THIS REPORT WAS PREPARED BY ANA RITA MIRANDA, A MASTERS IN FINANCE STUDENT OF THE NOVA SCHOOL OF BUSINESS AND ECONOMICS, EXCLUSIVELY FOR ACADEMIC PURPOSES. THIS REPORT WAS SUPERVISED BY ROSÁRIO ANDRÉ WHO REVIEWED THE VALUATION METHODOLOGY AND THE FINANCIAL MODEL. (SEE DISCLOSURES AND DISCLAIMERS AT END OF DOCUMENT) See more information at WWW.NOVASBE.PT Page 1/33 MASTERS IN FINANCE EQUITY RESEARCH As a result of EDP’s privatization process, China Three Gorges (CTG) acquired a sizable position in EDP’s capital structure with positive impacts on share prices (+9.53%) and financing requirements. CTG is identified as an important strategic partner that facilitates access to alternative markets and potential joint-participations in other investments. The Iberian market (MIBEL) is becoming fully integrated with lower days of market splitting in 2013. This imposes more efficiency to companies in production and increases the importance of possessing the “right” source of production. EDP has under construction six hydro power plants with a total installed capacity of 1,697MW. Iberian activities have recently suffered due to changes in regulation, a direct result of the current economic environment in this region. Major changes include the CMEC remuneration, reduction in remuneration rates of the regulatory asset bases, and the introduction of new taxes such as the energy tax of 0.85% of assets. This is a segment with low future growth perspectives. EDP is currently pursuing the liberalization of its supply activity which will require significantly higher efforts from the company side given increased competition. The company will have to become more dynamic on several fronts in order to maintain its current market positioning. As the actual incumbent, EDP is regarded as having a comparative advantage over its peers. This procedure is expected to conclude in the end of 2015. Brazil currently poses as a major source of future opportunities given the country’s ever growing market. Demand for energy is expected to increase through the following decades (4.7% per year) in spite of the regulatory system that is currently in place. Developing economies have displayed environment concerns that have recently led to the increase in Renewables. Based on future EU targets on CO2 reductions and EDPR expansion strategy, EDP has much to gain from this segment. Our Target price is €2.86 and the recommendation is to Hold. Company description EDP is an electric utility company founded in 1973 operating worldwide. Currently, EDP is a group of companies operating throughout the value chain of electricity. It also operates in the gas segment and in the renewable sector. It is the major electricity company in Portugal. EDP – ENERGIAS DE PORTUGAL COMPANY REPORT “ELECTRIC UTILITIES” 06 JANUARY 2014 ANALYST: ANA RITA MIRANDA [email protected]Time of Changes Challenging Liberalized Markets Recommendation: Hold Vs Previous Recommendation HOLD Price Target FY14: 2.86 € Vs Previous Price Target 2.86 € Price (as of 3-Jan-14) 2.69 € Reuters: EDP.LS, Bloomberg: EDP.PL 52-week range (€) 2.22-2.82 Market Cap (€m) 9,704 Outstanding Shares (m) 3,627.3 Source: EDP and Bloomberg Source: Bloomberg 2012 2013E 2014E Revenues (€ millions) 16,340 16,992 15,851 EBITDA (€ millions) 3,628 3,614 3,985 Net Profit (€ millions) 1,182 843 1,033 EPS (x) 0.32 0.24 0.28 P/E (x) 8.84 12.40 10.12 Net Debt/EBITDA (x) 5.19 5.09 4.22 Debt/Assets(x) 0.48 0.48 0.45 EV/EBITDA (x) 9.18 9.22 8.36 ROA (x) 2.77 1.98 2.51 Source: EDP and Nova Research Team 50 70 90 110 130 150 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 EDP PSI20
33
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THIS REPORT WAS PREPARED BY ANA RITA MIRANDA, A MASTERS IN FINANCE STUDENT OF THE NOVA SCHOOL OF BUSINESS AND
ECONOMICS, EXCLUSIVELY FOR ACADEMIC PURPOSES. THIS REPORT WAS SUPERVISED BY ROSÁRIO ANDRÉ WHO REVIEWED THE
VALUATION METHODOLOGY AND THE FINANCIAL MODEL. (SEE DISCLOSURES AND DISCLAIMERS AT END OF DOCUMENT)
See more information at WWW.NOVASBE.PT Page 1/33
MASTERS IN FINANCE
EQUITY RESEARCH
As a result of EDP’s privatization process, China Three Gorges
(CTG) acquired a sizable position in EDP’s capital structure with positive
impacts on share prices (+9.53%) and financing requirements. CTG is
identified as an important strategic partner that facilitates access to
alternative markets and potential joint-participations in other
investments.
