During the past twelve months, Vodafone (LSE: VOD) has traded as high as 258p and as low as 180p. Unfortunately, these price swings have only complicated things for investors. The jump from 180p to 258p has made it exceptionally difficult to calculate an appropriate entry price.
Additionally, it’s difficult to value Vodafone using traditional metrics like the P/E ratio. At present, City analysts expect Vodafone to report earnings per share of 5.4p for the company’s 2016 financial year. These forecasts mean that the company is trading at an eye-watering forward P/E of 46.
Maintaining a global telecommunications business requires a hefty amount of investment in capital equipment, which has to be depreciated over time. A depreciation expense has a direct effect on the profit that appears on a company’s income statement.
The larger the depreciation expense in a given year, the lower the company’s reported net income. As a result, Vodafone’s net income figure is weighed down by a hefty depreciation expense and is, to a certain extent, misleading.
For example, last year Vodafone reported earnings before interest, taxes, depreciation and amortisation of £11.7bn. But, after deducting depreciation and amortization the company reported earnings before interest and taxes of £2.1bn.
However, depreciation is a non-cash expense and as a result, the cost doesn’t change the company’s cash flow. So, the best way to try and place an accurate value on Vodafone’s shares is to value the business based on cash flows. The company generated £9bn in cash from operations last year.
You could also use a sum-of-the-parts (SOTP) valuation, which is also known as a break-up analysis.
A SOTP analysis provides a range of values for a company’s shares by adding together the value of its individual business segments.
By using a SOTP valuation coupled with cash flow models, Goldman Sachs believes that Vodafone’s shares are worth 220p each. This price target is based on the assumption that Vodafone’s shares trade at the same multiples as the company’s peers.
Moreover, Goldman’s analysts believe that any deal between Vodafone and Liberty Global could unlock up to 30p per share, depending on how the deal is structured. It’s assumed that an agreement between these two telecoms giants will unlock value from assets and help to cut costs.
Another set of analysts, this time at UBS believe that an agreement between Vodafone and Liberty could unlock between 32p and 96p per Vodafone share in value. So, estimates from these two groups of analysts imply that if a deal between Vodafone and Liberty goes ahead, Vodafone’s shares could jump by 30p.
A final value
Overall, on a SOTP basis, Vodafone’s shares are worth 220p. Nevertheless, if the company agrees a deal with Liberty to sell-off some unwanted European assets an additional 30p per share of value could be unlocked.
What’s more, if Vodafone does decide to sell off its European business to Liberty, the company is likely to return any cash received from the deal to shareholders — there could be yet another special dividend windfall on the cards for investors.
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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.