Diageo

Dear Students,

Hope this email finds you all well.

As you might have all realised, I will be your Teaching Assistant throughout the entire of the summer period. Before I walk you through the main purpose of this email, I wanted to share a few details with you, and the way in which I intend to run this supervision process.

Aside the 4 meetings which we will have together (on an individual basis) over the next couple of months, I intend to be sending you notes which I have personally written, which will facilitate the writing of your project. These notes will essentially guide you effectively towards the build-up of the entire of your project.

Today, and before the commencement of the 1st phase of meetings, I am sending you a detailed idea of the project as a whole, and the structure that you are recommended to follow (although, definitely, this structure is not set-in-stone, and you are highly recommended to change it, where you feel it's needed). This is merely an initial guide, to provide you an a good insight of the content itself.

Please find below various elements which you are recommended to cover in your report (definitely, you can go into more detail with this by splitting each section into further sub-sections, where you deem necessary). Further, you can add some sections (if you deem necessary). 

Note: Before proceeding to the information below, I just wanted to say that you should NOT write a literature review. This is not an academic piece of writing; rather, it's a practical project. Please see below a general overview of what you could include (note, however, that the list is not restricted, and you are HIGHLY RECOMMENDED to add any other sections that you seem relevant, alongside maybe sub-dividing some of the following headings into further - more transparent - sub headings). Further, you can merge any of the following (if you perceive this to be appropriate for the nature of your project). It's on you how you structure your report. However, below, you can find very useful (and important) information that you are generally highly recommended to use (not necessarily in the precise format... but the following are ideas which you can have in mind whilst preparing your report).

1.Introduction

In the introduction, you can include information relevant to the objectives of the paper itself (i.e. what is the aim of the project; to derive the intrinsic/fundamental value of company "X"). Further, you can include information relevant to the 'framework' that you intend to build upon (including how your project intends to unfold - for instance, introducing subsequent sections and even briefly stating the models used... as a minimum, you must use the "discounted cash flow model". The 2nd model is entirely your choice (but, if you want, you can select the "relative valuation model" and I can definitely help you on this when the time comes... I would be more than happy to help you). 

Also, you can include information relevant to the company background and corporate strategy of the company. Note that information relevant to the company background and its corporate strategy can be found in the annual report of the company. Here, you shall provide a general background of the company that you analyse. For example, you can include information relevant to the services/operations it provides. Further, you shall provide information in regards to where it is located (areas/countries of operation). You can also include the type of segments it has. Further information that you could include is its market share in the industry (and maybe how this compares to its competitors). Further, you could include information relevant to the corporate strategy of the company itself (for instance, the drivers it uses to achieve competitive advantage; does it focus on revenue enhancement, on cost reduction etc).

Note: The above can be sub-divided into sections (for a better organisation of your ideas).

 

2. External analysis

Here, you can provide a general global economic analysis and an industry analysis. Overall, it is good if you go through the annual report of the company (the 2020 report) and provide a general analysis of the industry itself and economy overall (that is, the external environment of the company that you analyse). Further, it would be nice if you could include some charts to provide real life data examples.

You can include certain macroeconomic effects (i.e. economic growth, inflation rate, interest rate, does the company operate in a recessionary period/inflationary period, you can include certain political/economic events, trade tensions)... the impact that these had on the industry in which your company operates (i.e. on the demand and its performance subsequently). Also, you can include Porter's five forces within this section.

Again, as mentioned, the annual report is a great starting point; and, please, make sure not to go off topic (remember to stay within topic).

These are just a few ideas; definitely, you can omit some of them (and include others of your own). I am just providing a small list with things that you could include. But, please, remain on topic (don't go out of topic).

