The Sources of Fundamental Risk Involved in Investing in Microsoft Stocks - Essay Example

The Sources of Fundamental Risk Involved in Investing in Microsoft Stocks Analyzing the risks involved in a company’s stock requires a test of its fundamentals. Fundamental analysis is the technique used to conduct such a test. This particular analysis involves an examination of the underlying forces that affect the health of the economy, industry groups, and companies. The objective of this analysis is to derive a forecast and profit from any future price movements. At the company level, it involves examination of its financials, management, business strategy and the competitive forces surrounding the company. There are two main approaches to conducting a fundamental analysis; top down approach involves analyzing first the economy, then the industry group and finally, the company. The bottom-up approach works in the opposite way starting at the company level and then going up to industry and the overall economy. Fundamental analysis has its strengths in forecasting long-term trends, determining the company’s fair value in terms of asset valuation, strong balance sheet, earnings stability, and staying power1. There are certain risks involved in any stock investments. A company may face one or more of the several sources of fundamental risk, namely, business risk, financial risk, liquidity risk, exchange rate risk, country risk, interest rate risk, and credit risk2. Domiciled in Seattle, US, Microsoft has its offices in 100 countries. As per the information excerpted from its annual report for the year 2006, Microsoft reported a net income of $12.5 billion. Such profitability, however, does not get achieved without taking risks. Investors need to be aware of what risks Microsoft tackles with in order to satisfy its stakeholders. Microsoft, in its operations, encounters business risk which is the risk reflecting uncertainty in cash flows caused due to a number of reasons. Microsoft faces intense competition across all markets for its products and services. 1Jones, C.P. (1996). Investments: Analysis and Management. John Wiley & Sons Inc., New York. 2Clark, E., Levasseur, M., & Rousseau, P.(1993). International Finance. Chapman & Hall, New York. Its competitors range from Fortune 100 companies to small, specialized single-product businesses. With low barriers to entry, this business segment is facing a fierce competition worldwide. These competitive pressures have the capability to threaten Microsoft’s sales volumes and operating costs resulting in lower revenue. Microsoft faces a challenge in combating unlicensed use of its software and intellectual property rights3. It spends a fortune every year to educate the public regarding abuse of its software. However, continued educational efforts may not succeed in implementing Microsoft’s desired security objectives and any reductions in the legal protection of its intellectual property rights can adversely affect revenue. Due to its geographic dispersion, Microsoft is subject to tax risk. Tax risk affects investors because it affects net earnings4. Being accountable for tax in the US as well as numerous foreign jurisdictions, there is uncertainty over Microsoft’s tax liabilities. Therefore, tax provisions may not be accurate which can significantly impair its earnings. Other examples of business risk that may affect Microsoft’s revenue are delays in product development, lawsuits and claims, changes in accounting standards, and maintaining uniformity in pricing structures due to global presence. Another challenge for Microsoft is to tackle with market risk that comprises of foreign exchange risk and interest rate risk. It is quite obvious that having operations worldwide Microsoft is deemed to face risk of foreign currency losing value relative to its domicile currency. However, as mentioned in its annual report, Microsoft manages this risk by hedging its foreign exchange exposure and constantly monitoring it to maximize its overall effectiveness. The principal currencies hedged are euro, Japanese yen, British pound, and Canadian dollar. Similarly, interest rate risk affects fixed-income securities in Microsoft’s portfolio which is diversified to minimize credit risk. Generally, interest rate, or inflation, risk can have an adverse impact on its stock. When rates go up, its stock can lose value. Therefore, fundamental analysis helps in determining the health of the economy to check if it is due for a correction by controlling the monetary policy. 