The project is conducted in an effort to evaluate the performance of Hyflux Limited over the five year period from 2006 to 2010 via Dupont System and to estimate the intrinsic value of common shares of Hyflux Limited. It is the world leading water treatment system which is incorporated in Singapore on 31 March 2000 in term of market capitalization in Singapore through four valuation models, including dividend discount model, price/earnings ratio model, price/book value model and net tangible asset backing model. The findings from the project will facilitate the decision making process of investors, who have the intention to put their funds at this company.
The paper makes use the Dupont system of financial analysis to evaluate the performance of Hyflux Limited over the period 2006-2010.
The four valuation models, which are the most popular common stock valuation models, indicated that the common shares of Hyflux Limited are undervalued as the estimated intrinsic value of the stock is higher than the prevailing current market value. Therefore, it is highly recommended that investors, who have the intention to park their funds at Hyflux Limited, should quickly purchase the shares as they are currently valued wrongly. Besides, a low P/E ratio indicates that Hyflux Limited is a valued investment that investors can receive handsome returns in the long run.
1.0. Introduction
There have main six parts in this assignment. First it will have an introduction of Hyglux Limited. Then the second it will focus on the external and internal environment of Hyflux Limited, and what impacted the performance of Hyflux over the past five years. The third part will evaluate the performance of Hyflux Limited from 2006 to 2010 with Dupont System. The fourth part uses four valuation models to estimate the value of common shares of Hyflux Limited. The fifth part wills analysis the results from four valuation models then estimates the shares. The final part of the project is a conclusion. It will conclude the whole parts.
2.0. Company��s profile
Hyflux Limited is world leading water Treatment Company which is incorporated in Singapore on 31 March 2000. The company is well-known in the world through its membrane technologies. Its water treatment system applied advanced water treatment and filtration of membrane. Hyflux provides services as one-stop shop, it shown below:
i. Design
ii. Fabrication
iii. Installation
iv. Commissioning
v. Maintenance of water treatment
vi. Wastewater treatment
vii. Water recycling
(Source: Hyflux Limited Prospectus, 2011)
3.0. External and internal factors influence Hyflux��s performance
3.1. External Factors:
3.1.1. Political factors
Locating its headquarter as well as the vast majority of business in Singapore is advantageous for OCBC Bank as the country has a stable political system. The Singapore government has maintained a clean, corruption-free image. In fact, Singapore is ranked 5th in the word and 1st in Asia for having the least corruption in its economy (IDM World Competitiveness Report, 2010). There has a pro-business environment in Singapore.
Figure 1
(Sources: KPMG 2010, p30)
3.1.2. Economic factors
The global economy has to muddle through one of the most difficult period since the Great Depression. Subprime mortgage crisis is the Major resistance on the world economy from the end of 2007 in the U.S. It triggering a full range of credit crunch, then it reverberated throughout the global financial system.
Singapore's economic performance in the period 2006 to 2010 is quite good. Domestic production the gross (GDP) increase of 8.7% and 8.8% respectively in 2006 and 2007.Singapore achieved a record growth of 14.5 percent in 2010 (Department of Statistics of Singapore, 2010).
Hyflux needs many workforces that are specialized in plain and machinery operations. They are the one who will contribute to the success of the business operations within Hyflux. Without them, Hyflux market leader position will not be easy to sustain. In Figure 3, Singapore encompasses 3.8% of these specialists who are unemployed.
Thus, Hyflux do not need to worry about the excessive vacancies for plant and machinery operators as these vacancies will be filled by them
Figure 2
(Sources: MAS, 2011)
Figure 3
(Sources: Manpower Research and Statistics Department Singapore, 2011)
3.1.3. Social factors
Most Singaporeans are health conscious nowadays. The availability of clean water plays an essential part in this aspect. As the problem of water pollution is becoming serious annually, it is suggested that without proper treatment, water is unclean and unsafe to consume. This creates advantages to Hyflux as they can get more business from customers although the price is high due to the health concerned.
Many of the residents want to change their lifestyle with more healthier when the living standards had risen. The residents also have the ability to change it. (The Singapore Green Plan 2012, 2006, p56) The first thing was obtaining clean water. And Hyflux will provide this service. Most customers will subscribe the services.
