Financial Investment and Options for Investment Decision - Research Paper Example

? Financial Investment Introduction The investment style of an individual varies from another depending on various opportunities and investment constraints. Individuals generally invest a certain portion of the surplus left after all necessary expenditures are carried out. Some clients invest a part of their savings in different avenues such as banks, capital market instruments, money market instruments, mutual funds, derivatives etc. The most common objective however is to maximize their return on investment. As the financial manager researching investments for clients it is important that research is conducted in line with the expectations and investment goals of the client. Ratio analysis and share price analyses are 2 most important and commonly used tools to analyze the financial position of a particular stock. A proper fundamental and technical analysis generally provides a basic idea regarding these aspects and helps investors make informed investment decisions. Generally the intrinsic value of the stock is determined from the financial facts given the annual report of the company using free-cash flows and it is compared to the current market price of the stock. When the stock is found to be undervalued then it provides an opportunity for the investor to buy the stocks at lower current price and then sell it in future when stock prices approaches target price. This strategy will help the investor make profits by buying stocks at lower price and then selling it when stock prices appreciates and ceteris paribus. Options for Investment Decision While there are many options available to an investor for investment, it is important to note that not all investment destinations are equally safe for investment when risk of investment is considered. The safest investment destination is government securities because there are very limited chances that the government will default. Another most commonly preferred investment avenue is common stocks of publicly traded companies. Companies whose stocks are listed in stock exchanges (like NASDAQ, NYSE, etc.) may be traded in secondary markets. But whenever the investor considers investment in equity oriented securities and stocks the risk of investment significantly increases. This is because when the investor buys equity shares of any company the investor actually subscribes to paid-up equity capital of the owners of the company. This automatically makes the investor the new stocks holder and assumes that the investor will bear the risk associated with business. Purchasing equity shares provides the investor the opportunity to earn dividends and residual profits proportionate to respective subscription or investment. Equity stocks are risky because the shareholders are entitled to earn from investment only after all liabilities of the business entity has been paid-off. This means that in case the business has no profits left for distribution to shareholders after honoring business liability then no dividends will be paid to shareholders. Thus, investment in company stocks is both risky and rewarding in the sense that higher the risk the higher would be the expected return. It is advised that before making any investment decisions for investment in particular stocks the financial managers must gather all necessary information related to business regarding financial position, outstanding financial liabilities and the ability of the business to honor such liabilities. Company Overview The company chosen for financial analysis is Apple Inc. (Ticker Symbol AAPL) which is a Fortune 500 company whose shares are publicly traded. Apple Inc. is a leading hardware and software company which has headquarters in Cupertino, California, U.S. The company has over 400 global retail stores spread in over 14 countries and it is listed in NASDAQ as a publicly traded company. Apple also forms a component of S&P 500 composite index and NASDAQ-100 component. The financials of the company is very strong and for the year ending 2012, the company reported a net profit of over UD$ 41 billion from total revenues of over US$ 156 billion. The net operating income of the company