The Iberian market (MIBEL) is becoming fully integrated with
lower days of market splitting in 2013. This imposes more efficiency to
companies in production and increases the importance of possessing the
“right” source of production. EDP has under construction six hydro
power plants with a total installed capacity of 1,697MW.
Iberian activities have recently suffered due to changes in
regulation, a direct result of the current economic environment in this
region. Major changes include the CMEC remuneration, reduction in
remuneration rates of the regulatory asset bases, and the introduction of
new taxes such as the energy tax of 0.85% of assets. This is a segment
with low future growth perspectives.
EDP is currently pursuing the liberalization of its supply activity
which will require significantly higher efforts from the company side given
increased competition. The company will have to become more
dynamic on several fronts in order to maintain its current market
positioning. As the actual incumbent, EDP is regarded as having a
comparative advantage over its peers. This procedure is expected to
conclude in the end of 2015.
Brazil currently poses as a major source of future opportunities
given the country’s ever growing market. Demand for energy is expected
to increase through the following decades (4.7% per year) in spite of the
regulatory system that is currently in place.
Developing economies have displayed environment concerns
that have recently led to the increase in Renewables. Based on future EU
targets on CO2 reductions and EDPR expansion strategy, EDP has much
to gain from this segment.
Our Target price is €2.86 and the recommendation is to Hold.
Company description
EDP is an electric utility company founded in 1973 operating worldwide. Currently, EDP is a group of companies operating throughout the value chain of electricity. It also operates in the gas segment and in the renewable sector. It is the major electricity company in Portugal.
ELECTRICITY IN THE WORLD AND IN EUROPE ...................................................... 6 ENERGY IN THE WORLD ......................................................................................... 7 CO2 EMISSIONS ..................................................................................................... 8
DISCLOSURE AND DISCLAIMER ..........................................................33
EDP – ENERGIAS DE PORTUGAL COMPANY REPORT
PAGE 3/33
1. Company overview
Company description
Energias de Portugal (EDP) is a vertically integrated electric utility company
that operates across multiple sectors. The company was created in 1976 from
the merger of 13 public enterprises and experienced significant growth over the
next decades. Although the company is smaller than most of its comparables,
EDP has one of the highest return on equity (ROE) which is derived from its high
leverage, much above its comparables. EDP exhibited stable return on assets
(ROA) since 2009 having one of the highest values among the most relevant
European competitors.
Sources: Bloomberg, and NOVA Research Team.
The activities of EDP are split across the following sectors: Iberian electricity,
Iberian natural gas, Brazil, and Renewables. Since many of these activities are
capital intensive (e.g.: electricity production and distribution), EDP is largely
affected by regulation and is under the scrutiny of ERSE1.
The electricity sector is comprised by electricity production, distribution, and
supply (commercialization). Production is carried out in two different regimes:
conventional regime with installed capacity of 13,343 MW, and special regime
with installed capacity of 466 MW. The special regime (PRE) has priority
dispatch in the electricity markets and it was developed due to the finite
character of fossil fuels and the need to diversify energy sources. This regime
currently includes mini-hydroelectric2, cogeneration, and biomass and residuals
production. For the purpose of this report, the production segment is valued by
differentiating the production from regulated and from liberalized production. The
share of hydro and wind’s installed capacity has increased, while thermal and
combined cycle maintained a stable share of installed capacity. Regarding the
1“Entidade Reguladora dos Serviços Energéticos” (ERSE) is the Portuguese supervisor for energy services (electricity
and gas). 2Hydroelectric power plants with an installed capacity below 10MW.
Table 1: Comparables' Data
Inst.
Capacity
(MW)
Net
Debt/
EBITDA
Net
D/E
EV/
EBITDA P/E
P/
Book
Rating
(S&P)
EDP 23.38 5.1 161.7% 8.67 10.00 1.15 BB+
EDF 139.50 2.3 90.4% 5.82 9.59 1.47 A+
RWE 51.98 1.1 77.9% 3.02 179.63 1.53 BBB+
Iberdrola 46.04 4.7 76.7% 9.66 9.89 0.81 BBB
Endesa 39.40 0.1 2.8% 4.23 10.62 0.99 BBB
EDPR 8.15 3.5 57.4% 7.17 24.77 0.58 N.A.