3Microsoft Annual Report, 2006. http:// Microsoft.com 4Emery, G.W. (1998). Corporate Finance: Principles & Practice. Addison-Wesley, New York Microsoft stock is prone to country, or political, risk. Having operations in numerous countries, Microsoft has to have a high tolerance for an abrupt political change, or a terrorist activity, or even an armed conflict in affected countries. Such mishaps warrant immediate remedial measures like tightening of security or shutting down operations temporarily. These measures can dramatically increase operating costs. Moreover, different social, labor, political and economic conditions prevail in every country, and managing them puts an additional burden on the operating costs of the company. Microsoft has a strong balance sheet with current assets outweighing its current liabilities by a ratio greater than 2:1. This is strong evidence of the company’s financial position and clearly indicates that Microsoft does not pose liquidity risk to its creditors as well as investors. This means the company can meet its short-term obligations without any dire effects on its operations. Moreover, its debt-equity ratio further supports its credentials and convinces the creditors regarding its solvency. This is clear evidence of Microsoft’s sound capital structure and leverage position. Thus, investors need not worry about Microsoft posing any financial risks. Every organization faces a challenge in this competitive world to achieve its desired goals and Microsoft is no exception. Prior to investing in Microsoft stocks, it is imperative that the inherent risks are uncovered and fully understood by the investors. Fundamental analysis is a helpful tool that performs this task and assists investors not only in determining the risks but also their sources. b) Calculate and explain relevant measures of expected returns and different types of risk components (including beta) using Excel functions introduced in lecture notes. Translate these monthly measures into annual measures using the following relationships: Expected Return per Annual = 12 * Expected Return per Month Variance per Annual = 12 * Variance per Month Solution: Expected return for Microsoft stock can be calculated using arithmetic mean. Arithmetic mean sums all observations and divides by the number of observations. Mean for Microsoft Stock = 0.33 Therefore, monthly expected return for Microsoft stock is 0.33% which translates to 3.96% annually (0.33 * 12). Risk reflects the chance that the actual return on an investment may be very different than the expected return5. One way to measure risk is to calculate the variance and standard deviation of the distribution of returns. Standard deviation measures the dispersion of returns of the stock from its mean. In other words, it measures the variability of returns. Standard deviation is the positive square root of variance and can be calculated in excel by using the standard deviation formula. Index St. Deviation (monthly) St. Deviation (annual) Variance (Monthly) Variance (Annual) MSCI 3.64 43.68 13.25 159 S&P 500 3.67 44.04 13.47 161.62 5Emery, G.W. (1998). Corporate Finance: Principles & Practice. Addison-Wesley, New York Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Total risk comprises of systematic as well as unsystematic risk. Systematic risk, also called non-diversifiable risk, includes factors such as changes in GDP, interest rates, etc. Unsystematic risk can be caused by factors specific to the stock like strikes in the company, lower revenues, etc. Beta is useful for comparing the relative systematic risk of different stocks and, in practice, is used by investors to judge a stock’s riskiness. Beta measures the sensitivity of the stock’s returns to the overall market. The formula for the Beta of an asset within a portfolio is Where Ra = return on asset, in this case, Microsoft Rm = return on market, in this case, S&P 500 index Alternatively, beta can also be computed using