crossed US$ 55 billion in the year 2012. The company also has a very strong asset base with total assets of over US$ 176 billion and total equity over US$ 118 billion. As on January 2013, Apple Inc. was the second largest corporation in the world in terms of market capitalization with a total estimated value over US$ 410 billion. Range of Products and Services offered by the Company The company sells its products globally through retail outlets, online stores and direct sales with the help of third party distribution networks. The company is best known for its innovative hardware products and next generation media including iPhone, iPad, iPod, Smart Phones, and so on. The company’s products and services also include MAC, iCloud, App stores, Apple TV, App Stores, MAC App Stores and iBookstores. Their software services include iOS operating system, OS X, iTunes, iWork and iLife production and creativity suites. The company’s customers are small and medium sized businesses, retail customers, enterprises, educational institutions, and government customers. Business Strategy The company delivers innovative products and services to customers that include software, hardware, peripheral, and applications. Apple is committed to providing best user experience by leveraging its ability of producing unique design. The company continuously invests in marketing, advertising, research and development in order to boost sales and produce innovative products and technologies. The company’s long term strategy includes expansion of distribution network for reaching more customers globally in developing countries and providing them with high quality sales and support experience. Rationale for Choosing the Company Apple Inc. is the second largest company in information technology sector in the world. In terms of revenues, only Samsung Electronics (leading Korean company and key competitor of Apple) exceeds the consolidated revenue of Apple. It is also the third largest maker of mobile phone in the world only after Samsung. In the year 2008, Fortune magazine name the company as the most admired company in United States as well as globally. According to Forbes, Apple Inc. dominated the list of world’s most valuable brands as first half of 2013 (Forbes, 2013). After analyzing the financial statements of the company it was found that the increase in total revenues of Apple was over annual growth rate of 37% during the past five years. However, the cost of sales also increased by approximately 39.2% during the 2009 to 2013 which was mainly caused by supply constraints that raised the prices of inputs. The company’s gross profit also grew at 35.8% year on year due to significant contribution from the sales in emerging economies. The net income of the company increased at annual growth rate of 38.3% from 2010 to 2013 which is really impressive considering the global slowdown. After analyzing the balance sheet of the company it was found that the total assets of the company increased by over 40% annual growth rate, net cash and equivalents increased by 8.2% from the year 2010 to 2013. It is important to note here that Apple does not significant long term liabilities with respect to its earnings which give it ample opportunity in future to leverage their balance sheet and increase their EPS (earnings per share) for the shareholders. Ratio Analysis The financial statement of a company aims to provide information about the enterprise’s financial position on a given date. Such information helps the investors and other decision makers to strategize correct course of action especially regarding whether to invest in a particular stock or not after considering its profitability, solvency, liquidity, etc. As the financial manager it is important to analyze the financial position of the target company and take informed decision regarding whether to invest in company’s stocks or not. The financial statements such as the company’s income statement and balance sheet in isolation are not enough to give meaningful information unless it is compared with other financial statements. A year-on-year (Y-O-Y) comparison provides a glimpse of how the particular company has been performing over the years. Managers will also have to