The Beta Values of British American Tobacco and the Petrofac - Case Study Example

Strategic and Financial Decision-making Assignment Table of Contents Introduction 3 Data and its Sources 4 Calculation of Beta 4 The Published Beta and the Calculated Beta 7 The Beta of the Two Companies 8 Capital Asset Pricing Model 9 Organic Growth and Non-Organic Growth 10 Conclusion 10 Reference 11 Introduction The capital market is the largest market where most of the investors invest their money in numerous public sector companies. The stock exchanges act as intermediaries between the investors and the companies. Due to heavy fluctuations in the stock prices, the capital markets are considered to be the most risky market to invest in. The term ‘risk’ denotes the uncertainty associated with return; it may be positive return and it may be negative return. The stock analysts and the statisticians have developed various models and tools to measure or to estimate the volatility and the returns of the market. The ‘beta’ is the most important statistics tool to measure the volatility and the Capital Asset Pricing Model (CAPM) is a popular model to calculate the return on stock. In this report the beta values of two companies will be calculated using the share prices of the last 24 months. These two companies are British American Tobacco (BATS) and the Petrofac (PFC.L) and both of them are listed in the London Stock Exchange (LSE). British American Tobacco is one of the leading tobacco companies in UK. British American Tobacco produces cigarettes under different brands and has different price range. “Petrofac is an international provider of facilities solutions to the oil & gas production and processing industries” (Petrofac, 2010). The beta values of both the companies will be calculated using different methodologies that include covariance of the stock return with market returns and the variance of the market returns and the linear regression analysis. Data and its Sources For calculating the betas, the monthly stock prices of both the companies were obtained and for market return the index FTSE 100 has been used. All these are the secondary source of data obtained through online sources. The historical stock prices of the both the companies are obtained through ‘Yahoo Finance’ and the historical data of FTSE 100 is also taken from the same online source (Yahoo Finance. 2010). The calculated beta values have been compared with the beta values from the published source. The published source for betas has been taken from the online source, MSN-Money (MSN-Money, U.K. 2010.). The published betas of British American Tobacco and Petrofac are 0.47 and 1.06 respectively. Calculation of Beta The two methodologies for beta calculation have been used. The first methodology will use the covariance of stock return with market return and the variance of the market return. The following model explains the beta (β) under the same method. β = COV(Ri , Rm)/Var (Rm). Where, Ri = monthly returns on stock for the last 24 months. Rm = monthly returns on market for the last 24 months. The calculation has been done using the MS Excel. The following table is showing the covariance of both the companies with the market return and the variance of the market return. Using the covariance and the variance, the beta for both of the companies has been calculated. The beta of Petrofac (PFC.L) and British American Tobacco (BATS) are 1.016 and 1.383 respectively. The second methodology is the linear regression analysis. The regression analysis measures the beta in context to the independent variable and the dependent variable. Here, the independent variable is the market return of FTSE 100 and the stock return of the company is dependent variable. The linear regression analysis has been done for both of the companies keeping the market return as independent variable fixed. “The expert uses this regression relation (market model) and the actual market return during the period of interest to predict the particular stock’s return”(Weil. et.al. 2001. P.57). The following tables are showing the results of regression analysis that has been calculated using the MS Excel. The linear regression analysis measures the relation between the independent and the dependent variables where a change in the independent variable causes a corresponding change in the dependent variable. The regression model is as follows. Y = a + βX + ei Where, Y = dependent variable i.e. the return on stock. X = independent variable i.e. the market return of FTSE 100 and the ‘a’ is a fixed factor and ‘ei’ is the standard error. Therefore, the linear regression line for Petrofac (PFC.L) is “ Rp = 0.0298 + 1.249*Rm”. In this equation the beta (β) is 1.249 that means the change in market return (Rm) will lead to the change in the return on Profact’s share by 1.249. The same model is applied for British American Tobacco’s stock return (Rb) and the regression model is “Rb = 0.0897 + 1.388*Rm”. This equation explains that there will be a change of 1.388 in stock if there is a change in the market return. The Published Beta and the Calculated Beta Beta is the most important statistical tool that measures the volatility of the stock return in respect to the market return. Beta helps the investors to hedge and to calculate their risk before investing in the capital market by purchasing the stock for a particular company. “The tendency of a stock to move up and down with the market, and thus its market risk, is reflected in its beta coefficient. Beta is a key element of the CAPM” (Brigham. et.al. 2007. p.266). The CAPM model helps to determine the stock return. The rational investors and the financial analysts access the risk before investing in the stocks. Beta is a very useful indicator to manage a portfolio. The betas of various companies are generally published by financial institutions like security brokers or the exchanges in which the companies stocks are traded. In this section, the beta of two companies, British American Tobacco (BATS) and Petrofac (PFC.L) have been taken from MSN-Money, U.K. The published data of the two companies are 0.47 and 1.16 respectively. The beta of the BATS provides more consistent result as compared to the beta of PFC.L. The calculated betas of the BATS and PFC.L are 1.383 and 1.016 respectively, according to the covariance of stock return with the market return and variance of the market return. According to the regression analysis, the betas are 1.387 and 1.249 respectively. There is a contradiction between the calculated and the published betas. The published data indicates that there is less volatility in the BATS stock than the ones from the market and that the PFC.L’s stock is 16% more volatile as compared to the market. Generally, published betas are calculated using a large range of data that seem to be more reliable. These data are calculated using the latest analysis software. Therefore, the accuracy is better maintained in the published beta. The calculated betas, on the other hand are