Endesa Iberdrol
a
EDF
EDP
GDF
EDPR E.ON
RWE
0%
3%
6%
9%
12%
15%
100 200 300
RO
E (
Percen
t)
Total Assets (€ billions)
Graph 1 - Comparables1\
Source: Bloomberg. 1\ Size corresponds to market capitalization.
0%
1%
2%
3%
4%
5%
6%
7%
2009 2010 2011 2012
Graph 2: Return on Assets
(Percent)
EDP Iberdrola
Endesa EDPR
EDF RWE
Source: EDP, Endesa, Iberdrola, EDF, RWE, and NOVA Research Team.
EDP – ENERGIAS DE PORTUGAL COMPANY REPORT
PAGE 4/33
net production, wind has doubled its weight in total production, while the
combined cycle has decreased exponentially. EDP’s distribution of electricity is
performed in high, medium, and low voltage and it consist in a large network that
covers 223,734 Km in Portugal and 22,986 Km in Spain. Given that these
networks imply large investments in fixed assets, the activity is capital intensive
and is classified as a natural monopoly that requires the intervention of
regulatory institutions in order to establish the remuneration in the segment. The
supply activity consists in the commercialization of electricity and it was
originally fully regulated. With the liberalization of the market, the relative size of
regulated and last resort supply (LRS) activities compared to total EDP’s supply
has steadily decreased and it currently accounts for 67% of commercialization in
Portugal and 4% in Spain. EDP’s commercialized a total of 29,603 GWh3 in
Portugal and 20,252 GWh in Spain, denoting a much larger presence in the
Portuguese market given the differences in each country's size and population.
The natural gas sector includes storage, distribution and supply with operations
in Portugal and Spain. EDP, which is the second largest operator in both
markets, can either sell the gas or use it to produce electricity in its CCGT plants.
In 2012 EDP supplied more than one million consumers, counted with 14,196 km
of distribution grid and commercialized more than 35 TWh.
Similarly to the Iberian activities, the Brazilian sector also incorporates
production, distribution and supply of electricity. Production is mostly focused on
the conventional regime and installed capacity amounted to 1,974 MW in 2012.
Distribution is performed through EDP Bandeirante and EDP Escelsa, and it is
characterized by a network extension of 85,749 Km. Supply of electricity in Brazil
consisted in 24,923 GWh during 2012 where 63% was regulated.
Renewables, operated by EDP Renováveis (EDPR), comprises mainly the wind
generation and amounted to a total of 8,145 MW of installed capacity, being
present in Europe, north and south of the American continent. In 2012, EDPR
produced 18,445 GWh which were entirely sold due to its priority in dispatch
while subject to feed-in-tariffs4.
Shareholder Structure
EDP currently possess a total of €3,656.5 million shares, all of them class A
shares5 with nominal value of one euro and fully paid. Its shareholder structure
has changed over time mainly through its reprivatization process that began in
3One Gigawatt hours (GWh) is equivalent to one million kilowatt hours (KWh). One KWh is the output of a power
station with an installed capacity of 1KW operating during one hour at its full capacity. 4Tariff/price entitled to renewables technologies in order to encourage investment in these types of technology.
5Until recently, there were also class B shares which were the ones to be reprivatized.
13%
9% 0%
10%
20%
30%
40%
50%
2009 2010 2011 2012
Graph 6: Iberian Market Shares
(Percent)
Electricity Supply - Market Leader
Electricity Supply - EDP
Gas Supply - Market Leader
Gas Supply - EDP
Source: EDP.
-20%
0%
20%
40%
60%
80%
100%
2010 2011 2012 2013E 2014E
Graph 4: Turnover
Breakdown (Percent)
Reg. Production Lib. ProductionDistribution SupplyGas BrazilRenewables Other and Adjustments
-20%
0%
20%
40%
60%
80%
100%
2010 2011 2012 2013E 2014E
Graph 5: EBITDA
Breakdown (Percent)
Reg. Production Lib. ProductionDistribution SupplyGas BrazilRenewables Other and Adjustments
Source: EDP.
