Capital Investment and Fundamental Analysis of Stock - Essay Example

Capital Investment Q. What are the ‘fundamentals’ that analysts refer to in relation to share prices? Do the fundamentals really determine share price movements? A. While describing fundamental analysis of any stock, Arnold (2008) emphasizes on several factors that play a critical role in deciding whether the stock is fit for investment. Some of the basics of fundamental analysis include qualitative and quantitative factors that decide about intrinsic value of the company. Fundamental analysis deals not only with the stock but the industry itself and the economy as a whole. While evaluating quantitative factors, some of the fundamental questions that analysts usually ask are: where the company stands in terms of overall performance in comparison to rivals? What market share the company enjoys? Some of the financials such as debt-equity ratio, earning per share, dividend payout, yield, current price-earnings (P/E) ratio, net profit margin, liquidity or quick ratio are calculated to look at the current state of the company versus others in the industry (Arnold, 2008). These ratios provide only current status of the company but it does not give information about future potentials. It is essential to know whether the company is growing and if yes, then at what rate? Does its growth rate exceed its rivals? Is the market share of the company rising or stable? Is the industry growing or stagnating due to the reasons that lie in external environments? No analysis is complete unless qualitative factors such as brand equity, quality of man power, research and development activities, patents owned and its future implications, the company’s image among stake holders in terms of its management, ethical business dealings and corporate social responsibility factors, the new markets discovered, new projects undertaken for growth are evaluated thoroughly though one many question about the tangibility of these factors; nevertheless, they are equally important. Investors tend to buy any stock because they see the potential of appreciation in its price; in other words, when the stock trades much below its real value also called the intrinsic value then it is a right time to buy the stock. Opposite is also true that when the stock price exceeds its intrinsic value then it is time to sell the stock; however, there are certain important questions to be asked whether calculated intrinsic value is correct and how long will it take to reflect the intrinsic value of the stock in the stock market. Timing is an important factor while deciding about the investment on fundamental factors (Bodie, Kane & Marcus, 2011). It will be interesting to know about the key investment secrets that Warren Buffet – one of the most successful stock market investors in the world often renders to the investors, "Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results" (Velasco, 2013). The advice makes sense because one needs to be quite choosy on price while making the investment decisions. Once an investor has made the investment, little they can do to alter the decisions. Warren Buffet also ensures that the company must have a competitive advantage in the given industry. One of the important criteria is to invest in the stocks that offer value investing meaning the company stock is available for investment at steep discount to its intrinsic worth. Stock market does not always follow fundamentals. It could be highly risky, at times, to follow purely fundamentals and ignore other aspects that also play an important role in deciding the stock movements. As applicable in the other markets, at any given point of time, the demand and supply of the stock will eventually decide the movement of the share price. That is why it is quite common to experience fall in the stock price once it is selected based on its fundamentals. Little (2013) argues that economic fundamentals, other than stock fundamentals, play a crucial role in movement of the stock. Certain sectors are cyclical in nature and it is important to track periodic boom and bust cycle. The point is that change in economic fundamentals can set the price in motion for long run and the investor needs to enter for investment in the fundamentally strong stock to take advantage. Q. There are two types of interest rates – real and nominal – and interest rates at different maturities for each type. Which interest rate does a central bank (say in the US) influence? How