consider many external factors such as macro-economic scenario, competition level, policy constraints, demand-supply scenario, expansion strategy, etc. before finally recommending the stocks to their client/investors. In order to assess the financial position of a company the ratio analysis is often used as popular tool. Ratio analysis has immense application in interpretation of financial statements and also helps to analyze the profitability, solvency and liquidity trends over a certain period of time. Generally, the most commonly used types of ratio for financial analysis are profitability, solvency, activity and liquidity ratios. Profitability Ratios The profitability of a company can be measured in terms of gross turnover or sales or the capital employed, or total assets. It is a key indicator of the company’s performance in its industry of operation and also helps to measure the company’s financial position. These ratios are mainly derived from the income statement of the company. Some example of profitability ratios are Gross profit Margin, Net profit Margin, Operating Margin, Return on capital employed etc (Thukaram, p.99). The overall profitability trend of Apple Inc. has been stable and very marginally improving from 2010 to 2013. However, the operating profit and net margin of the company has increased at an annual rate of 0.6% and 0.3% respectively during the same period under observation. Solvency Ratios The solvency ratios help to analyze the ability of a company to meet its long term obligations. The ratio focuses on the actual after tax income of the company by quantifying profit after taxes and other liabilities. However, the ratio may also consider the depreciation expenses, which is a source of free cash, in contrast to the total debt of the organization. The ratio provides an appraisal of the probability of a company to continue honoring its debt liabilities to external investors. The acceptable or ideal ratio varies from one industry to another, but in general it is accepted by analysts that if the company has solvency ratio higher than 0.2 or 20%, then such companies may be considered as financially sound (Siddiqui, pp.642). From the above it is clear that the company had solvency ratio higher than 0.2 or 20% from 2010 to 2013 implying that it may be considered as a financially sound organization. Activity Ratios The turnover or activity ratios help to evaluate the activities level of business in terms of sales or turnover. The higher the activity, the higher would be the turnover of the business. The activity ratios state the number of times an asset is utilized in business to generate revenues. It is also known as the activity ratios and helps to determine how efficiently a company utilizes the assets and liabilities of the organization. These ratios are very useful when the performance of a particular company is compared to its competitors. Thus, from the definition of activity ratios, it can be said that the higher values of activity ratios indicate improved efficiency by better utilization of assets and consequently higher profitability. The financial ratios for activity of AAPL indicate that the company has not utilized its assets in most efficient way as the values have declined over the years. There is an opportunity for the company to expand its operations in emerging economies such as China or India where the market is largely untapped and holds great potential for the company to utilize its resources in new markets through diversification. Liquidity Ratios The liquidity ratio measures company’s skill to meet its working capital requirements. An asset is considered liquid if it can be transformed into cash and cash equivalents in short amount of time. The current ratio and the quick ratio are examples of liquidity ratios. The standard value should be at least 1 since failure to meet external commitments may lead to liquidation of the company. The current ratio is an indicator for the firm’s short term liquidity management, hence it is also known as the working capital ratio. The two basic constituents for this ratio are the current asset and the current liabilities. The faster the current assets can be converted to cash and cash equivalents the