Ex-Post Valuation Of Deere & Company: Free Cash Flow And Residual Earnings Method

Overview of the Agricultural Equipment and Tractor Market

The purpose of this report is to conduct an ex post valuation of the stock of Deere & Company using the data collected from the financial statements published by the firm during the period starting from 2018 to 2020. The report evaluates the theoretical fundamental intrinsic value of the company’s stock and compares it with the observed market value of the share at the end of 2018. The report commences with the evaluation of the business model of Deere & Company and the performance of the sector that the company belongs to. The report also demonstrates the current economic and industrial environment of the country that the company is operating in. The two equity valuation techniques that were employed to calculate the intrinsic value of the stock were Free Cash Flow valuation method and Residual Earnings method, which use different set of information from the financial statements to arrive at the intrinsic value. An evaluation of both the valuation technique was conducted highlighting the effectiveness and usefulness of the techniques in valuing the company. The concluding section of the report compares and contrasts the value of the company’s stock ascertained using the valuation technique with the observed market price of the stock which prevailed in the year 2018.

The agricultural equipment and tractor market play an important Part in the economy because contemporary and technologically sophisticated equipment and techniques allow a country to improve the quality and quantity of agricultural harvests with minimal labor. In the year ending 2021, the market for agricultural equipment was predicted to be worth $113 billion, while the sector is worth $41.2 billion in the United States (Ibisworld 2022). Due to a large portion of the people residing in the region and a rising reliance on agriculture to meet economic and demographic expansion, the Asia Pacific region is the largest contributor to this industry. The growing need for modernization of farms and agricultural areas in emerging countries, owing to a decrease in labor quantity and quality, as well as a decrease in the average ownership of agricultural land by country inhabitants, is driving the worldwide agricultural equipment market. The market is predicted to increase at a compound annual growth rate of 4.6 percent over the following decade, beginning in 2021, as a consequence of the factors mentioned above. Figure 7 in the appendix demonstrates the expected growth of the agricultural equipment market across the globe for the period of 2021 to 2030 as suggested by the (Globalnewswire.com 2022). The market is expected to grow to a valuation of $168.8 billion till the year 2030 and a major portion is attributable to the markets of Asia and North America.

The company that is chosen to complete the ex-post valuation is the Deere & Company which operates under the brand name of John Deere and is an American corporation operating in the agricultural machinery and heavy equipment industry. The company is a manufacturer and distributor of equipment which are utilized for the purpose of agriculture, construction, turf care and forestry. The segments of the company include construction and forestry, agriculture and turf and other financial services. The agriculture and turf segment of the company is involved into manufacturing and distribution of agricultural and turf related full line of inventory and other service Parts required for the sector. Machines and service components for construction, earthmoving, road construction, material handling, and wood harvesting are available under the Construction and Forestry section. The financial services segment is involved in financing the sales and leases that the dealers of John Deere of old and new agricultural equipment, construction and forestry equipment requires. The company was awarded with a global rank of 329 in the year 2019 and was included in America’s top fortune 500 companies assigned with a rank of 84 in the year 2020. The company is headquartered in Moline, Illinois and is a listed company with stocks of the company being traded on the New York Stock Exchange.

Equity valuation is a method for determining the fair value of a company’s equity in order to aid decision-making. A potential investor can evaluate a company using a variety of equity valuation methodologies and make judgments based on the difference between the intrinsic value and the actual observed market value (Pinto 2020). The Dividend Discount Model, Free Cash Flow Model, Comparable Company Approach, Residual Earnings Method, and Earnings Growth Analysis are some of the stock valuation approaches accessible. The Discounted Free Cash Flow model and the Residual Earnings model were used to value the shares of Deere & Company, the methods and assumptions of which are detailed below:

The Discounted Free Cash Flow Model is one of the most widely used valuation models in the financial world. It involves discounting the free cash flow that a company is expected to generate in the future using an appropriate weighted average cost of capital, which represents the company’s cost of capital. Discounted free cash flows will indicate unlevered cash flow before debt capital payments are made, as well as free cash flows accessible to the company’s equity owners and debt holders (Fernandez 2019).