obtained by using the monthly stock prices of the last 24 months. As the data are analyzed in Excel so accuracy of the result is more or less authentic. However, the small data range makes it less reliable than the published one. The Beta of the Two Companies The calculated betas of the both the companies indicates the volatility of their stock in the market. According to both the methods, the betas of British American Tobacco (BATS) are 1.383 and 1.387 respectively whereas the betas of Petrofac (PFC.L) are 1.016 and 1.249 respectively. Higher betas of BATS indicate that the stocks of this company are riskier. The risk and the return are directly connected; therefore the risk and the return both are higher in respect to the market return. The beta of the PLC.L proves that it is more consistent with the previous one. An investor can expect a better uniform return from the PFC.L’s stock and the risk level is also lesser that BATS. The calculated betas differ in their values when used for both the methodologies. The beta calculated by regression analysis is considered to more reliable as this method considers certain factors which are ignored by the covariance-variance method. The regression model is “Y = a + βX + ei”. In this model ‘a’ is the other constant factor and ‘ei’ is the standard error. These two factors are adjusted in this model while the former method doesn’t take this into account. Therefore, the betas of the regression analysis are more valid. Beta of a company is an important tool for the management or the decision makers of that company. “Beta emphasized the importance of timely and accurate pricing information to their business. It considered the ability to pass on pricing changes across the wider value system as quickly as possible to be a source of competitive advantage” (Barnes. et. al. 2006. p.166). Beta is influenced by the performance of the company. Generally companies with higher growth have higher beta as higher growth also implies higher risk. If we analyze the financial statements of the larger companies whose beta rates are lower, it will be found that they have shown a consistent growth over the period and hence they have a less chance of decline in profitability. Capital Asset Pricing Model The capital asset pricing model (CAPM) is the most popular model to determine the return required on investment after taking into account the associated systematic risk and the risk free rate of return available in the market. The CAPM model represents the linear regression model. It relates the return on investment and the risk in a linear manner. The CAPM model is “E(ri) = Rf + βi(E(rm) - Rf)”. Where, E(ri) is the required rate of return on stock, Rf is the risk free rate of return, βi is the beta for the stock and E(rm) is the return on market. According to Gray, Cusatis and Woolridge, the CAPM is the most common and important way to determine the discount rate while valuing a stock (Gray. et.al. 2003. p.54). Hamilton’s comment on CAPM is very much valid as the CAPM includes some important advantages. Firstly, it considers the systematic risk. Secondly, it takes into account the relationship between systematic risk and the required rate of return. Thirdly, it is a better model than dividend growth model as it takes into account the company’s level of risk in respect to the stock market and lastly, for using investment appraisal which is more useful than the weighted average cost of capital. Organic Growth and Non-Organic Growth The managements of each company want to expand their company in the industry or to enter a new industry. The quality and the decision style of the management team decide the nature of the company’s growth. There are two ways of expanding a company; organic growth and non-organic growth. “Organic growth is generated by more customers, new products and operational efficiencies. Organic growth represents the underlying strength and viability of a business.” (Hess.2006. p.ix). Non-organic growth is referred to the acquisitions, takeovers, mergers etc. organic growth enables a company to be consistent in the market and to attain its strategic goals. Organic growth makes a company an experienced player of the industry with a good market share. Acquisition or mergers often results to issues like crashes of culture and the risk associated with the acquired company. Apart from that, the acquisition process requires huge expenses that sometimes lead to several financial crises. Organic growth also requires monetary expenses but it is cheaper than acquisition. However, acquisition helps a company to grow too fast as market share, customer base etc of both combines together, whereas organic growth is the fruit of an efficient and consistent management. Conclusion Beta of a company is important not only for the shareholders but also for the investors of the companies as it measures the volatility of stock return in the market. The higher beta of a company indicates its inconsistent performance in the capital market. Therefore, it gives an idea of company’s performance in the capital market and hence the management considers betas values while making decisions. Beta is an inevitable factor which is required in the CAPM to calculate the required rate of return on investment. The CAPM is the most commonly used model to calculate the value of a stock. The beta of companies which are having organic growth differs with those which are having non-organic growth. The performance of the stock depends on the nature of the growth. Reference Barnes, S. & Scornavacca, E. 2006. Unwired business: cases in mobile business. Idea Group Inc (IGI). Brigham, E.F. & Houston, J.F. 2007. Fundamentals of financial management. Cengage Learning. Gray, G. Cusatis, P. & Woolridge, J.R. 2003. Streetsmart guide to valuing a stock: the savvy investors key to beating the market. 2nd ed. McGraw-Hill Professional. Hess, E. D. 2006. The road to organic growth: how great companies consistently grow market share from within. McGraw-Hill Professional. MSN Money, U.K. 2010. Market: Petrofac Ltd. [Online] Available at : http://uk.moneycentral.msn.com/investor/quotes/quotes.aspx?Symbol=GB%3APFC. [Accessed on: May 19, 2010]. MSN Money, U.K. 2010. Market: British American Tobacco PLC. [Online] Available at : http://uk.moneycentral.msn.com/investor/quotes/quotes.aspx?symbol=BATS. [Accessed on: May 19, 2010]. Petrofac. May 2010. About Us. [Online] Available at: http://www.petrofac.com/About.html. [Accessed on: May 19, 2010]. Yahoo Finance. 2010. Investing: BR.AMER.TOB. ORD 25P (BATS.L). [Online] Available at : http://finance.yahoo.com/q/hp?s=BATS.L&a=04&b=1&c=2008&d=04&e=19&f=2010&g=m. [Accessed on: May 19, 2010]. Yahoo Finance. 2010. Investing: (PFC.L). [Online] Available at : http://finance.yahoo.com/q/hp?s=PFC.L&a=04&b=4&c=2008&d=04&e=19&f=2010&g=m. [Accessed on: May 19, 2010]. Weil, R.L. Wagner, M.J. & Frank, P.B. 2001. Litigation services handbook: the role of the financial expert. 3rd ed. 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