easier it is for the firm to cover its current liabilities with current asset. Current liabilities include bill payable to creditors, income tax payable, etc. Another popular indicator for measuring company’s short term liquidity is the Quick-ratio which is same is current ratio except that since the inventories are not very liquid as other short term assets, so it is subtracted from other current assets. The rest of the formula is same as that current ratio. It is a more conservative ratio than the former because it measures the actual current asset to liabilities by eliminating the inventories. This method is widely accepted by most business concerns because the companies often find it harder to convert the inventory into cash in short time. It is more used in the automotive and realty sectors as their current ratio will not reflect true picture of the firm (Sheeba, pp.121-126). Stock Price Analysis Determination of Free-Cash Flows The free cash flows are used to measure the financial performance of the company and it is calculated by subtracting capital expenditures from operating revenues. The free cash-flow represents the company’s ability to generate money required for expanding asset base and hence they are important to identify opportunities that can enhance shareholders’ value. Cash is very important to invest in new products, make M&A, reduce debt and pay dividends. The FCF is calculated using the following formula: In order to determine the intrinsic value of the company, the free-cash flows of the company has to be forecasted for at least the next 5 years and then the company’s potential FCF has to be determined as follows: 1 2 3 4 5 Items/Year 2014 2015 2016 2017 2018 EBIT 48,999 67,552 93,130 128,393 177,008 Depreciation & Amortization 6,757 9,342 12,917 17,859 24,692 Capital Expenditure -8,165 -11,289 -15,608 -21,580 -29,837 Increase in Working Capital 5,824 8,052 11,133 15,393 21,283 Free-Cash Flow (FCF) 43,397 80,131 110,522 152,439 210,255 Key Assumptions in Valuation Model The following key assumptions were made in order to forecast the company’s FCF on the basis of past earnings and current financial position of assets and liabilities of the company: ASSUMPTIONS % Change Revenues 1.01% Cost Of Goods Sold 7.20% GROSS PROFIT -2.83% Selling General & Admin Expenses, Total 0.47% Depreciation & Amortization, Total -0.84% Other Operating Expenses -10.53% Accounts Payable 15.58% Accrued Expenses 9.47% Cash And Equivalents 8.59% TOTAL CASH AND SHORT TERM INVESTMENTS 6.70% Accounts Receivable 4.74% Inventory 13.47% Long-Term Debt 5.53% TOTAL CURRENT ASSETS 3.23% NET PROPERTY PLANT AND EQUIPMENT -3.89% Long-Term Investments 12.59% TOTAL CURRENT LIABILITIES -4.67% Share Price Analysis Details: Outstanding Shares (million) 899.70 Current Price ($) 566.32 Beta (B) 0.61 historical market risk premium 7.50% Cost of Equity 7.08% Cost of Debt (Before tax) 2.40% After-Tax Cost of Debt 1.68% Tax 30% Growth Rate 3.25% Market Price of Equity (in Million AUD) 467439 Risk-free Rate (US 10 Year bond) 2.50% Average Market Return 7.50% 1 2 3 4 5 Items/Year 2014 2015 2016 2017 2018 EBIT 48,999 67,552 93,130 128,393 177,008 Depreciation & Amortization 6,757 9,342 12,917 17,859 24,692 Capital Expenditure -8,165 -11,289 -15,608 -21,580 -29,837 Increase in Working Capital 5,824 8,052 11,133 15,393 21,283 Free-Cash Flow (FCF) 43,397 80,131 110,522 152,439 210,255 NPV (FCF) 41,443 73,077 96,254 126,781 166,991 TPV 599,728 Value of Company (in Million AUD) 599,728 WACC 4.72% Target Debt-to-Equity ratio 0.6 Terminal Year CF 2984 Estimated Value per Share of AAPL ($) 666.59   Trailing Leading Market Price/Share $ 566.32 $ 666.59 Earnings/Share $ 41.17 $ 56.75 P/E Ratio $ 13.75 $ 11.75 P/E Ratio (TTM) $ 14.21   Annual Dividend $ 12.20 $ 12.20 Price/Share $ 39.63 $ 39.63 Dividend Yield 2.26% 0.78% Recommendations The brand Apple is known for delivering high quality and reliable products to customers. The future growth of the company will mostly depend on the Consumer spending and international diversification into emerging economies. The strength of the company lies in its cash position and in the fact that the company has negligible long term liabilities compared to its earnings. Apple has $107.46 billion of cash and cash equivalent for the year ending 2012 with no long term loans. This means that the company will be able to finance its long term strategies for investing in R&D and marketing activities in emerging economies with any requirement for borrowings. There are unlimited opportunities for the company to leverage the balance sheet and use debt capital for financing future expansions. This will help the investors to earn higher earnings per share because when company employs debt capital the number of outstanding capital decreases. Also not to mention that debt capital is much cheaper than equity capital and also act as tax shield for the company and interest liability is passed on to investors. Hence, considering the current scenario it may be expected that if the company announces inclusion of debt capital in their capital structure in future then the investors and the market will react positively and stocks prices of the company will rise. The current market price per share of the company is $ 566.32 and from the FCF analysis or discounted cash flow analysis it was found that the ‘Intrinsic value’ of the company is $ 666.59 which is leading at P/E multiple of 14.21 times (Yahoo Finance, 2013). Since the current market price of Apple Inc. is less than its intrinsic value, this implies that the company is currently undervalued and there is every possibility that the share prices of AAPL will rise in future considering its financial position analyzed earlier using ratio analysis. So, if an investor buys the shares of AAPL at CMP of $566.32 and sells it in future when the price per reaches target price of $666.59, then the investor will make profit of $100.27 per share (Gitman, pp.289-302). This means that by purchasing of 100 shares of AAPL, the investor will be able to make total profit of $10,027 (100 x 100.27). Hence, as the financial manager of my client I would advise you to purchase the stocks of Apple Inc. considering its strong cash position, high brand recognition, current undervaluation of stock prices in the market, negligible financial and business risk. References Bloomberg. (2013). Apple Inc (AAPL: NASDAQ GS). Retrieved from http://investing.businessweek.com/research/stocks/financials/financials.asp?ticker=AAPL Forbes. (2013). Apple Dominates List of the World’s Most Valuable Brands. Retrieved from http://www.forbes.com/sites/kurtbadenhausen/2013/11/06/apple-dominates-list-of-the-worlds-most-valuable-brands/. Gitman, L. (2007). Principles of Managerial Finance. New Delhi: Pearson Education India. Sheeba, K. (2011). Financial Management. New Delhi: Pearson Education India. Siddiqui, S. (2006). Managerial Economics and Financial Analysis. New Delhi: New Age International. Thukaram, R. (2007). Management Accounting. New Delhi: New Age International. Yahoo Finance. (2013). Apple Inc. (AAPL). Retrieved from http://in.finance.yahoo.com/q?s=AAPL. Appendices Table 1 – Income Statement Income Statement of Apple Inc. ITEMS 2010 2011 2012 2013   all figure in millions of US dollars           Revenues 65,225.00 108,249.00 156,508.00 170,910.00 TOTAL REVENUES 65,225.00 108,249.00 156,508.00 170,910.00 Cost Of Goods Sold 39,541.00 64,431.00 87,846.00 106,606.00 GROSS PROFIT 25,684.00 43,818.00 68,662.00 64,304.00 Selling General & Admin Expenses, Total 5,517.00 7,599.00 10,040.00 10,830.00 R&D Expenses 1,782.00 2,429.00 3,381.00 4,475.00 OTHER OPERATING EXPENSES, TOTAL 7,299.00 10,028.00 13,421.00 15,305.00 OPERATING INCOME 18,385.00 33,790.00 55,241.00 48,999.00 Interest Expense -- -- -- -136 Interest And Investment Income 311 519 1,088.00 1,616.00 NET INTEREST EXPENSE 311 519 1,088.00 1,480.00 Currency Exchange Gains (Loss) -- -- -655 -300 Other Non-Operating Income (Expenses) -156 -104 89 -24 EBT, EXCLUDING UNUSUAL ITEMS 18,540.00 34,205.00 55,763.00 50,155.00 EBT, INCLUDING UNUSUAL ITEMS 18,540.00 34,205.00 55,763.00 50,155.00 Income Tax Expense 4,527.00 8,283.00 14,030.00 13,118.00 Earnings From Continuing Operations 14,013.00 25,922.00 41,733.00 37,037.00 NET INCOME 14,013.00 25,922.00 41,733.00 37,037.00 NET INCOME TO COMMON INCLUDING EXTRA ITEMS 14,013.00 25,922.00 41,733.00 37,037.00 NET INCOME TO COMMON EXCLUDING EXTRA ITEMS 14,013.00 25,922.00 