and why? A. Real interest rates can be derived by deducting inflation rate from the applicable nominal interest rates. It is important to note that real interest rates between 2011 and 2012 period have remained negative as can be observed from the following graph. Source: http://uneasymoney.files.wordpress.com/2013/07/real_and_nominal_interest_rates.jpg Post 2008 financial crisis, economy of the many developed countries deteriorated significantly that forced many central banks to lower their policy interest rates near to zero. In December 2009, the nominal interest rates in the US and the UK were 0.12 and 0.45% respectively. Central banks use the interest rates as a monetary tool to target the inflation rate; in a way, they influence real interest rates. Amano and Shukayev (2010) argue that a negative real interest rate becomes a necessity to counter an economic downslide, especially after the financial crisis. The point is that during the time of economic weakness, the central banks lower their policy interest rates to make real interest rates near to zero so that economic activity could be sustained. The Federal Open Market Committee (FOMC) in the US decides about the Fed funds rate (interest rate) based on the economic conditions of the nation. The committee decides the targeted rate at its periodically scheduled meetings. Banks need to lend funds to each other to meet their statutory requirements called reserve requirements set by the Federal Reserve. Usually, the Fed uses open market operations to force banks to either lower or higher the interest rates. When the Fed purchases treasury bills/notes from the bank, they credit it to the banks reserve account. Due to this, the bank has surplus reserves that they can lend to other needful banks by lowering the Fed funds rate. That is how the Fed maintains the desired interest rates (Amadeo, 2010). Moreover, the Fed has other mechanics to set the funds rate called the discount rate. The Fed provides their own discount window to lend money, if need arises, at the discount rate so that banks could meet their reserve requirement. The key point is that the Fed rate among the banks is always lower than the Feds discount rate. So any bank will use the discount window only when they cannot get loans at the Fed rate from other banks. This is usually needed only during crisis situations. The discount rate is kept above the Fed funds rate by 100 basis points to discourage excessive liquidity (Amadeo, 2010). The Federal Reserve and other Central Banks such as the Bank of England took some of the extraordinary steps on the aftermath of 2007 financial crisis to provide the needed liquidity in the market and to thwart an economic recession turning into a great depression. The major objective was to stabilize the market economy and restore confidence among the business participants. That is why the concerned central banks resorted to lowering down the interest rates to an unprecedented level approaching near zero. The Central Banks resorted to the purchase of government papers in huge quantities to enhance the liquidity in the market. This helped to support the price of several assets such as stocks and houses (Waring, 2013). In the month of September 2013, the Federal Open Market Committee (FOMC) met and decided to maintain the Fed rate between 0 and 0.25 percent at least until the unemployment rate remains above 6.5 percent and the inflation rate not exceeding 2.5 percent. Thus, the Fed fund rate significantly depends upon the fluctuations that take place in the demand and supply of reserves in the entire banking system. It also informs about the credit availability in the financial market (Federal Reserve, 2013). Bank of England uses change in interest rate to control inflation. The Central Bank sets an interest rate for lending to financial institutions. This interest rate subsequently decides about the interest rates of lending institutions. A reduction in interest rates leads to less savings and tends to boost borrowing that, in turn, stimulates spending. Post 2008 financial crisis, the Central Bank reduced the bank rate to 0.5% (Bank of England, 2013). Q. Consider two companies. Marks & Spencer and Amazon. Which one has been a better investment over the past year? How would you compare the two? (After explaining how you would compare the two, you should actually go ahead and compare the two). Note that you should discuss the natures of the risks and returns of the two firms. A. In order to find out