Discounted cash flow analysis utilizes actual financial numbers which are reported by the company in its financial statements each year. Financial figures like net profit, depreciation, interest expense, taxes paid and several others are required to arrive at the free cash flow of the company (Bukit and Nasution 2015).

• Free Cash Flows – This is the cash flow accessible to the company after accounting for the firm’s external and internal liabilities. It is the cash available to the company’s management to pay down its current investors’ interest and dividends (Nekhili et al 2016). There are several techniques for determining a company’s free cash flow. The cash flow from operations for 2019 and 2020 were collected from the company’s Cash Flow Statement to calculate the free cash flow for Deere & Company. To calculate free cash flow, the company’s annual capital expenditure for the same time was subtracted from the cash flow from operations (refer figure 1 and 2 in appendix).
• Terminal value – The cash flow of the company taking place after the end of the valuation period is reflected in the terminal value. It forms a major Part of the company’s values as it incorporates the long-term growth prospects of the company. The EV/EBIT exit multiple method was utilized for arriving at the terminal value of the company. The average of EV/EBIT multiple for four comparable companies was used as the exit multiple which was then multiplied with the EBIT of Deere & Company in the year to reflect the future value of the company after the period of analysis (Panigrahi 2021). The following table contains the details about the comparable companies and the multiples:

• Discount rate – The discount rate should accurately reflect the investor’s opportunity cost of investing in other similar firms’ initiatives. The Weighted Average Cost of Capital (WACC) is a rate that represents an investor’s expected return on a different investment with the same level of risk as the firm being appraised. The WACC considers both the cost of equity and the cost of debt, as well as the debt-to-equity capital ratio of the company (Jagannathan et al 2016). It was assumed that the interest expense represents the cost of debt for the company. The after-tax cost of debt was computed using real interest costs and Earnings before interest and taxes figure from the company’s financial statement for 2018, and it came to 13.14 percent. The CAPM method of valuation was used to value the cost of equity, which was equivalent to 13.73 percent, with the following assumptions:

Risk free rate (2.21%) – The 10-year yield on the bond issued by the US government was taken as the proxy for risk free rate.

Market return (13.85%)– The 10-year average return on the S&P 500 index was used as the proxy for market return.

Beta – The beta of the stock was taken from yahoo finance which was equal to 0.99.

The resulting WACC using the formula (Wd kd(1-T) + We ke) was equal to 13.31% and was used in discounting the free cash flows.

The firm’s worth was assessed using the DCF model to be $50,478.17 million, which translates to an intrinsic value per share of $156.47 after adjusting for the number of outstanding shares in 2018.

The residual earnings approach is a sort of absolute valuation model that is less common than the DCF method, but is used by a number of equities analysts. After subtracting all of the company’s cost of capital, residual income is computed. On the company’s net profit, a charge is applied for the opportunity costs incurred by the company’s common shareholders. The main idea behind the residual earnings technique is that it implies that the company’s net income does not accurately reflect the underlying profitability for investors since it excludes the charge for equity capital (Penman 2015). The notion is based on the premise that net income is derived after integrating the cost of debt in the form of interest expenditure, but not the cost of equity, because dividends paid are not subject to deduction from a company’s net profit. Hence, a positive net income of a company is irrelevant as may not be adding value for the investors of the company. A residual income method recognizes all the costs of all the sources of capital used by the company in conducting its operations and generating profit. The residual income calculated after adjusting for the equity charge based on the cost of equity, is then discounted using the cost of equity and a similar process to the DCF model is followed afterwards which include assessing the terminal value and discounting it with the cost of equity. A DCF technique of valuation is not appropriate for evaluating a company’s shares if it does not generate positive free cash flows in the near future. The Residual Earnings method, on the other hand, can be used to determine the intrinsic value.

