Investment Decision and Stock Price Evaluation - Essay Example

Investment Decision and Stock Price Evaluation Table of Contents Task Valuation of BP plc. 3 a) Net Asset Value 3 b) Cost of Capital 3 c) DividendGrowth Model 4 d) Price Earnings (p/e) Ratio 5 Task 2: Investment Advice 5 Task 3: Share Price Tracking and EMH 8 Reference List 10 Task 1: Valuation of BP plc. a) Net Asset Value The net asset value per share of British Petroleum (BP) has been calculated as follows: It is seen that the net asset value for BP had fallen in the year 2014 as compared to 2013. A fall in the value of net assets can be considered as the prime reason behind such a decline in the ratio. This indicates inefficient performance of the firm and its lack of ability to maintain market value (Pastor and Pietro, 2003). b) Cost of Capital i) Cost of equity using capital asset pricing model (CAPM): ii) Cost of debt capital: iii) Weighted average cost of capital (WACC): c) Dividend Growth Model The theoretical price of a share has been calculated using the dividend growth model as follows: d) Price Earnings (p/e) Ratio The price earnings ratio of the oil and gas industry is seen to be 12.8 % approximately. In the year 2013, the p/e ratio is seen to be much lower than the general industry standard. However, for BP, the price earnings ratio for the year 2014 is much higher than the general industry standards. The ratio is seen to be as high as 30% (Damodaran, 2012). Task 2: Investment Advice a) Whether making investments in the shares of BP is profitable or not, has been analysed on the basis of the above calculations in respect to p/e ratio and the share price value calculated using the dividend growth model. The p/e ratio aids investors to understand the market prospects of a given stock. A higher p/e ratio is generally considered to be better as it results out of higher earnings and market value existing for a share. It is also considered that firms having a higher p/e ratio is likely to give more dividends (Bakshi and Chen, 2005). The ratio helps investors to decide upon the price at which shares must be purchased based on the evaluation of its earnings. The ratio therefore aids in establishing a relationship between earnings and the market value per share. It is extremely essential that the ratio is studied by investors based on industry average and previous year’s values. The ratio can be interpreted wrongly if not suitably compared with the p/e ratios of previous years and the general ratio existing in the industry (Sharpe, 2002). From the calculations carried out it has been seen that the p/e ratio of BP in the 2013 has been lower than the general industry standards. The industry standards were at 12.8 while the ratio for BP was as low as 6.49%. This indicates that the market value of shares and the EPS values for the year 2013 of BP were lower than the general industry standards. On the other hand, it was seen that the p/e ratio for the year 20014 had risen to 30%. This was identified due to a fall in the earning per share (EPS) values, although the price of shares had experienced lower level of decline. Although a higher p/e ratio is considered to be better, it may be judged wrongly if not compared with the figures of the previous year. In case of BP, although the p/e ratio had risen, the cause behind it was a fall in the EPS which cannot be considered to be a positive indication (Core, Guay and Kothari, 2002). The p/e ratio of BP is considered to be highly instable due to the fluctuating levels of EPS. Hence, investors must not depend upon only evaluating the p/e ratio while taking investment decisions (Rutterford, 2004). It is essential to consider other profitability and efficiency ratios while taking investment decisions. In case of BP, the p/e ratio in the year 2014 is adequately high as compared to the industry standards and the ratio of the previous year. Although this may be perceived as a positive factor, the massive difference in the values indicates high instability (Makivic, 2000). P/e ratio offers the scope for accountants to manipulate figures by basing the calculations on wrong EPS or market prices. For such reasons, it requires to be compared with the ratios of other firms to take effective decisions. BP’s main factor for inflated p/e ratios are reduced EPS. So ultimately, even if investors consider investing in the firm, the reduced earnings will provide them with lower dividends (Graham and Harvey, 2002). The dividend growth model facilitates calculating the intrinsic value of a stock based on the expected level of dividends paid out. The formula used for calculating the value based on dividends, discounts the value back to their original value. Intrinsic value is estimated on the basis of discounting the future cash inflows (Dunis and Reilly, 2004). The dividend based model of calculating the value of shares takes into consideration the stream of dividend expected to be earned and then discounts it to ascertain the present value. There exists essentially two important ways in which the dividends earned in a future period of time