Source: EDP.
Source: EDP.
EDP – ENERGIAS DE PORTUGAL COMPANY REPORT
PAGE 5/33
June 1997. This process has been characterized by 8 stages where the most
recent and relevant one occurred in October 2011 in which shares detained by
Parpública6, a public holding that owned golden-shares at EDP
7, were sold in two
phases.
The first phase included a sale of 21.35% of capital which was acquired by China
Three Gorges (CTG), a Chinese government owned company operating in the
energy sector with an installed capacity of 74.8GW. This transaction amounted to
€2.7 billion that represents a price per share of €3.45 and a premium of 53%8,
with a positive impact on market share prices of €0.22 (+9.53%) through the
following two weeks9.CTG’s entry into the company’s capital is perceived
positively given the significant share price appreciation that has been observed
since the transaction. For instance, during the last two years EDP’s stock price
has increased by 23.86%, amounting to 11.29% per year.
The second phase took place in February 2013 where the remaining Parpublica’s
stake of 4.14% was sold as free float given that an agreement with CTG was not
achieved. This stake was sold at a price of €2.35 per share, which represented a
discount of 2.97% compared to the previous day’s closing price. After the sale
EDP’s shares experienced a decline of 8% that took approximately one month to
recover from.
CTG’s strategy lies in renewable energies and aims, with the investment in EDP,
to become a strategic partner in this field. This led to its current agreement that
includes a 4 year lock-up and standstill period by CTG which, in addition to a
granted credit facility of €2 billion for a maturity of 20 years, contributed to
stabilize the shareholder structure and improve EDP’s liquidity position which is
very important due to the recent financing restrictions that Portuguese
corporations have experienced.
In 2011 it was estimated that EDP needed refinancing of about €2.6 billion per
year during three years10
. Furthermore, 2011’s annual accounts also indicated
debt repayments of €3.0 billion in 2012, and €2.7 billion in 2013. This entire
standing improved due to CTG’s entry and current EDP estimates suggest that
no more refinancing will be required until the end of 2014.
EDP is presently pursuing a deleveraging strategy and aims to achieve the target
of three times the debt-to-EBITDA ratio by 2015. The agreement has also settled
the purchase of minority stakes by CTG in the renewable sector. This gives EDP
6 DL 106-A/2011, from October 26
th, in which the disinvestment of Parpublica in EDP has been authorized.
7 Golden shares gave the right of veto regarding some matters.
8 According to recent news, this premium was based on expected standstill regulatory environment.
9 Increase from 22 of December 2011, when the purchasing was agreed, until 2 of January 2012.
10 Financial Times.
1.55%
2.47%
1.74%
0.0%
1.0%
2.0%
3.0%
0
200
400
600
Net
Generation
(TWh)
Net
Consumption
(TWh)
Installed
Capacity
(GW)
Graph 7: EDPB and Brazilian
Market (Percent)
Brazil % EDPB
Sources: EDP, World Bank, and NOVA Research Team.
7.99
0
2
4
6
8
10
12
14
Iber
dro
la
ED
PR
ED
F
RW
E
Fer
sa E
ner
gia
s
Ren
ovab
les
Graph 8: Wind Installed
Capacity (GW)
Sources: EDP, Iberdrola, EDF, RWE, Fersa Energias Renovables, and NOVA Research Team.
Table 2: Shareholders' Structure
SHAREHOLDERS %
Capital
China Three Gorges 21.4%
Oppidum 7.2%
Iberdrola Energia S.A.U. 6.7%
Capital Group Companies, Inc. 5.0%
José de Mello Energia, S.A. 4.6%
SENFORA SARL 4.0%
Grupo BCP; FP do Grupo BCP 3.4%
Sonatrach 2.4%
Qatar Holding LLC 2.3%
Massachusetts Financial
Services Company 2.2%
BlackRock, Inc. 2.0%
Banco Espírito Santo, S.A. 0.3%
EDP (Treasury Stock) 0.8%
Free Float 38.5%
Total 100.0%
Source: EDP.
EDP – ENERGIAS DE PORTUGAL COMPANY REPORT
PAGE 6/33
the opportunity to become more active in the upside potential of the growing
Chinese market as well as a joint-participation in other investments as are the
ones recently announced in Africa and Brazil11
.