Equity Valuation Techniques

The company’s cost of equity was determined using the Capital Asset Pricing Model (CAPM), which claims that only a company’s systematic risk represents the stock’s intrinsic risk because unsystematic hazards are easily diversifiable. The technique and assumptions used to calculate the Cost of Equity using CAPM were identical to those used to calculate the DCF. To get at the equity charge, the cost of equity was computed and then modified with the company’s shareholder equity. The residual income for a given year was the excess of net profit over the equity charge for that year. The following table represents the residual income calculations for the company:

The residual income for the year 2019 and 2020 were discounted using the cost of equity of the company along with the terminal value which was ascertained using the exit multiple method. The value of the firm was calculated to be equal to $47,395.5 million which when converted into intrinsic value per share results in $146.92. The book value per share of the company which was equal to $34.99 was added to the intrinsic value per share and the resulting final value per share was equal to $181.91.

The table below summarizes the intrinsic value of the shares calculated using the Discounted Free Cash Flow model and the Residual Earnings method and compares it with the actual market value of the share observed at the end of the year 2018:

Each approach was given equal weight in determining the ultimate intrinsic value of the stock, which was $169.19. The intrinsic value of the share is more than the stock price on the valuation date, indicating that the company’s stock is undervalued. Because the DCF model is quite detailed and takes into account all of the aspects that have the ability to affect the company’s future worth, the model was able to produce an intrinsic value that was closest to the observed market price. At the start of the year 2019, the company’s stock price converged with the intrinsic value computed using two techniques. The company’s stock went on to soar from $150 in the beginning of 2019 to $420 in 2022, confirming a three-year period of above-average growth in returns.

The credit quality of the company has been stable since the beginning of 2018 as the company’s leverage and other metrics related to the credit quality improved due to an increase in demand for agricultural equipment. The company acquired Wirtgen for $5.2 billion and majorly used cash for the purpose of acquisition. The company had a lower leverage compared to the peak levels of demand in the year 2013 and 2014. The share repurchase program conducted by the company was mostly financed by a strong operating cash flow number. The pension plan operated by the company was 92% funded which indicated contribution requirement cropping up for the company. The company was assigned a credit rating of A in the year 2018 with a stable outlook on the scale of Long-term and short-term issuer default ratings. The senior unsecured bank credit facilities were rated as A which depicted low risk of default from the company due to strong operational performance reported (Fitchratings.com 2018).

Free Cash Flow Valuation Method

On the back of a strong balance sheet and continued growth of operations and profit, the company’s credit rating by Fitch for its short- and long-term debt were reaffirmed at the previous levels. The Moody’s investor services Inc assigned a rating of A2 to the senior long-term debt of the company along with a rating of Prime-1 to the short-term debt of the company with a stable outlook for the future. Although the operational performance of the company has weakened in 2019 compared to what it was in 2018 due to unfavorable spread in financing, growth in loan and lease portfolio and maintaining the quality of the portfolio. The leverage for the company in the year was fairly higher than all other financing companies but remained lower compared to the captive finance peers. The financial stability and the improvement in credit quality can be supported by the fact that the about 86% of the JDCC’s debt were unsecured resulting in less pressure on the company’s assets to service the debt in case of default (Fitchratings.com 2019).

As a result of the Covid 19 epidemic, the company’s leverage rose as a result of the impact of unpredictable economic conditions. The company’s leverage measures were lowered as a result of the new debt issue in 2020, which was combined with the country’s dismal economic situation. Fitch ratings, Moody’s investors service Inc, and Standard & Poor’s respectively given the company’s senior long-term debt positive ratings of A, A2, and A, signifying stable credit quality. The credit quality was bolstered by a 5% increase in net revenue from financial services and the loan and lease portfolio being stable at the levels of $46 billion in the year 2020 (Fitchratings.com 2020).

The following section assess the credit risk of the company throughout the years 2018 to 2020 using financial ratios representing long term solvency, short-term liquidity and operating profitability of the company:

The current ratio of the company represents the ability of a firm to pay off its short-term obligations with the current assets which are available at disposal for the company (Madhushanka and Jathurika 2018). A current ratio more than or equal to industry average indicates sound liquidity environment in the company as it confirms that the company would be able to pay off its debts with current levels of cash, inventory, and receivables from the debtors of the company (Husna and Satria 2019). The following table represents the current ratio of the company for the period starting from 2018 to 2020.

It can be seen from the above figures that the current ratio for the company has been improving over the three years. The time series plot of the current ratios is displayed as figure 4 in appendix.