3. Internal (i.e. company/financial performance) analysis

Here you can provide a general information internal to the company (that is, company analysis). Further, you can comment on the company's main value drivers (whatever these are); make sure you go through the annual report for these. Further, you could comment on individual segments of the company and provide an analysis for each of these segments (i.e. comment on the performance of each segment, given the performance of the current (and even future) period. You can comment on the corporate strategy of each of these segments (perhaps, statistics of each of these segments etc.). You might also wish to include some accounting ratios (if useful).

Again, the above are just an indicative list (you are not obliged to include everything). And you can definitely (and highly recommended) to include your own ideas as well.

 

4. Valuation

Then you shall proceed to your valuation section. The idea is to calculate the fundamental value for 2020. To do this, you MUST use the discounted cash flow model, and you can also use a 2nd model as well (perhaps, the relative valuation model). But, definitely, you MUST use (as a minimum) the discounted cash flow model.

In this email, I will explain the Discounted Cash Flow model (and you can approach me by email (or at our next meeting) if you want a description on the 2nd model --> although, to be honest, the relative valuation model is one which I go through in detail in one of my other emails that I intend to send you subsequent in the weeks.

With the discounted cash flow model, here is a very very simple - and, definitely, NOT the final - structure that you are recommended to use (observe your company, as perhaps more items shall be included in the following list):

Revenue

-Cost of Goods Sold

+Other Operating Income

-Operating Expenses

=Operating Income

+Non-cash items (i.e. depreciation)

=EBITDA

-Corporate Tax

-Change in Non-cash working capital

-Net Capital Expenditure

- etc

- etc

- etc 

= Free Cash Flow to Firm

Note: As mentioned, please observe your company, as, perhaps, much more items need to be added in the above list (and even some items included here can be omitted altogether).

Please remember that your aim is to compute the intrinsic/fundamental value as of 30th June 2021 (I will go more into details with the intrinsic value calculation in subsequent weeks) --> but, for now, please aim to calculate the "Free cash flows to the firm" for the years 2016, 2017, 2018, 2019, 2020, 2021, 2022, 2023, 2024, 2025, 2026 (that is, 5 years back of 2021 and 5 years forward of 2021).

Hence, as a first step, it is necessary to download the annual reports from 2016-2020. Since the above items are given in the annual reports, it is very easy to compute the "free cash flow to the firm" for the years running between 2016-2020.

Further, to be able to compute the intrinsic/fundamental value for 2021, it is essential to forecast how much the "free cash flows to the firm" worth in 2021-2026... however, to be able to predict the free cash flows for the years 2021-2026, then, judging from the structure above, you need to have a number of items, including the "revenue", "cost of goods sold", "etc..."... clearly, these items - for the years 2021-2026 - are not given in the past annual reports (and hence you need to forecast these items for the years running between 2021-2026)... the method to apply is the following... 

Let's take "revenues" as an example (which is the first line item above)... the way in which you can predict the revenues is the following:

Going to the statement of profit and loss (in each of the years 2016-2020), you can find the revenue associated with each of the year... the idea is to observe the change in items over time (for instance, observe the percentage increase in revenues from 2016-2017, then the percentage increase in revenues from 2017-2018, then the percentage increase in revenues from 2018-2019 and then then the percentage increase in revenues from 2019-2020). Now, you have '4' growth rates ahead of you (from one year to the next). Add these up and then take the average of these... the average of these is the historical average growth rate... and this will be used as a BASIS for the future... 

let's assume that the average revenue growth rate (across the past 4 years) is 3% (this is an assumption... you need to calculate it to see how much this is)... THEN, you need to make some independent research (i.e. perhaps, the latest annual report in 2020), and see what are the future investment opportunities of the company itself (and challenges), and adjust the growth revenue rate accordingly (up or down)... and make estimations up to, approximately, 5 years ahead (i.e. 2021-2026). And do the exact same things for all other items (including, cost of goods sold etc).