can be discounted and the value of shares are determined (Koller, Goedhart and Wessels, 2010). Firstly, by discounting the cash inflows occurring to the firm, it is possible to determine the value of shares. The cash inflows are required to be discounted after interest expenses are paid off. The remaining revenue is essentially the earnings which are available to shareholders. Another method is discounting the cash earnings available to shareholders directly. The second method is what is essentially known to be the dividend discounting model. The Gordon growth model is known to be the simplest model for calculating the value of stocks (Leung and Sircar, 2009). In the current assignment, the Gordon’s growth model has been applied to ascertain the value of stocks of BP. The formula used for valuation of shares under the dividend growth model is as follows: Value of share = {D*(1+G)} / (r - G). Where, D= expected dividend r= cost of equity or required rate of return G= expected growth rate on dividends. The dividend growth model established by Gordon is based on certain important assumptions. It is assumed that the financial condition of the business is stable and it would not essentially come to an end for a considerably long time (Demirakos, Strong and Walker, 2004). The stocks have been valued on the basis of growth rates established at 0% and 2%. Accordingly, the stock values ascertained were $309 and $426. A low growth rate was ideologically set for BP considering the rapid fluctuations in their revenues. From the calculations carried out, it can be stated that the dividend paying capability of BP is likely to vary highly as its growth rates and its revenue earnings vary vastly (Daves, Ehrhardt and Shrieves, 2004). Moreover, it can be seen from the earlier calculation in respect of p/e ratio is that, earnings of the firm are not stable. As a result, the probability of the organization to provide stable returns is low. Accordingly, it can be stated that taking investment decisions on the basis of the dividend growth technique is not considered to be feasible as the firm fails to meet one of the basic criterions of the model, which is earning stable returns. The evaluation clearly depicts BP as a risky firm for making investments based on both the accounting income and the discounting cash flow techniques. b) The p/e ratio calculations reveal that the EPS values of the firm are not stable. Hence, the financial condition of the firm fluctuates highly from time to time. Investors may perceive such a firm to be risky for making investments. The calculations carried out in respect of valuation of shares also reveal that the net asset value per share has also declined in the year 2014 as compared to 2013. Although the dividend growth model indicates that the firms share value is likely augment if the growth rate is upward rising and the returns are more or less stable. This might not be the actual scenario for the company in the forthcoming times (Devers, Wiseman and Holmes, 2007). The investor may take up a more detailed financial analysis such as leverage evaluation and other financial ration to gain a clearer picture regarding the financial steadiness of the firm. It also suggested that the investor must wait for a few more financial years before investing in the shares of BP as the company’s revenues and earnings are seen to be going through a phase of decline. The balance sheet also indicates a fall in the value of fixed and current assets, indicating a reduction in the span of activities. Considering such essential factors, it is suggested that BP refrains from investing in the company’s shares at present (Demirakos, Strong and Walker, 2004). Task 3: Share Price Tracking and EMH The share prices of BP have been analysed between the periods of January 2015 and April 2015, as shown in the following figure: (Source: Yahoo Finance, 2015) The share prices have been evaluated on a daily basis between the selected time span. However, plotting in the graph has been shown between intervals of seven days for each of the four months. The average share value during this period was seen to be 39.38142. As compared to the industry statistics, BP’s share values can be considered to be adequately low. The market capitalization of other firms such as Royal Dutch and Gazprom are comparatively higher than BP. Their share values are also adequately high. In case of BP, the share values are seen to remain adequately stable (Timmermann and Granger, 2004). The prices had fallen in the month of March but were seen to be revived in April. Since the share values have not fluctuated much, shareholders are not expected to incur much loses if at all prices fall. However, such an investment is only suitable if the investor buys and sells off the shares within a short duration. If the investors aim is to gain revenue by way of dividends, then investing in the shares of BP might not be suitable considering their low dividend yield. Hence, gains can be only be achieved by investors on the basis of the differences occurring the in prices of BP shares (Malkiel, 2003). EMH (efficient market hypothesis) is considered to be an effective technique for taking investment decisions through share price evaluation. The EMH techniques involves solely analysing the share prices of an organization, based on the consideration that share prices reveals all types of financial information regarding a firm. Such EMH is based on the historical prices of stocks. There is less scope of d-future analysis and speculating the movement of prices in the future based on such a model (Eom, et al., 2008). The EMH technique which has been utilized in the current paper to evaluate the share prices of BP shows that, the company’s share prices have remained more or less stable. However, such EMH technique is not suitable for investors who consider earning returns by retaining the overall shares for a longer period of time. Since EMH only provides share price information, it is useful for traders who gain out of the differences of the face value of share price. Considering the fluctuations in the EPS and the low dividend yield, it is advisable that investors do not hold the shares for a long duration and selling it off when the market values are up. It is also essential to understand that share values rise and fall out of demand conditions. Hence inflation, interest rates and exchange rates are aspects which impact their stock prices in the market (C. C. Lee, J. D. Lee, and C. C. Lee, 2010). A clear picture regarding the internal financial conditions is often not procured. Hence, even if a company’s share prices are adequately high due to enhanced trading activities, it cannot be stated that the revenues and the earnings per share are also high. In depth financial evaluation is crucial. For instance, in case of BP, although share prices are quite stable, the firm incurs lower dividends and earnings. Therefore while taking investment related decisions and while analysing a firm’s financial condition, it is essential to consider a number of aspects such as its revenue position, financial ratios and leverages (Borges, 2010). Reference List Bakshi, G. and Chen, Z., 2005. Stock Valuation in Dynamic Economies. Journal of Financial Markets, 8(2), pp. 111-151. Borges, M. R., 2010. Efficient Market Hypothesis In European Stock Markets. The European Journal of Finance, 16(7), pp. 711-726. Core, J. E., Guay, W. R. and Kothari, S. P., 2002. The Economic Dilution of Employee Stock Options: Diluted EPS for Valuation and Financial Reporting. The Accounting Review, 77(3), pp. 627-652. Damodaran, A., 2012. Investment valuation: Tools and techniques for determining the value of any asset. New Jersey: John Wiley & Sons. Daves, P. R., Ehrhardt, M. C. and Shrieves, R. E., 2004. Corporate Valuation: A Guide for Managers and Investors. Mason: Thomson/South-Western. Demirakos, E. G., Strong, N. C. and Walker, M., 2004. What Valuation Models do Analysts Use? Accounting Horizons, 18(4), pp. 221-240. Devers, C. E., Wiseman, R. M. and Holmes, R. M., 2007. The effects of endowment and loss aversion in managerial stock option valuation. Academy of Management Journal, 50(1), pp. 191-208. Dunis, C. and Reilly, D., 2004. Alternative Valuation Techniques for Predicting UK Stock Returns. Journal of Asset Management, 5(4), pp. 230-250. Eom, C., Choi, S., Oh, G. and Jung, W. S., 2008. Hurst Exponent and Prediction Based on Weak-Form Efficient Market Hypothesis of Stock Markets. Physica A: Statistical Mechanics and its Applications, 387(18), pp. 4630-4636. Graham, J. and Harvey, C., 2002. How do CFOs make Capital Budgeting and Capital Structure Decisions? Journal of applied corporate finance, 15(1), pp. 8-23. Koller, T., Goedhart, M. and Wessels, D., 2010. Valuation: Measuring and Managing the Value of Companies. New Jersey: John Wiley and Sons. Lee, C. C., Lee, J. D. and Lee, C. C., 2010. Stock Prices and the Efficient Market Hypothesis: Evidence from a Panel Stationary Test with Structural Breaks. Japan and the World Economy, 22(1), pp. 49-58. Leung, T. and Sircar, R., 2009. Accounting for Risk Aversion, Vesting, Job Termination Risk and Multiple Exercises in Valuation of Employee Stock Options. Mathematical Finance, 19(1), pp. 99-128. Makivic, M. S., 2000. U.S. Patent No. 6,061,662. Washington, DC: U.S. Patent and Trademark Office. Malkiel, B. G., 2003. The Efficient Market Hypothesis And Its Critics. Journal of Economic Perspectives, 1(1), pp. 59-82. Pastor, L. and Pietro, V., 2003. Stock Valuation and Learning about Profitability. The Journal of Finance, 58(5), pp.1749-1790. Rutterford, J., 2004. From Dividend Yield to Discounted Cash Flow: A History of UK and US Equity Valuation Techniques. Accounting, Business & Financial History, 14(2), pp. 115-149. Sharpe, S. A., 2002. Reexamining Stock Valuation and Inflation: The Implications of Analysts Earnings Forecasts. Review of Economics and Statistics, 84(4), pp. 632-648. Timmermann, A. and Granger, C. W., 2004. Efficient Market Hypothesis and Forecasting. International Journal of Forecasting, 20(1), pp. 15-27. Yahoo Finance, 2015. BP plc. [Online] Available at: [Accessed 19 May 2015]. Read More