Investment Analysis of BHP Billiton Company - Case Study Example

?INVESTMENT ANALYSIS INVESTMENT ANALYSIS (Your instruction) (Your (Year) Event study Commonwealth Bank of Australia is a company that is based on Sydney Australia, it as founded in 1911 and its main line of business is provision of various banking and financial products and services to retail, small businesses corporate customers as well as institutional customers in Australia, New Zealand, the Asia pacific region, United Kingdom and the United States (Yahoo finance, 2012a). An event study was carried out to determine the impact of the announcement of the 25 basis points decrease in cash rate by the Reserve Bank of Australia on 6th December 2011. The event window used to carry out this event study is the 10 days before the event announcement date, the event announcement date and the 10 days after the event announcement date denoted as day -10 to day +10 and the event announcement date is day zero. The estimation period on the other hand is period between day -510 and day -11. The closing adjusted weekly prices for the Commonwealth Bank of Australia and the all ordinaries index were obtained from yahoo finance for the estimation period and the closing adjusted daily prices were also obtained from yahoo finance for the event window (Yahoo finance 2012b and 2012c). The all ordinaries index represents the market returns. Estimation of the market model The weekly returns of the Commonwealth Bank of Australia and the weekly logarithmic returns of the All Ordinaries Index were calculated using the formula ln (Pt/Pt-1) where Pt is the adjusted closing price of the security at time t and Pt-1 is the adjusted closing price of the security at time t-1. The returns of the Commonwealth Bank of Australia and the returns of the All Ordinaries Index for the estimation period as presented on a linear graph are as shown in the chart below. As shown in the chart above, the returns of the CBA and those of All Ordinaries Index have a linear relationship that is represented by the regression equation y = 0.6967x – 0.001. This indicates that the value of beta is equal to 0.6967 and that of alpha is equal to -0.001. However, the chart above shows that there are many outliers that are not represented by this equation indicating that regressing the returns of the CBA on those of the All Ordinaries index would yield a better result that will incorporate the effect of the outliers (Uliana Flynn & Correia, 2007). The regression result is as shown in table below. As shown in the table above, the value of alpha as represented by the intercept is equivalent to 0.00094 while the value of beta is equivalent to 1.00742. This indicates that the regression equation representing the relationship between the CBA returns and the Market returns as represented by the All Ordinaries Index is equal to Y = 1.00742x + 0.00094. This is the market model where Y is the dependent variable which is the expected returns of the Commonwealth Bank of Australia during the event window while x is the independent variable which is the market returns during the event window and alpha is the constant which is otherwise referred to as the intercept (Uliana, Flynn and Correia, 2007). Market model adjusted abnormal returns The market model adjusted abnormal returns is equivalent to the difference between the expected returns and the actual returns of Commonwealth Bank of Australia during the event window. The abnormal returns are the accumulated to arrive at the cumulative abnormal returns of the Commonwealth Bank of Australia during the event window as shown in the table below; As shown in the table above, the abnormal returns are given by the actual returns minus the expected returns of the Commonwealth Bank of Australia during the event window. The expected returns are calculated using the market model shown above. Findings As shown in the market model above, the beta of the Commonwealth Bank of Australia is equivalent to 1.0074 indicating that it is a growth stock because it has a beta that is more than one. In addition to this, the share prices before the announcement of the cash rate fluctuated up and down leading to fluctuations in abnormal returns especially 10 days before the event day and 5 days before the event day as shown in the chart below. 3 days to the event announcement date the cumulative abnormal returns which were already positive started to increase consistently indicating that the market was expecting the cash rate to decrease and as such the price of the Commonwealth Bank of Australia started increasing in anticipation of the decrease in cash rate. This is an indicator of a strong form of market efficiency. The Commonwealth Bank of Australia recorded positive cumulative abnormal returns throughout the period after the announcement of the decrease in rate indicating that the announcement had a positive effect on the share price of the bank (Lee 2001). Asset pricing models The regression equation states that the expected return denoted as (rp – rf) is equivalent to 0.434225 + 1.039073(rm – rf) where rp is the return of the portfolio, rf is the risk free rate of return and rm is the return of the market. This means that the portfolio’s alpha is equivalent to 0.434225; the portfolio beta is equivalent to 1.039073 indicating that the portfolio is a growth portfolio with high risk in relation to the market because it has a beta value that is more than one. This indicates that if the market return is equivalent to