a time and observing the results. In the present case, sensitivity analyses were done by changing the values of a few variables. The values that were changed, the extent of changes, and the resulting NPV after incorporating the changes are shown in Table – 2.

Table – 2

From Table - 2, it can be seen that variations in growth rates and discount rates do not affect the NPV significantly. However, the valuation is highly sensitive to changes in the costs. In this case, when costs increase by approximately 3%, the NPV is reduced by nearly 20%.

(Note: The Cost/Turnover ratio was changed from 12.5% to 10%.Thismeans that costs have increased from 87.5% to 90%, representing an increase of 3 %.)

Critical Evaluation of the methodologie

The discounted cash flow methods use the projected cash flows from the project as the basis of valuation. Projected cash flows are facts (subject to assumptions) and are not based on judgments like accounting profits.

Earnings based methods rely on judgments such as market assessments about this or similar class of investments. They can therefore vary depending on market perceptions.

Dividend based models consider only the dividends and not the retained earnings. Although this makes sense to the investor, in the long run, retained earnings also belong to the shareholder, and should be included in the valuation for greater accuracy.

The discounted cash flow method offers several advantages over other methods because it considers the time value of money. Some of the advantages of this method are:

• These methods consider the actual cash flows, reducing the subjectivity in the assumptions.
• Discounted Cash Flow methods consider the time value of money, and hence the valuation will be more accurate. (Shim & Siegel 2007, p. 210)

However, these methods also suffer from some deficiencies.

• Discounted cash flow methods are usually sensitive to the discount rates and other variables assumed. Hence changes in the cost of capital can vitiate the results.
• DCF calculations are made on the basis of a number of assumptions. Variations in any of these assumptions can render the calculations less reliable.
• Discounted cash flow methods make an implicit assumption that any surplus available with the business because of surplus cash flow generation can be employed in such a manner as to yield the same return as required by the cost of capital. This may not be true in all cases. (Polimeni, Handy & Cashim, 1993, p.158)
• Many of the valuation and appraisal methods, including DCF methods ignore the risk factor altogether. Although sensitivity analyses can throw some light on the extent to which these factors are likely to affect the results, more precise methods are now available to assess the impact of risks. Activity based methods, for example, can be used to vary the activity drivers and their levels to get a more realistic view of the risks and variability of results. (Cook, Grove & Coburn 2000, p. 305)

Conclusion

Based on the available facts and the above considerations, the business is valued at £438.88 million. In the absence of information about the number of shares issued, the price per share could not be calculated. The above valuation can be significantly changed if the input costs vary substantially.

Works Cited

1. Cook, T. J., Grove, H. D., & Coburn, S. 2000, ABC Process-Based Capital Budgeting,. Journal of Managerial Issues, 12(3), 305.
2. Datamonitor 2009, United kingdom – Apparel Retail, Datamonitor.
3. Dayananda, D., Irons, R., Harrison, S., Herbohn, J., & Rowland, P. 2002, Capital Budgeting:  Financial Appraisal of Investment Projects. Cambridge University Press, Cambridge, England.
4. Harman, Bryn 2010, Top 3 DCF Analysis Pitfalls,[Online] Available at <http://www.investopedia.com/articles/07/DCF_pitfalls.asp>
5. Mcmenamin, J. 1999, Financial Management: An Introduction, Routledge, London.
6. Mramor, D., Joksimovic, D., and Mcgoun, E. 2003, "2 How Uncertain is Firm Valuation?". In Practical Financial Economics:  A New Science, ed. Murphy, Austin:13-30. Praeger, Westport, CT.
7. Polimeni, RS, Handy, SA, and Cashim, JA 1993, Schaum’s Outline of Theory and Problems of Cost Accounting, McGraw-Hill, New York.
8. Portsmouth Business School 2010, Business Valuation, Portsmouth Business School.
9. Shim, J. K., & Siegel, J. G. 2007, Schaum's Outline of Financial Management (3rd ed.), McGraw-Hill, New York.

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