3.1.4. Technology factors
As the intervention of the Biological Nutrition Removal (BNR) which is supported by Singapore government by Dr James L Bernard in the year 2011 (Esther Ng, 2011) in Singapore, this promotes competition challenges to Hyflux��s proprietary membrane and desalination technologies. Besides that, there will be another technology development that will bring challenge to Hyflux membrane and desalination system. Nanostart is working together will Membrane Instruments and Technology Pte. Ltd (MINT) to develop fully automated nanotechnology system that is capable of achieving a high level of water quality. It is expected to be profitable and monopolized about 16% of the market share in future (Nanostart Investment Asia, 2011). Thus, this may affect the position of Hyflux Limited as market leader for next generation.
3.1.5. Environment factors
As the construction of plant is mandatory for the success of projects undertaken by Hyflux in Singapore, thus, the environment challenge will be the destruction of natural habitat for the aquatic life in Singapore and more seriously, the extinction of aquatic life. There will be pressures from environment concerned groups such as Singapore Reef and Marine Conservation Committee (SRMCC) which will urge government to take appropriate action in relation of these problems through the enforcement of environmental law.
However, although the construction of plant leads to environment problems, however, it can also be vice versa. For example, the construction of desalination plant can reduce thermal energy consumption in water treatment process (Hyflux Brochure 2011, p7). National Environment Agency (NEA) nowadays encouraging the company incorporated in all industries to give more attention energy consumption reduction. Thus, Hyflux can achieve this by having the desalination plant in Singapore.
3.1.6. Legal factors
Singapore had set up a board known as SPRING Singapore (Standards, Productivity & Innovation Broad) to govern the compliance of the standard of processes of a company with the set benchmark to ensure a product safety. In water treatment industry, SPRING board had set the benchmark in relation to the level of cleanliness and safety of water for example, odous and flavor of water after treatment process which is specified under Singapore Standard 375 Odour and Taste of Water (SPRING Singapore, 2008). However, this provides challenge to Hyflux as the standard set by the board is relatively high. Failure to comply with the standard will be penalized under Singapore Clean Water Act and in the event the offence is serious, company will not be capable to continue its business in Singapore.
3.2. Internal Factors:
Internal factors include factors include its strengths, weaknesses, opportunities and threats.
Table 1: Hyflux��s SWOT analysis
STRENGTHS
The chief executive officer (CEO) of Hyflux, Olivia Lum successfully brings the company from a small company to become market leader in the water treatment industry. Together with strong vision, she had also success in the expansion of water purification business involving the usage of oil-recycling. In addition, she will do what she promises to do such as entering into energy sector (Hyflux Limited Annual report, 2011).
* Strong Products
It is very difficult to find a substitute for Hyflux��s well-know membrane technologies. In addition, the technologies can serve a wide range of industries. This provides a strong barrier for the entrance of new competitors.
* Strong in research and development
It is obvious that the research and development activities contribute the most to the success of Hyflux Limited today. Hyflux is putting more attention in this aspect for the purpose of developing more technologies which are beneficial to Hyflux. In 2004, Fyflux Limited has set up its largest research and development centre in Japan. The center had successfully come out with oil recycling engine business (Hyflux Limited Annual Report, 2004).
In 2010, Hyflux also decided to set up Hyflux Innovation Center in Singapore for the purpose of enchancing the development of membrane technologies (Hyflux Limited Annual Report, 2010).
In 2007, the orders received by Hyflux had doubled. Recurring income will be generated for 25 to 30 years as a result of the lengthy operations and maintenance projects undertaken in Singapore.
In addition, the estimated recurring income is in the region of $80 to $90 million. Hyflux will be able to monopolize the water treatment industry as desalination��s market will grow for 160% over 10 years (Hyflux Annual Report 2004, p31).
* New venture
In 2007, Hyflux had successfully entered into Middle East and North America (MENA) due to the high demand of desalination technologies and energy sectors.
As a result of the increasing shareholder��s equity in 2006, the profit had declined more than half in that year (Hyflux Limited Annual Report 2007, p59). As Hyflux comprises strong desalination business; the company actually should not increase its shareholder��s equity in 2006. It can therefore indicate a poor judgment in capital allocation.
* Accounting function
Again, the decreasing profits in the year 2006 are due relatively to the high tax and deferred tax expenses from previous years.
This indicates the existence of problem in relation of the accounting practices.