2. Market Overview
Electricity in the World and in Europe
World’s installed capacity is expected to grow at an average rate of 1.6% per
year from 2010 until 2040 but with significantly different growth rates across
regions. OECD countries are expected to grow at an average of 0.9% per year,
while non-OECD countries are expected to grow at 2.3% on average, with Brazil
and China in the leading positions. This denotes a clear discrepancy between
developed and developing or emerging economies. In absolute values OECD
countries remain fairly stable in regards to total installed capacity, whereas non–
OECD greatly increase their share and China alone represents 27.4% of world’s
total installed capacity in 2040.
Regarding the world’s total generation of electricity it is forecasted to increase by
an average of 2.2% per year from 2012 to 2040, which is slower than the
preceding 7 years in which the average rate was 3.1%. This implies a change in
the sources’ shares over time. For instance, coal is forecasted to lose 4
percentage points between 2012 and 2040 whereas renewable sources increase
from 19% to 25% and natural gas from 20% to 24%.
World Demand12
exhibits an expected growth rate of 2.2% from 2010 until 2040
but with differences across regions. OECD countries present an average growth
rate of 1.1%, with US and OECD Europe both under the average with 0.8% and
11
Recent articles on newspapers (e.g.: Jornal de Negócios). 12
We used net generation as a proxy for demand.
17.33
21.41
25.37
39.03
0
5
10
15
20
25
30
35
40
45
2005 2010 2015 2020 2025 2030 2035 2040
Th
ou
san
ds
Chart 10: Electricity Generation by Fuel
('000 TWh)
Oil and other liquids Coal Nuclear Natural gas Hydro Wind Solar Other
2%
5%
39%
16%
40%
36%
4% 3%
14%
20%
38%
13%
15%
6%
17%
11%
23%
17%
21%
17%
24%
075
150225300375450525600675750825
1990 2000 2010 2020 2030 2040
Chart 11: World Energy
Demand
(Quadrillion Btu)
Non-OECD OECD
Source: EIA.
Source: EIA.
0
2
4
6
8
2005 2010 2015 2020 2025 2030 2035 2040
Th
ou
san
ds
Chart 9: Installed Capacity by Region/Country
(Gigawatthour)
US OECD Europe Other OECD China Brazil Africa Other Non-OECD
OECD
Non-OECD
Source: EIA.
EDP – ENERGIAS DE PORTUGAL COMPANY REPORT
PAGE 7/33
1.0%, respectively. Non-OECD countries present an expected growth rate of
3.1% with China above average (3.7%) and Brazil and Africa both with 3.0%
growth rates.
Energy in the World
World’s consumption of energy, which encompasses natural gas, coal, oil,
nuclear and others, presents the same trend. Non-OECD countries exhibit
exponential grow while developed countries experience a more moderate growth.
Coal
Coal consumption is expected to increase by an average of 1.3% although the
increase is driven by developing countries, mainly in Central and South America
and Asia. Developing countries are expected to decrease its consumption. Coal
used for electricity generation is expected to decrease its proportion in total
generation while increasing its absolute value which implies a significantly higher
growth for alternative inputs. On a side note, coal prices are expected to grow at
an average rate of 3%, according to the U.S. Energy Information Administration
outlook (EIA).
Natural Gas
Total natural gas consumption is expected to increase by an average rate of
1.3% per year, again driven by developing countries. Some of the natural gas
consumption will be in production of electricity, which is expected to increase
both in total share of generation and absolute value. As a fossil fuel natural gas
reserves are claimed to be finite and we will eventually become unable to extract
it. Nevertheless, technological advancements, new transformation processes,
and even the appearance of new theories suggest that these inputs are not as
finite as it was believed.
Natural gas consumption in electricity production will also depend on its relative
price to other energy sources. Its price has been decreasing remaining at low
levels but it is expected to increase at 3.4% yearly average until 204013
.
Nuclear
Nuclear consumption is expected to experience a high increase (2.5% average
per year) for which the major contributors are China, Europe and America, with a
combined consumption of 62% of total consumption in 2040.
Nuclear plants are on average one of the most efficient forms of production with
low marginal costs of production. Nevertheless, it is a very capital intensive type
13
EIA, Annual Energy Outlook (AEO), 2013.
Source: EIA.