regression analysis in excel. Following is the scatter diagram for Microsoft and S&P 500 that shows linear regression and beta estimate: Above figure shows a beta estimate of 1.03 from the regression equation. This estimate means that if the market (S&P 500) goes up, Microsoft will follow in the same direction and will increase relatively more than the market having a beta greater than 1. Beta greater than 1 means the stock is more sensitive than the market. Also, R2 of 0.32 means 32% of movement in Microsoft is explained by the movement in S&P 500. Beta for MSCI is 0.9 from the regression equation. This means that if MSCI goes up, Microsoft will follow MSCI in the same direction, however, the magnitude of movement will be lesser than MSCI. Beta of 0.9 means the stock is relatively less sensitive than the market. R2 of 0.24 means 24% of movement in Microsoft is explained by the movement in MSCI World Equity Index. This is evidenced in the following graph: c) Explain which stock index you believe may be the better choice of market portfolio. Calculate what percentage of total risk is systematic risk, and what percentage is specific risk. Explain implications for your client. Solution: In order to choose which stock index is a better for the market portfolio, standard deviation needs to be calculated. Standard deviation measures variability in a portfolio’s returns. Variability reflects the level of risk and is predicted in such a way that the greater the variability of returns, the greater is the risk involved in that particular investment. Standard deviation results for both the indices under review are tabulated below. As can be seen from the results, there is not much difference between the standard deviation of S&P 500 and MSCI World Equity Indices, however, MSCI is slightly lower than S&P 500. Based on this insignificant difference, choosing MSCI as market portfolio would not be a wise decision. Another risk tool can be employed in this case to justify the choice. Beta can be used as an additional tool to choose the right index as a market portfolio. The formula for beta is as follows: Index / Stock Variance Beta MSCI 13.25 0.89 S&P 500 13.47 1.03 Using the above formula, beta for MSCI is 0.89 as compared to the beta for S&P 500 which is 1.03. The higher the beta, the higher the volatility depicted by the index. Therefore, based on beta and standard deviation figures, we can conclude that MSCI Index is a better choice of market portfolio posing lesser risk to the client. Beta represents systematic risk. For MSCI, systematic risk makes up 89% of returns and unsystematic risk accounts for the remaining 12%. For S&P 500, systematic risk is greater than 100%, so there is virtually no unsystematic risk associated with this index. Based on this, it is prudent for the client to reduce concentration of funds in S&P 500 since it has higher beta (volatility) as compared to MSCI. d) The current yield (return) on 3-month US Treasury bill is about 4.95% per annual, use this as the risk free rate, and assume the US equity risk premium is about 6% per annual. Calculate the expected return on Microsoft stocks using CAPM. Compare this with the realized returns during the last 5 years, what recommendation will you give to your client? Solution: The formula for Capital Asset Pricing Model (CAPM) is: Ri= Rf + (Rm – Rf)β = 4.95 + 6 * 0.9 (msci) = 10.35% Therefore, the expected return on Microsoft stocks using CAPM is 10.35%. In calculating this return, beta used is in relation to MSCI index. The realized return on Microsoft stock during the last 5 years is 3.96% as calculated from annualized returns using the arithmetic mean formula in excel. Based on these figures, the return that Microsoft is providing is well under the expected return of 10.35%. This can have significant implications for my client who has invested a large amount of money in Microsoft. The asset allocation strategy requires reconsideration in this case. This is because the required return is well over the current return provided by the stock. In other words, the risk involved in this investment is not justified by the return provided especially taking into consideration the high beta of the stock. Even though the client has investments across various