* Over reliance on the proprietary membrane technology
The proprietary membrane technology is considered to be the capability of Hyflux Limited. Without the technology, Hyflux would not be able to be the market leader within the water treatment industry. in the event that new technology had been introduced, core rigidities might be occurring and this will certainly bring effect and damage to Hyflux business.
* From the previous two years, there had been excessive personal development expenses and finance costs. This will probably to occur again.
* The existence of competition between Hyflux and Japan��s Mitsui as it had undertaken project worth $3.8 billion in Qatar (Infinite Wealth, 2008). In Singapore, GE Water and Pentair and Pall are likely to compete against Hyflux in term of bidding project in Singapore (MITSloan Management, 2011).
* Intervention of new technologies. The intervention of Biological Nutrition Removal (BNR) and fully automated nanotechnology system will bring challenge to Hyflux proprietary membrane technology.
4.0. Evaluating the financial performance of Hyflux Limited through DuPont system
According to CFO Magazine, the DuPont system of financial analysis was created by a finance executive at E.I. Under the DuPont system, ROE is broken down into three components, including net profit margin, total asset turnover and financial leverage or equity multiplier. The decomposition of ROE is beneficial to an investor as well as management team of a firm as it provides insights into the causes of the firm��s ROE or any changes in it (Brown & Reilly, 2009).
ROE = Net Income/Net Sales �� Net Sales/Total Assets �� Total Assets/Common Equity
= Net Profit Margin �� Total Asset Turnover �� Financial Leverage
����
There are some significant trends in the DuPont results of Hyflux Limited in Table 2:
The company earned a net margin of 34 percentage points in average over the period. The net margin series experienced a steady increase from 22 percent in 1Q2009 to almost a peak value of 48 percent in 1Q2010. The margin went all the way down in 2008 and early 2009 due to the global financial crisis. It hit the bottom of 22 percentage points in 1Q2009. However, the margin quickly returned to normal level, which showed resilience of the bank during tough time. Hyflux Limited could generate and maintain handsome margin as compared to two local peers.
The total asset turnover ratio of Hyflux Limited was stable from 2006 to 2010. In average, the company could make use of its net total assets 0.019 times to generate income. There were minor differences among the ratios of Hyflux Limited and its two local peers. This showed a high effectiveness of three local companies in utilizing their total assets.
There were small changes in the financial leverage of Hyflux Limited over the five-year period. For every dollar of total assets, more than 80 cents came from creditors. The ratio decreased steadily after the 2008 global financial crisis as the bank was required to reduce its leverage. This provides investors more confidence when putting their money in the bank.
ROE of Hyflux Limited was quite low as compared to its regional peers. The low ROE of Hyflux Limited indicated the weakness of the company in utilizing its total assets as compared to foreign competitors. However, the ratio was also attributable to high Tier 1 capital ratio of Hyflux Limited as company in Singapore are required by the government to maintain Tier 1 capital ratio of at least 6 per cent (Chanckr, 2011). The ratio consists of retained earnings and equity. A high number enables Hyflux Limited to provide more loans and protects the company from adversity.
Table 2: Components of Return On Total Equity For Hyflux Limited
Profit Margin
Asset Turnover
Leverage
On Equity (%)
5.0. Estimating value of Hyflux��s shares
The prime objective of estimating the value of common shares of Hyflux Limited is to figure out the fair value of shares at a particular rate of return and compare it to the prevailing market price (Brown and Reilly, 2009).
5.1. Dividend Valuation Model
Under the dividend valuation model, the value of a common share is the present value of all future dividends (Brown and Reilly, 2009):
Vi =
where:
Vi = intrinsic value of stock i
Dt= dividend during period t
k = require rate of return on stock i
In the context of the project, we employ the Gordon Growth Model, which is used to value a firm that is in ��steady state�� with dividends growing at a rate that can be sustained forever.
Vi =
where:
D1 = expected dividends one year from now
k = required rate of return for equity investors
g = growth rate in dividends forever
Rationale for using the model to estimate the value of Hyflux Limited shares
The company is in stable growth based upon its size as well as the area that it serves.
The company is in stable financial leverage. Over the five-year period from 2006 to 2010, the equity multiplier averaged at 9 times.
There is not much room for the company to expand its business as the company industry in Singapore is mature.
It is not possible for the company to experience supernormal growth in the years to come due to the harsh competition from its peers both local and foreign.
The dividend payout ratio was set to be 45 per cent of core earnings since August 2006.