The current ratio for the company witnessed a rise in value reaching at the level of 2.19 in 2020 from 1.85 in the year 2018. This implies that the short-term liquidity of the company has been increasing since the beginning of the year 2018. The company witnessed a jump in cash and cash equivalent in the year 2020 compared to the year 2019 which was the major reason behind the rise in liquidity. The current liabilities of the company also witnessed a steady fall over the course of three years along with a stable level of accounts receivables resulting in the rise of liquidity as indicated by the current ratio.

Residual Earnings Method

A solvency ratio measures the company’s ability to remain solvent and pay off its long-term obligations with the assets and is often used by lenders to assess the credit quality of the company. The two solvency ratios that assess the quality of the company’s stability were the interest coverage ratio and the Debt to Equity ratio (BRÃŽNDESCU 2016).

The interest coverage ratio is a solvency ratio which measures the capability of a company to pay off the interest on long-term debt. The interest coverage ratio is measured by dividing the operating profit of the company by the interest expense of the firm (Setiany 2021). The following table represents the interest coverage ratio for the company throughout the three years:

The interest coverage ratio has seen a slightly downward trend from the year 2018 to 2020 (Annual report 2020). The coverage ratio dipped in the year 2019 to 2.77 on the back of rising debt and interest expense for the debt taken in the year 2019. The time series plot of the company’s times interest earned ratio is shared in the figure 3 of appendix.

Debt to equity ratio was calculated using the long-term borrowings and the equity capital of the company for the years 2018 to 2020. The debt to equity ratio measures the debt levels of the company in comparison to the equity capital. The ratio measures the assets of the company which are financed by each unit of equity. The higher the debt to equity ratio of the company higher the solvency risk for the company (Nuryani and Sunarsi 2020). The following are the Debt to Equity ratio of the company. The time series plot of the debt to equity ratio of the company was displayed in figure 5 in the appendix.

The company’s debt levels were high in 2019 (Annual reports 2019), increasing by roughly 10% year over year. A debt-to-equity ratio of 2 to 2.5 is regarded healthy, and the company’s ratio has been consistent over the last three years hovering around the levels of 2.5. The company’s capital structure appears to be quite steady, with credit risk not dramatically growing as a result of strong operational success.

The operating profit margin measures the operational profitability of the company by adjusting the profit of the company with variable cost of production but without adjusting the interest and tax (Kayathiri and Buvaneshwaran 2015). The following table represents the operating margin for the company. The time series plot of the operating profit margin of the company for the three years is shared as figure 6 in the appendix.

The operational profit margin has been steady in the years 2018 and 2020, as seen in the graph above, declining by a little margin in the year 2019 (Annual reports 2019). The company’s sales declined by roughly 9% in 2019 compared to 2018, while the company’s net profit fell by around 5% compared to 2018 (Annual report 2018). The overall operational performance of the company has been stable withstanding the impacts of the Covid-19 pandemic in the year 2020.

Comparison of Valuation Techniques

Conclusion

The purpose of this study is to calculate the ex post value of Deere & Company’s stock using data acquired from the company’s financial records from 2018 to 2020. The research evaluates the stock’s theoretical fundamental intrinsic value and compares it to its observed market price at the end of 2018. For the aim of completing ex-post valuation of the company’s shares, the discounted cash flow approach and the residual earnings method were utilized. The DCF technique estimated an intrinsic value of $156.47 per share, which was close to the observed market price of the company’s shares, which was $145.28. The residual earnings technique predicted an intrinsic value of $181.91, which was higher than the stock’s observed value in 2018, indicating that it was undervalued. The stock rose from $150 at the beginning of 2019 to $420 in 2022, confirming a three-year run of above-average returns. The company’s credit quality has been stable since the beginning of 2018, and its credit ratings have been consistent throughout the assessment period, thanks to a solid balance sheet and continuing increase in operations and earnings, according to the second Part of the study. The company’s short-term liquidity is increasing, as seen by the rising current ratio during the last three years. Throughout the three years, the company’s debt levels remained steady, and the company’s revenues were adequate to cover the interest payment. The company’s operating margin remained constant during the three years, with just a slight drop in earnings in 2019.

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