the risk free rate, the portfolio expected return will be equivalent to 0.434225 meaning that the fund manager’s claim of generating at least 43 basis points of abnormal returns is correct. However, the regression equation’s value of Adjusted R square is equivalent to 0.75 indicating that there is a 25% chance that the results obtained were by chance. This means that the returns of the portfolio can only be explained by the returns of the market to the extent of 75%. This means that there are other factors that can control remaining 25% meaning that the simple regression equation is not fully representative (Lee, 2001). The Fama-French three factor model which incorporate market capitalization factors and book to market value ratios into the capital assets pricing model. The estimated model indicates that the expected return is equivalent to 0.129548 + 1.101335(rm – rf) + 0.227787SMB + 0.636524HML indicating that the portfolio alpha is equal 0.129548, the coefficient associated with the difference between the Small market capitalization stocks minus big market capitalization stocks is equivalent to 0.227787 while the coefficient associated with the high book to market ratio minus low book to market value ratio is equal to 0.636524. This indicates where market return is equal to the risk free rate, the difference between high cap and small cap stocks is zero and the difference between high book to market value and low book to market value is zero, the expected return of the portfolio is equal to alpha which is equal to 0.129548 indicating that the fund manager’s claim is not true. The regression equation’s value of adjusted R square is equal to 0.856 indicating that the portfolio returns can be explained by the three factors to the extent of 85% meaning that it is more representative than the CAPM model (Brigham and Daves, 2009). Security analysis The investor is 50 years of age, he will retire after 10 years, his risk appetite is low and as such he seeks to invest in a stock that offers high returns at low risk most preferably defensive stocks. The stock being analyzed is the BHP Billiton plc which is involved in the business of diversified natural resources worldwide. The company’s return on equity as at 19th March 2012 is equal to 38.32%, the company’s price earnings ratio is equal to 8.28 indicating that the market has confidence in the business since its price is 8.05 times the earnings generated per share. The company’s earnings per share is equal to 4.26 indicating that the company is profitable than the industry which recorded an average earnings per share of 3.25 within the last one year. The company has a price to book ratio of 2.90 indicating that it is profitable as is shown by the return on equity. The company’s beta is equivalent to 1.09 indicating that the company is a growth stock because it has a beta that is more than one. Therefore the investor should buy the stock above to include it in his portfolio because it offers a high return with low risk and it has growth potential as shown by the value of beta and by the ratios shown below (Brigham and Daves, 2009). As shown in the table above, over the last five years BHP Billiton recorded a mean annual return of 7.54% which was much higher than the market as represented by All ordinaries index which recorded a mean return of -4.78%. The beta of the company over the five year period between March 2007 and March 2010 is equal to 1.09. A risk free rate of 5% has been used to calculate the expected return of BHP Billiton which is equal to -5.66%. This indicates that the stock performed much better than expected and also outperformed the index by a high margin. It also performed better than all the other four companies scrutinized as shown in the table above indicating that it is the ideal stock to invest in. Recommendation Therefore this stock should be bought and included in the portfolio. Other factors affecting the company (BHP Billiton) The company has international operations indicating that foreign currency exchange rate movements affect its returns, however since it has operations in various parts of the world like the United Kingdom, United States, Australia and several other parts of Asia and Europe, it can effectively shield itself against foreign currency risk by trading all the currencies of the countries it operates in. The inflation levels in Australia have been declining over the last 20 years indicating that the company is shielded against the risk of inflation (Reserve bank of Australia 2012). References Brigham, E, F. & Daves, P, R. (2009). Intermediate Financial Management. Florence: Cengage Learning Lee, C, F. (2001). Advances in investment analysis and portfolio management. Maryland Heights: Elsevier Reserve Bank of Australia. (2012). Monetary Policy: Inflation Target. Retrieved on 19th March 2012 from http://www.rba.gov.au/monetary-policy/inflation-target.html Uliana, E, Flynn, D, & Correia, C. (2007). Financial Management. Cape Town: Juta and Company Ltd Yahoo finance. (2012a). CWLTH Bank FPO (CBA.AX): Business summary. Retrieved on 19th March 2012 from http://finance.yahoo.com/q/pr?s=CBA.AX Yahoo finance. (2012b). CWLTH Bank FPO (CBA.AX): Historical prices. Retrieved on 19th March 2012 from http://finance.yahoo.com/q/hp?s=CBA.AX&a=00&b=4&c=2008&d=11&e=22&f=2011&g=d Yahoo finance. (2012c). ALL Ordinaries (^AORD): Historical prices. Retrieved on 19th March 2012 from http://finance.yahoo.com/q/hp?s=%5EAORD&a=10&b=27&c=2009&d=11&e=20&f=2011&g=d Read More