Archer-Daniels-Midland Valuation

Archer-Daniels-Midland Company procures, transports, stores, processes, and merchandises agricultural commodities and products in the United States and internationally. The Company’s operations are classified into three segments: Oilseeds Processing, Corn Processing and Agricultural Services.

For Food Processing Companies marginal investor is institutional investor, having 42,37% of outstanding stock (2010 data) and insiders hold 11,07%. In Archer Daniels Midland institutional investors are dominant, as 71% of shares are held by institutional and mutual fund owners, with the largest investor being STATE FARM MUTUAL AUTOMOBILE INSURANCE CO holding 8.76% of shares (Yahoo! Finance). We can see that the marginal investor in this company is well-diversified, as 17 out of top 17 investors are institutional holders and mutual funds with no managers or large inside holders among them. Only 2% of shares are held by all insider and 5% owners that shows they have little power. 1

According to regression Jensen’s Alpha of ADM is -0,04% , showing that company did worse than expected, hence the annualized excess loss will be -0,48%. 

Beta = 0,81.

R-squared of 31% is showing that 31% of the risk of ADM’s shares is attributed to the market risk, while 69% is the company’s specific risk that can be diversified. 

The standard beta error of 0,12 indicates that the true beta is lying in the interval 0,69-0,93 with 67% confidence and in 0,57-1,05 with 95% confidence. This shows that we should carefully rely on this coefficient and estimate additionally bottom-up beta.

With risk-free rate of 3,78%, risk premium of 4,50%, expected return is 7,43%. Expected return shows that despite of the reduced shares profitability (excess return was negative), ADM’s still an attractive company to invest in. 

As the company’s rating is A+ (Interest Coverage Ratio = 2677/430 = 6,23), Pre-tax Cost of Debt is 6,03%, After Tax Cost of Debt is 3,62%. But Effective Tax rate gives additional advantages as it draws the cost of debt down. 

MV of Debt = $8031,15, estimating from BV of debt = $8204, interest expense = $430, Pre-tax Cost of Debt 6,03% and maturity of 3 years. After-tax Cost of Debt = 3,62%.

Because the regression beta has a large standard error (0,12) we estimate bottom-up beta that is equal to:

Unlevered beta = 0,72 (Source: Unlevered Beta for Food Processing Companies, Prof. Damodaran).

Levered beta = 0,72*(1+(1-0,4)(8031,15/17019))=0,92.

Having Debt/Equity ratio and unlevered beta we got ADM’s bottom-up beta, that is a bit higher that the industry’s average beta of 0,86. The result of 0,92 not too much differs from the historical beta according to Bloomberg’s regression (0,81) but is more realistic risk reflection and measure for Archer Daniels Midland.

Using ADM’s current market values of debt and equity, risk-free rate of 3,78% and a risk premium of 4,5% we count ADM’s cost of equity and cost of capital. 

Cost of Equity = 3,78% + 0,924*4,5% = 7,94%.

Cost of Capital = 7,94%*0,68 + 3,62%*0,32 = 6,5526%. This is the amount the company has to receive on its investments to reach the break-even point.

Despite of the fact that the firm can be a good investment opportunity, especially for long-term investors, we can measure ADM’s return on capital. In 2009 the company earned $ 2677 Million as pre-tax operating income, with book value of capital invested $ 24535 M in 2008. The after-tax return on capital will be:

ROC = 2677*(1-0,40)/24535 = 6,5466%.

If we compare this to the cost of capital, ADM seems to earn as much as its cost of capital. 

EVA = (0,065466-0,065526)*24535 = — 1,47 $. No profit was earned by the firm above the required return, for the shareholders of a company.

To compare ADM’s EVA to the industry average we will estimate company’s EVA if it has the same return spread as the industry has.

EVA* = (0,185-0,0716)*24535 = 2782,3 $. If the company had a return spreads average to the industry its operating in it would have created shareholder value of 2782,3 $. 

Negative EVA means that a company suffers excess loss (as well as Jensen’s Alpha showed) but it is expected to rise into a positive territory.

To get to know the trends, we can compute the EVA and ROC over the past 5 years.

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*Market Capitalization is estimated for June, 30 of every year. Risk premiums are based on Customised Geometric risk premium estimator. Unlevered betas used as average for industry.

We can see that since 2005 both ROC and EVA had positive trends, both gaining year-on-year growth. However in 2009 ROC dropped by 25%, ending in negative EVA. This can be explained by additional short-term debt taken by the company in 2008 to finance its projects and financial crisis of 2008-2009. However the company managed to pay out this debt and in 2010 it seems it will have positive EVA, as the amount of invested capital in 2009 decreased and EBIT has a long-lasting positive trend to grow if the company will continue with its development and projects.

However the company should take a sharp look at investing in emerging markets that may carry high risk.

To measure of how much debt and equity the company is using we can look at Debt to Capital Ratio, estimated in market and book value.

Debt Ratio (MV) = 32%

Debt Ratio (BV) = 37,8%.