125
150
175
200
225
2009 2010 2015 2020 2025 2030 2035 2040
Chart 13: World Coal
Consumption
(Quadrillion Btu)
0
4
8
12
16
Chart 14: Henry Hub Natural
Gas Spot Prices
(USD/MMbtu)
Source: EIA.
Source: Bloomberg.
0
10
20
30
40
Th
ou
san
ds
Chart 12: Net generation by
Region/Country
(Billion KWh)
US OECD EuropeOther OECD ChinaBrazil Africa
Source: EIA.
100
120
140
160
180
200
20092010201520202025203020352040
Chart 15: World Natural Gas
Consumption
(Trillion cubic feet)
Source: EIA.
EDP – ENERGIAS DE PORTUGAL COMPANY REPORT
PAGE 8/33
of production with some environmental concerns, mainly after the incident in
Fukushima, Japan.
CO2 emissions
Concerns about the environment have been growing around the world, which has
implications on the decision of each source of energy to use. The European
Union (EU) has established targets for 2020 currently called “20-20-20”14
, in
which the ambition is to reduce by 20% greenhouse gas emissions (versus
1990), to increase to 20% consumption of renewable sources, and to reduce by
20% the use of primary energy (versus 2007). The EU is also committed to a
“low-carbon economy” and until 2050 aims to reduce greenhouse gas emissions
to 20% of 1990 levels15
.
This might have implications in the CO2 prices and consequently in the decisions
of the companies in regards to energy source selections and investment
valuations.
3. Valuation
The valuation of the company is done through a Sum of the Parts approach
where each business is valued separately. A Discounted Cash flow model is
applied for each segment where the Free Cash Flow (FCF) is discounted at the
Weighted Average Cost of Capital (WACC), a measure that captures each
business’ risk.
To compute the WACC there are three major terms to be considered: the cost of
debt, the cost of equity and the target debt-to-equity ratio.
In regards to the cost of debt, EDP can finance itself as a whole which offers
better conditions than separate financing for each business unit. Therefore, the
cost of debt was computed for the whole company and considered equal across
units. Nevertheless, in order to reduce exchange rate risk the company borrows
in local currencies (e.g.: euros, Brazilian reais and US dollars). This cost was
computed using two different approaches.
The first approach determines the cost of debt by adding the risk free rate to a
spread based on the rating of the company. EDP’s rating is currently BB+ which
corresponds to a spread of 3.00%16
. For the risk free we have considered an
14
European Directive 2012-727/EU. 15
This vision incorporates intermediate milestone goals of 60% by 2030 and 40% by 2040. 16 Data collected by Aswath Damodaran, a Professor of Finance in Stern School of Business at New York University.
2,000
3,000
4,000
5,000
6,000
20092010201520202025203020352040
Chart 16: World Nuclear
Consumption
(Billion KWh)
860 690 670
400
0
200
400
600
800
1000
Coal Gas oil Fuel Oil NaturalGas
Chart 17: Implied GHG emissions from electricity generation
(CO2/KWh)
Source: EIA.
Source: “CO2 emissions from fuel combustion”, 2012 Edition, IEA.
Sum of the Parts approach, valuing each business separately.
EDP – ENERGIAS DE PORTUGAL COMPANY REPORT
PAGE 9/33
historical average of the 10 year German bond for the Iberian activities (2.36%).
These computations provide a cost of debt of 5.36%. For the particular case of
Brazil where activities are accounted in Brazilian reais the risk free was
determined using the covered interest rate parity17
, with the 10 year German
bond, the current exchange rate, and the 5 year forward exchange rate. We have
also looked at the inflation rate differential between these two countries. For this
valuation, the risk free rate for Brazil is considered 4.96%.
The second approach takes into account EDP’s current 10 year yield from a zero
coupon bond, along with the historical probability of default and recovery rates of
companies with similar ratings18
. EDP’s 10 year yield currently stands at 4.47%,
and the probability of default and the recovery rates of BB+ rated companies
correspond to 10.51% and 70.70%, respectively. This computation provided a
cost of debt of 4.82%. For the purpose of the valuation we shall rely on the
second approach as it is more detailed.
Even though the risk free rate is considered to be different in Brazil, the cost of
debt will be considered the same as we are using the method based on market
yields and default rates.