which company is better for investment, certain financial ratios such as liquidity ratios, profit margins, earning per share and existing P/E ratio will be calculated; this will inform about the liquidity risks that each company may face in the future and the likely future performance. Amazon.Com: Key Financial Ratios (All figures taken from the company’s annual report of 2012) Year ended December 31 (in Millions) Liquidity Ratios 2011 2012 Current Ratio = Current Assets/Current Liabilities 17,490 21,296 14,896 19,002 1.17 1.12 Quick Ratio = (Cash & Equivalents + Accounts Receivable (5269+2571+4307) (8084+3364+3364) + Short-term Investments)/Current Liabilities 14,896 19,002 0.82 0.78 The debt-equity ratio 14896+255+2370 19002+3084+2277 = total liability/shareholders equity 7,757 8,192 2.26 2.97 It is quite clear from the above calculations that liquidity ratio of Amazon has worsened in 2012 over previous year and even total debt has increased for the year 2012 over 2011. Profitability Ratios Net Profit Margin =Net profit/ revenue 631/48077 (39)/61093 1.3% Loss Profitability on shareholders’ fund 631/7757 (39)/8192 = net profit/ total equity 8.1 Loss Earnings per Share (EPS) $ 1.39 (0.09) Last closing price of Amazon.com as on November 11, 2013 is $354.38 (finance.Yahoo.com , 2013). Marks & Spencer: Key Financial Ratios (All figures taken from the company’s annual report of 2012-13) Year ended 31 March 2011-2012 2012-2013 Liquidity Ratios Current Ratio = Current Assets/Current Liabilities 1460.1/2005.4 1267.9/2238.3 0.73 0.57 Quick Ratio = (Cash & Equivalents + Accounts Receivable (196.1+253+67.0) (193.1+245.0+42.5) + Short-term Investments)/Current Liabilities 2005.4 2238.3 0.25 0.21 The debt-equity ratio = total liability/shareholders equity 4494.5/2778.8 5081.3/2486.4 1.62 2.04 Profitability Ratios Net Profit Margin 489.6/9934.3 458.0/10026.8 =Net profit/ revenue 4.93 4.56 Profitability on shareholders’ fund 489.6/2778.8 458.0/2486.4 = net profit/total equity 17.6 18.4 Earnings per Share (EPS) £ 0.325 0.292 Closing price of Marks & Spencer as on 11 November, 2013 is 499p (uk.finance.yahoo.com, 2013). Investment Analysis – Amazon.com Amazon.com has its corporate office in Seattle, Washington. The company went public in 1997 listing its stock on the Nasdaq Stock Exchange. The company caters consumers through its retail website and provides digital delivery too. The companys competitors include media companies, online e-commerce sites that sell even digital content, publishers, vendors, physical-world retailers and many more. Price, convenience and quick services play a critical role in this business. Many of the Amazon competitors have larger resources, greater brand recognition and longer business history and they offer formidable competition. The company also suffers from the seasonality factor in business activities and the company usually registers higher sales in fourth quarter and more than one-third of the revenue comes in the last quarter (Annual Report, 2013). Share price movement of Amazon for last five years has been shown in the following graphics. Source: http://finance.yahoo.com/q/bc?s=AMZN&t=5y&l=on&z=l&q=l&c= The company’s revenues are growing at the rate of 30% since last couple of years; however that is not reflected in the profit margins. The company has embraced technology model of business and aiming to build up the strength; however, facing stiff competition from the traditional players in the publication business. While scrutinizing the key financials, the company appears to be on a slippery ground as evident from the liquidity ratios for last two years. Even the debt-equity ratio is higher than the recommended norms of keeping it below 2. Net profit margin was a meager 1.3% for year 2011 and the company could not improve it in 2012. Currently, the companys stock is hovering at $350 that seems pretty high. In recent years, Amazon has been accused of many unethical business practices that include patent infringement lawsuits. The lawsuits filed are from the Trustees of Boston University for an unspecified amount of damages. In May 2013, Cloud Satchel LLC filed a lawsuit for the infringement of their patent rights seeking an undisclosed amount of damages and injunctive relief. In all, Amazon has been inflicted with total 6 lawsuits that may impact the company severely, if some of the court judgments go against them (Bishop, 2013). Thus, investing in Amazon is highly risky until the dust settles and more clarity