We can see that ADM’s financial mix consists of 32% of debt and 68% of equity. We estimate debt as long and short term debt (including current maturities of long-term debt). Total debt is in UDS.
Food Processing average MV Debt Ratio is 22,67%, indicating that ADM has more debt as companies in its industry have.

ADM has a marginal tax rate of 40% and the effective tax rate of 32,6%, the average effective tax rate for industry is 17,29%. Reaching the marginal tax rate will bring greater benefits of debt and the higher optimal debt ratio available. Added discipline: as a company well-diversified with the largest stockholder owing 8.76% of ADM’s shares, and both individual stockholders and institutions limited influence on management, as the separation between them is wide enough the company should gain from the usage of existing and new debt. At June 30, 2009, the Company had $1.6 (increased by 23% with respect to 2008) billion of cash, cash equivalents, and short-term marketable securities and a current ratio of 2.2 to 1. Company has stable earnings, low bankruptcy risk (probability of bankruptcy 0,6%) and can borrow more for new projects. Agency costs: lenders can monitor how the borrowed money are used, as they are used primarily in construction of new processing plants, maintenance and reconstruction of existing ones and purchases of transportation equipment. Future Flexibility: Company has a strategic aim to raise its flexibility by raising liquid assets, having $6.5 billion unused credit line and is carefully forecasting its future funding needs.

As we used actual rating to compute the current cost of capital, we can see that the current cost of capital is lower than the optimal if we calculate the optimal debt structure using actual ratings. The cost of capital was 6,55% and proposed optimal 6,58%. We can switch to synthetic ratings to calculate the optimal capital structure.

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According to analysis we can see that the optimal structure of finance resources of the company is at debt ratio of 50%. ADM has already the structure with D/(D+E) ratio being 32%, and we can see that company is under levered and has too little debt. According to this analysis firm value will increase by $ 2799 and ADM can take additional debt of $ 4494. If company wants to have 30% debt ratio and AA rating it would cost it $ 2804. To move to its optimal ADM should borrow additional $ 4494 and buy back stock, and make some increase in dividends payments. Because of the large market capitalization and projects that will bring profits making EVA positive again, we would recommend ADM to use more efficiently its debt capacities to invest in new projects (since ROE > Cost of Equity), to finance new projects with debt, and expand its business over emerging markets. As the company is expanding to Latin America and Eastern Europe the company should think about future debt in another currency than dollar (euro for ex.), better long term (or medium-term) with floating rates. We can recommend to use long-term debt with floating rates, 5% in Euro, and approximately 6% in other currencies (depending on the preferred directions in Latin America, mostly in BR because of the advantageous marginal tax rate). It’s worth pointing out that quite a big portion of the company’s debt is floating rate debt (more than 50%), adding flexibility to ADM, giving the ability to cope with the inflation. For real estate (factories, plants) ADM better has mortgage bonds.

Cash Flow Potential is 13,6%, comparing with industry average 12,43% indicates that company has higher CF than its competitors. As operating income is 11% of the market value of the firm with optimal debt ratio of 50%, this ratio can increase to 60% if the operating income will increase to 15% of the company value.

Payout Ratio in 2009 is 20,33%, Dividend yield is 2,04%, that is higher than the industry average 1,01%. By the estimation in 2009 ADM could have paid $ 1690 in dividends/stock buybacks, but in fact company paid total $ 447 cash to stockholders. Since the average (ROIC – Cost of Capital) was 0,59% and positive over the last 4 years and ADM has a history of good projects ending in positive (ROC – WACC) (except the last year), stockholders can allow to trust managers giving them some flexibility to keep and reinvest cash and set the dividends. 

Between 2006 and 2009 ADM has generated a return on equity on its projects about 7,17% more than the cost of equity, on average each year. Between 2006 and 2009 ADM’s stock has delivered (0,35%) less than the cost of equity on average basis. Required returns were calculated as the expected returns from the CAMP, using historical T-bond rates and Premiums. As required rate of return, return on equity is used, calculated on the base of bottom-up beta. If we compare ROE and Actual Return with Required Return, calculated on the base of Bloomberg’s beta of 0,81 and historical T-bond rates and Premiums we can see that average (ROE – Required Return) is 7,19% and (Actual – Required Return) is -0,32%.

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If we believe ADM to be a stable growing firm we can calculate its value by using stable growth model. ADM’s ROC is equal to 6,55%, and company is quite for a long time in this business and we can expect the stable growth rate of 5%. Reinvestment Rate = 5%/6,55% = 76,36%. Expected EBIT(1-tax) in 2010 will be 1686,5$. Expected reinvestments in 2010 = 1288,09$. Expected FFCF = 398,4$. So the value of working assets of the company with the stable growth rate of 5% will be $ 25662. We add here cash and marketable securities, subtract BV of Debt we will have the value of the capital equals to $ 21443 or $33,4 per share.

We can compute firm value by using 2-stage FFCF valuation.

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Value of firm is $ 51529,57 and market value of equity/per share is $ 67,75.

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