Since we utilize a sum of the parts approach, the cost of equity was determined
with the intent of valuing each segment separately. The basis of our approach
lies on CAPM19
. However, since company returns only yield aggregated results,
we rely on comparables to assess the systematic risk of each activity. This is not
a straightforward task as the majority of companies do not operate in one single
business. Therefore, we define comparables as companies that, while still
possessing activities throughout the entire value chain, tend to emphasize a
particular segment, while having a similar size, and rating20
. We can find in the
Appendix 2 more details on this selection.
17
( ) where stands for the domestic interest rate and for the foreign interest rate.
18 , where corresponds to the market yield of a 10y zero coupon bond,
to the probability of default of BB+ rated companies, and to the recovery rate of BB+ rated companies.
Moody’s Investors Service. February 2009. “Corporate Default and Recovery Rates, 1920-2008.”
Standard&Poors. March 2011. “Default, Transition, and Recovery: 2010 Annual Global Corporate Default Study and
Rating Transitions”. 19
Capital Asset Pricing Model (CAPM), used to compute the expected return of the asset using the following equation:
( ) to estimate the parameters. This methodology only takes into account the systematic
component of risk as investors are capable of diversifying the firm specific risk. We used ( )
where CRP stands for the country risk premium. 20
In “Principles of implementation and best practice for WACC calculation”, Independent regulators Group, 2007
Table 3: Default Spread
Spread
A 1.00%
A- 1.30%
BBB 2.00%
BB+ 3.00%
BB 4.00%
B+ 5.00%
Source: Damodaran.
Cost of Debt using EDP’s 10y yield, probability of default and recovery rates.
Cost of Equity determined using comparables and segment’s unlevered betas
EDP – ENERGIAS DE PORTUGAL COMPANY REPORT
PAGE 10/33
For each segment we have estimated the unlevered beta through the average of
comparables which was later relevered21
through the market debt-to-equity ratio.
Current market debt-to-equity ratio was determined at 2.1. Nevertheless, the
target lies below this number as EDP is pursuing a deleveraging strategy with a
target ratio of 2.0.
Market risk premium is assumed to be 5.7022
in accordance with literature.
Country risk premium (CRP) was computed using Credit default swaps (CDS)
and the relative weight of standard deviation of equities and bonds in the local
market. We have also looked at local and global market variances to have a
better sense of the value for CRP23
.
For the perpetuity we used the NOPLAT of the last year of the explicit period, the
growth rate for each economy, and the perpetuity formula24
.
For the growth rate, we have considered an inflation rate of 2% for Europe,
consistent with European Central Bank’s long-term strategy25
and for Brazil an
inflation rate of 4.5%, which is consistent with the International Monetary Fund’s
(IMF) projections for medium term and also according to Brazilian’s Central Bank
target for inflation26
. For the real growth rate we have looked at the projected real
GDP growth of the IMF, where we identify long-term growth of 1.8% in Portugal,
1.2% in Spain and 3.5% in Brazil.
21
*
+, although the implicit is not equal to zero, we currently face a situation where the risk
free rate is significantly below its historical value. This leads to an exaggeration in computations. 22
“Market Risk Premium and Risk Free Rate used for 51 countries in 2013”, 2013, Pablo Fernandez, Javier
Aguirreamalloa and Pablo Linares.
d as being the most probable value for market risk premium. 23
Systematic Country Risk Modulator in “Practical Approach for Quantifying Country Risk”, Jaime Sabal, ESADE.
24 To compute the perpetuity value we used:
(
)
, “Valuation”, McKinsey
&Company, Tim Koller, Marc Goedhart, Daviv Wessels, p.113. 25
According to the IMF, until 2018 it is expected an average inflation rate of 1.4% for Portugal and 1.5% for Spain, but
we have considered the long term expectations for the euro area. 26
Recent inflation rates in this country have been historically high, registering in 2012 an inflation of 5.84% (according
to the Brazil Central Bank).
Target D/E 2.00
Rd 4.82% Portugal 3.00% Portugal 3.25% Portugal 29.5%
rf (€) 2.36% Spain 3.00% Spain 3.10% Spain 30.0%
rf (br) 4.96% Brazil 5.00% Brazil 4.82% Brazil 34.0%
Buy Expected total return (including dividends) of more than 15% over a 12-month period.
Hold Expected total return (including dividends) between 0% and 15% over a 12-month period.
Sell Expected negative total return (including dividends) over a 12-month period.
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