Valuation
VHyflux = = = S$3.18
where:
�� Hyflux = 1.21 (Reuters, 2011)
Risk free rate = 2.37%. This is the coupon rate of Singapore Government Bonds, which are issued in 2011 and will mature on June 1st, 2021 (Singapore Government Securities, 2011).
Market rate of return = 6.3%. This is the average annual return of the Straight Times Index from 2006 to 2010 (FTSE International Limited, 2010).
k = E(R) = Rf + ��(RM �C Rf) = 2.37 + 1.21(6.3 �C 2.37) = 7.1253%
Dividend payout ratio = 40% (Hyflux, 2006)
ROE2010 = 11.5% (refer to Table 2)
g = b �� ROE = (1 �C Payout ratio) �� ROE = (1 �C 40%) ��11.5% = 6.9%
Dividend per share in 2010 = S$0.0067 (Hyflux, 2011)
Hyflux Limited was trading for S$1.23 on the date of this analysis (Jan 6, 2012). The stock would have been undervalued as the prevailing market value was smaller than the estimated fair value.
5.2. Price/earnings ratio model
The P/E ratio model, it is also called the earnings multiplier model. It is used by investors to estimate the value of a firm��s share of common stock by determining how many dollars they are willing to pay for a dollar of expected earnings (Bodie & Kane & Marcus, 2010).
Price/earnings ratio = Price/Earnings ratio =
The Earnings multiplier model can be produced from the Dividend valuation model as dividend is one of the variables that influence the P/E ratio over time.
The earnings multiplier model goes as follows:
Pi/E1 =
Returning the case of Hyflux Limited, the Earnings multiplier model for the share of common stock of the company goes as follows:
Pi/E1 = = = 177.54
A P/E ratio of 177.54 means that investors are willing to pay S$177.54 for every dollar of expected earnings of Hyflux Limited.
EPS of Hyflux Limited in 2011 is determined as:
E1 = E0 �� (1+g) = 0.1052(1+0.069) = S$0.1124
where:
E0 = S$0.1052 (earnings per share in 2010)
The estimated intrinsic value of the Hyflux Limited��s share of common stock is as
VHyflux = P/E �� E1 = 177.54 �� 0.1124 = S$19.96
Hyflux Limited was trading for S$1.23 on the date of this analysis (Jan 6, 2012). The stock would have been undervalued as the prevailing market value was smaller than the estimated intrinsic value.
5.3. Price/Book Value ratio model
The price/book value (P/BV) is a good indicator of the intrinsic value of a firm��s share of common stock. The ratio indicates how many times over the book value the common stock is traded (Brown & Reilly, 2009).
The P/BV ratio is specified as follows:
P/BV = Price per share/Book value per share (1)
Returning to the Dividend Valuation Model:
Vi = (2)
Combining equation (1) and (2), we have:
P/BV =
The P/BV ratio of Hyflux Limited is determined as:
P/BVHyflux = = = 20.4
The estimated intrinsic value of Hyflux Limited��s share of common stock is as:
VHyflux = P/BVHyflux �� BV per share = 20.4 ��7.85 = S$12.6
where:
BV per share = (Shareholder��s equity �C preferred equity)/Total outstanding shares
= 1 064 430 000/861 890 000 = S$1.23
Hyflux Limited was trading for S$12.6 on the date of this analysis (Jan 6, 2011). The stock would have been undervalued as the prevailing market value was smaller than the estimated fair value.
6.0. Conclusion
Hyflux Limited had developed from a small company to a market leader in the water treatment industry. The alteration of the core business surely will bring a major change in Hyflux business. The membrane and desalination technology provides a valuable aid to Hyflux aid to Hyflux as the technology will become the factor that will increase the gap between Hyflux and competitors. Hyflux had plant in Singapore, Malaysia and China.
The management of Hyflux put very much emphasis and focuses on the research and development process. The management believes that will the continuous development; Hyflux Limited can continue to retain its competitive advantage at marketplace. In my opinion, the diversification strategy undertaken by Hyflux will be beneficial to Hyflux in long-term.
Through a comprehensive understanding of Hyflux over five years from 2006 to 2010.It is the hard times during the Great Depression. Moreover, the common share of Hyflux is undervalued, and the intrinsic value of the share is higher than its current prevailing market value. So, it is recommended the investors who want invest their funds in the bank. They should purchase the common shares of Hyflux then the shares will rise in the future.
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