emerges. While analyzing risk-return profile, downward risk is very high compared to upward movement of the stock. Investment in the stock is not recommended. Investment Analysis – Marks & Spencer With its head quarter in London, Marks and Spencer was established a way back in 1884. Currently, it operates 766 stores across the UK besides having 418 international stores. The company is active in the retail business of food, clothing and a large variety of home products throughout the UK and some parts of Europe, Asia, North Africa and the Middle East. On its fundamentals, Marks & Spencer is certainly on a sound footing compared to Amazon. The company has high brand visibility in its line of business across the UK and Europe and known for its ethical business practices. Its current and quick ratios are not appreciable; however, its debt-equity ratio falls within the industry norms. The companys operations are certainly on a sound footing as can be seen by its net profit margin of 4.5%. On shareholders’ funds, the company provides a decent 18 percent return that must be seen in the light of ongoing recession and high unemployment rate across the Europe. Source: http://uk.finance.yahoo.com/q/bc?s=MKS.L&t=5y&l=on&z=l&q=l&c= Currently, Marks & Spencer stock trades at 500p. Based on the earnings per share (EPS) of 0.292 for the year ended 31 March 2013, the P/E ratio comes out 17. Post financial crisis the stock valuation touched at around 200p since then the stock has appreciated almost 250%. While evaluating risk-return profile, the company’s operations are stable and expanding at a steady rate. The major risks are external economic environment and prevailing high unemployment rates in the regions where the company has its operations limiting demands of its products. Based on the risk-return profile, Marks & Spencer stock is certainly a good long-term investment candidate, when it reacts by 20-25 percent from the current price. References Amano, R.; Shukayev, M. (2013). “Monetary Policy and the Zero Bound on Nominal Interest Rates”. bankofcanada.ca. http://www.bankofcanada.ca/wp-content/uploads/2010/09/amano_summer10.pdf [Accessed 11 November, 2013] Amadeo, K. (2013). “Federal Reserve Tools and How They Work”. about.com. http://useconomy.about.com/od/monetarypolicy/p/Other_tools.htm [Accessed 11 November, 2013] Annual Report: Amazon.com (2012). Amazon.com Inc. http://phx.corporate- ir.net/phoenix.zhtml?c=97664&p=irol-reportsannual [Accessed 12 November, 2013] Annual Report: Marks & Spencer (2013). corporate.marksandspencer.com. http://corporate.marksandspencer.com/documents/publications/2013/annual_report_2013.pdf [Accessed 12 November, 2013] Arnold, G. (2008). “Corporate Financial Management”. Pearson Prentice Hall. UK. Bank of England (2013). “How Monetary Policy Works”. bankofengland.co.uk http://www.bankofengland.co.uk/monetarypolicy/Pages/how.aspx [Accessed 11 November, 2013] Bishop, T. (2013). “Amazon hit with six new patent lawsuits covering Kindle, cloud and retail.” http://www.geekwire.com/2013/amazon-hit-patent-lawsuits-covering-kindle-cloud-ecommerce/ [Accessed 13 November, 2013] Bodie, z.; Kane, A.; Marcus, A. (2011). Investments. McGraw-Hill. uk.finance.yahoo.com (2013). “Marks & Spencer Group PLC.” http://uk.finance.yahoo.com/q?s=MKS.L [Accessed 12 November, 2013] Federal Reserve (2013). “Why are interest rates being kept at a low level?” federalreserve.gov. http://www.federalreserve.gov/faqs/money_12849.htm [Accessed 11 November, 2013] finance.Yahoo.com (2013). “Amazon.com Inc.” http://finance.yahoo.com/q/ks?s=AMZN+Key+Statistics [Accessed 12 November, 2013] Little, K. (2013). “Three Main Influences on Stock Prices.” Stocks.about.com. http://stocks.about.com/od/evaluatingstocks/a/0317threefact.htm [Accessed 11 November, 2013] Uneasy Money (2013). “Who Sets the Real Rate of Interest?” uneasymoney.com http://uneasymoney.com/2013/07/03/who-sets-the-real-rate-of-interest/ [Accessed 11 November, 2013] Velasco, S. (2013). “Warren Buffett: 10 pieces of investment advice from Americas greatest investor.” The Christian Science Monitor. http://www.csmonitor.com/Business/2013/0830/Warren-Buffett-10-pieces-of-investment-advice-from-America-s-greatest-investor/It-s-far-better-to-buy-a-wonderful-company-at-a-fair-price-than-a-fair-company-at-a-wonderful-price [Accessed 13 November, 2013] Waring, D. (2013). “How the Federal Reserve Influences Interest Rates” http://www.learnbonds.com/how-the-federal-reserve-works/ [Accessed 11 November, 2013] Read More