For instance, although the historical growth rate was 3% (our assumption above), over 2021 you can see that we had the coronavirus... hence, assuming that no positive opportunities arouse this year, you need to reduce this rate (and here you need to use your judgement of why you reduce it to, for example, 2.1%)... perhaps, you can find some estimation through certain terminals (i.e. bloomberg), which can provide you with an excellent guide of potential percentages.. then in 2022 when the economy is expected to start recovering from the coronavirus, you can raise this 2.1% to approximately 2.6% (closer to the historical one, as the economy has slightly recovered from the pandemic)...  but, as said, this also depends on the percentages which you come across, from your research --> it is only essential to be able to justify the adjustments in words .. for instance, whilst online on bloomberg you might find a percentage rate of 2.6% growth in revenue, you might not find a verbal explanation on this.. hence, please, make sure you justify this yourself, by putting forward some value arguments.. further, in 2025, you may observe in the annual report that the company intends to undertake an investment... this investment opportunity will improve its prospects and growth rate (And you would need to adjust it upwards again)... just have a look at the annual report of 2020 to see any FUTURE opportunities and challenges to explain any potential adjustment in the rate accordingly...

Bear in mind that there is no single answer... for instance, some students may increase it more (and others less)... what supervisors will be seeing is the rationale behind your adjustments... so make sure to be explicit in your explanations (behind each adjustment etc.)

Further, you can do the exact same thing with 'cost of goods sold' and with all other items (i.e. find the historical average rate, like above, and adjust it accordingly based on the economic environment in general)... the key here is to EXPLAIN why you adjust it upwards or downwards (or even keeping it constant)... for instance, the depreciation (non-cash item), is something which you might choose to keep constant (in absolute terms) as long as you justify it.

Overall, the key with each adjustment (and non-adjustment) is the rationale behind your decision (this is what examiners will be looking for). It is essential to communicate your ideas (i.e. not just increase/decrease a growth rate without explaining the reasoning behind this change). Make sure to be as analytical as possible.

Then, after you compute the "Free Cash Flow to the firm" for the years running between 2016-2026, it is essential to calculate the fundamental (intrinsic) value at 2021, as said earlier. This can be done by discounting all future cash flows to the present (at 2021) using the WACC. The WACC is something which I can discuss with you at another email that I will send subsequent in the weeks.

Further, in another email, I will also help you with the 2nd valuation model of your choice (as mentioned before, perhaps you could choose the "relative valuation model" and I would be more than happy to help you with this).

Sensitivity Analysis:

After you complete the Valuation section, perhaps you could include a sensitivity analysis section. This is essentially a "what-if" analysis scenario; i.e. what the intrinsic value would've been if I had used different variables (i.e. if the WACC was 1 basis point higher/lower). Or what would the intrinsic value would have been if the perpetual growth rate was higher/lower.

However, please, do not worry with this section for now. I will help with this subsequently (after you complete the above).

Conclusion:

Lastly, you provide your conclusion. In your conclusion, you summarise your findings and you provide a recommendation to the investor on whether it words to BUY or SELL the stock. Again, I will go into more detail with this in another email.

I really hope that all of the above are of help for now. I have tried to be as clear as possible.

Please note the following: The above is just a very simplistic format (you can include the above section, whilst breaking them down to further sub-section). Further, you can use slightly different headings etc. However, please, stick to this overall idea. Also, you can definitely add MORE information to the one that I have provided above (as long as you remain on topic). Also, please - where appropriate - include formulas that you use AND also please make sure to be as analytical as possible with the reasoning behind each assumption. You can also include graphs/tables where you deem appropriate. Bear in mind that presentation does matter, so please keep everything leniently.

Also, please feel free to email me at any point in time, and I would be more than happy to help you.

Hope these help for now, and please remember that I am currently in the process of conducting further notes, relating to (a) WACC, in the run-up of computing the intrinsic value, (b) the relative valuation model, (c) the sensitivity analysis, (d) conclusion.

I can guarantee to you that the notes which I aim to conduct for you will equip you very nicely with the writing of your project.