41,733.00 37,037.00 Table 2 – Balance Sheet Balance Sheet of Apple Inc. ITEMS 2010 2011 2012 2013 Assets: Currency in Millions of AUD           Cash And Equivalents 11,261.00 9,815.00 10,746.00 14,259.00 Short-Term Investments 14,359.00 16,137.00 18,383.00 26,287.00 Trading Asset Securities -- -- -- 44 TOTAL CASH AND SHORT TERM INVESTMENTS 25,620.00 25,952.00 29,129.00 40,590.00 Accounts Receivable 5,510.00 5,369.00 10,930.00 13,102.00 Other Receivables 4,414.00 6,348.00 7,762.00 7,539.00 Inventory 1,051.00 776 791 1,764.00 Other Current Assets 3,002.00 4,529.00 6,180.00 6,674.00 TOTAL CURRENT ASSETS 41,678.00 44,988.00 57,653.00 73,286.00 NET PROPERTY PLANT AND EQUIPMENT 4,768.00 7,777.00 15,452.00 16,597.00 Long-Term Investments 25,391.00 55,618.00 92,122.00 106,215.00 Goodwill 741 896 1,135.00 1,577.00 Other Intangibles 342 3,536.00 4,224.00 4,179.00 Other Long-Term Assets 2,263.00 3,556.00 5,478.00 5,146.00 TOTAL ASSETS 75,183.00 116,371.00 176,064.00 207,000.00           LIABILITIES & EQUITY:         Accounts Payable 12,015.00 14,632.00 21,175.00 22,367.00 Accrued Expenses 3,641.00 4,829.00 6,749.00 8,427.00 Other Current Liabilities 761 1,240.00 1,638.00 2,967.00 TOTAL CURRENT LIABILITIES 20,722.00 27,970.00 38,542.00 43,658.00 Long-Term Debt -- -- -- 16,960.00 Other Liabilities, Total 6,670.00 11,786.00 19,312.00 22,833.00 TOTAL LIABILITIES 27,392.00 39,756.00 57,854.00 83,451.00 Common Stock 10,668.00 13,331.00 16,422.00 19,764.00 Retained Earnings 37,169.00 62,841.00 101,289.00 104,256.00 Comprehensive Income And Other -46 443 499 -471 TOTAL COMMON EQUITY 47,791.00 76,615.00 118,210.00 123,549.00 TOTAL EQUITY 47,791.00 76,615.00 118,210.00 123,549.00 TOTAL LIABILITIES AND EQUITY 75,183.00 116,371.00 176,064.00 207,000.00 Table 3 – Cash Flow Statement Cash Flow Statement of Apple Inc. Activities 2010 2011 2012 2013   Currency in Millions of AUD NET INCOME 14,013.00 25,922.00 41,733.00 37,037.00 Depreciation & Amortization 958 1,622.00 2,672.00 5,797.00 Amortization Of Goodwill And Intangible Assets 69 192 605 960 DEPRECIATION & AMORTIZATION, TOTAL 1,027.00 1,814.00 3,277.00 6,757.00 Other Operating Activities 1,440.00 2,868.00 4,405.00 1,141.00 Change In Accounts Receivable -2,142.00 143 -5,551.00 -2,172.00 Change In Inventories -596 275 -15 -973 Change In Accounts Payable 6,307.00 2,515.00 4,467.00 2,340.00 Change In Unearned Revenues 1,217.00 1,654.00 2,824.00 1,459.00 Change In Other Working Capital -3,550.00 1,170.00 -2,024.00 5,824.00 CASH FROM OPERATIONS 18,595.00 37,529.00 50,856.00 53,666.00 Capital Expenditure -2,005.00 -4,260.00 -8,295.00 -8,165.00 Cash Acquisitions -638 -244 -350 -496 Sale (Purchase) Of Intangible Assets -116 -3,192.00 -1,107.00 -911 Investments In Marketable & Equity Securities -11,075.00 -32,464.00 -38,427.00 -24,042.00 CASH FROM INVESTING -13,854.00 -40,419.00 -48,227.00 -33,774.00 Long-Term Debt Issued -- -- -- 16,896.00 TOTAL DEBT ISSUED -- -- -- 16,896.00 Issuance Of Common Stock 912 831 665 530 Repurchase Of Common Stock -- -- -- -22,860.00 Common Dividends Paid -- -- -2,488.00 -10,564.00 TOTAL DIVIDEND PAID -- -- -2,488.00 -10,564.00 Other Financing Activities 345 613 125 -381 CASH FROM FINANCING 1,257.00 1,444.00 -1,698.00 -16,379.00 NET CHANGE IN CASH 5,998.00 -1,446.00 931 3,513.00 Table 4 – Ratio Analysis RATIOS ANALYSIS 2010 2011 2012 2013 A. Profitability Ratios   Gross Profit Margin= Gross Income/Sales 0.39 0.40 0.44 0.38 ROA= Net Income/Total Assets 0.19 0.22 0.24 0.18 Operating Profit Margin= Operating Income/Sales 0.28 0.31 0.35 0.29 Net Profit Margin= Net Income/Sales 0.21 0.24 0.27 0.22 B. Solvency Ratios   Total Debt to Assets Ratio= Total Debt/ Total Assets 0.36 0.34 0.33 0.40 Debt-Equity ratio= Total Debt/ Total Shareholder's equity 0.57 0.52 0.49 0.68 C. Liquidity Ratios   Quick ratio= Current assets - Inventory/ Current Liabilities-Bank overdraft 1.96 1.58 1.48 1.64 Current Ratio= Current Assets/Current Liabilities 2.01 1.61 1.50 1.68 D. Turnover Ratios   Return on capital employed= Net Income/ Capital Employed, where, Capital Employed=Debt Liabilities + Shareholder's Equity 0.26 0.29 0.30 0.25 Return on net worth/Return on Equity= Net Profit (after interest and tax)/ Shareholders fund 0.29 0.34 0.35 0.30 Read More