asset classes and geographical locations, benefits of diversification are not being achieved by investing a large sum of money in an underperforming stock. I would recommend my client to reduce the exposure to Microsoft stock and look out for stocks with relatively lesser beta value so as to reduce risk and also increase benefits that can potentially be obtained by investing in other stocks that justify returns compared to the risks involved. In order words, portfolio allocation should be altered and new stock investments should be included that are in parity with the overall investment objectives. REFERENCES Clark, E., Levasseur, M., & Rousseau, P.(1993). International Finance. Chapman & Hall, New York. Emery, G.W. (1998). Corporate Finance: Principles & Practice. Addison-Wesley, New York Jones, C.P. (1996). Investments: Analysis and Management. John Wiley & Sons Inc., New York. Microsoft Annual Report, 2006. http:// Microsoft.com APPENDIX Date Closing Prices $ Monthly Percentage Returns Name MSCI WORLD S&P 500 MICROSOFT MSCI WORLD S&P 500 MICROSOFT 30/09/2001 926.023 1040.94 25.585 31/10/2001 943.2 1059.78 29.075 1.85 1.81 13.64 30/11/2001 997.928 1139.45 32.105 5.80 7.52 10.42 31/12/2001 1003.516 1148.08 33.125 0.56 0.76 3.18 31/01/2002 972.418 1130.2 31.855 -3.10 -1.56 -3.83 28/02/2002 962.732 1106.73 29.17 -1.00 -2.08 -8.43 29/03/2002 1003.597 1147.39 30.155 4.24 3.67 3.38 30/04/2002 968.25 1076.92 26.13 -3.52 -6.14 -13.35 31/05/2002 967.847 1067.14 25.455 -0.04 -0.91 -2.58 28/06/2002 907.81 989.81 27.35 -6.20 -7.25 7.44 31/07/2002 830.549 911.62 23.99 -8.51 -7.90 -12.29 30/08/2002 830.582 916.07 24.54 0.00 0.49 2.29 30/09/2002 738.179 815.28 21.87 -11.13 -11.00 -10.88 31/10/2002 791.883 885.76 26.735 7.28 8.64 22.25 29/11/2002 833.471 936.31 28.84 5.25 5.71 7.87 31/12/2002 792.215 879.82 25.85 -4.95 -6.03 -10.37 31/01/2003 767.478 855.7 23.73 -3.12 -2.74 -8.20 28/02/2003 752.864 841.15 23.7 -1.90 -1.70 -0.13 31/03/2003 748.628 848.18 24.21 -0.56 0.84 2.15 30/04/2003 813.302 916.92 25.56 8.64 8.10 5.58 30/05/2003 857.649 963.59 24.61 5.45 5.09 -3.72 30/06/2003 871.066 974.5 25.64 1.56 1.13 4.19 31/07/2003 887.78 990.31 26.41 1.92 1.62 3.00 29/08/2003 905.324 1008.01 26.52 1.98 1.79 0.42 30/09/2003 909.641 995.97 27.8 0.48 -1.19 4.83 31/10/2003 962.707 1050.71 26.14 5.83 5.50 -5.97 28/11/2003 976.019 1058.2 25.71 1.38 0.71 -1.64 31/12/2003 1036.318 1111.92 27.37 6.18 5.08 6.46 30/01/2004 1052.288 1131.13 27.65 1.54 1.73 1.02 27/02/2004 1068.647 1144.94 26.53 1.55 1.22 -4.05 31/03/2004 1059.157 1126.21 24.93 -0.89 -1.64 -6.03 30/04/2004 1035.657 1107.3 26.13 -2.22 -1.68 4.81 31/05/2004 1042.626 1120.68 26.23 0.67 1.21 0.38 30/06/2004 1062.513 1140.84 28.56 1.91 1.80 8.88 30/07/2004 1026.991 1101.72 28.49 -3.34 -3.43 -0.25 31/08/2004 1029.631 1104.24 27.3 0.26 0.23 -4.18 30/09/2004 1047.861 1114.58 27.65 1.77 0.94 1.28 29/10/2004 1072.698 1130.2 27.97 2.37 1.40 1.16 30/11/2004 1127.339 1173.82 26.81 5.09 3.86 -4.15 31/12/2004 1169.341 1211.92 26.72 3.73 3.25 -0.34 31/01/2005 1142.35 1181.27 26.28 -2.31 -2.53 -1.65 28/02/2005 1176.702 1203.6 0 3.01 1.89 -4.26 31/03/2005 1151.184 1180.59 24.17 -2.17 -1.91 -3.93 29/04/2005 1123.642 1156.85 25.3 -2.39 -2.01 4.68 31/05/2005 1140.677 1191.5 25.8 1.52 3.00 1.98 30/06/2005 1148.813 1191.33 24.84 0.71 -0.01 -3.72 29/07/2005 1188.165 1234.18 25.61 3.43 3.60 3.10 31/08/2005 1194.807 1220.33 27.38 0.56 -1.12 6.91 30/09/2005 1224.314 1228.81 25.73 2.47 0.69 -6.03 31/10/2005 1193.88 1207.01 25.7 -2.49 -1.77 -0.12 30/11/2005 1231.412 1249.48 27.68 3.14 3.52 7.70 30/12/2005 1257.775 1248.29 26.15 2.14 -0.10 -5.53 31/01/2006 1313.214 1280.08 28.15 4.41 2.55 7.65 28/02/2006 1309.451 1280.66 26.87 -0.29 0.05 -4.55 31/03/2006 1335.069 1294.83 27.21 1.96 1.11 1.27 28/04/2006 1373.383 1310.61 24.15 2.87 1.22 -11.25 31/05/2006 1322.246 1270.09 22.65 -3.72 -3.09 -6.21 30/06/2006 1319.934 1270.2 23.3 -0.17 0.01 2.87 31/07/2006 1327.233 1276.66 24.06 0.55 0.51 3.26 31/08/2006 1358.871 1303.82 25.7 2.38 2.13 6.82 29/09/2006 1373.367 1335.85 27.35 1.07 2.46 6.42 STANDARD DEVIATION 3.64 3.67 Regression analysis results of MSCI and Microsoft are tabulated below: SUMMARY OUTPUT Regression Statistics Multiple R 0.49028 R Square 0.240374 Adjusted R Square 0.227277 Standard Error 5.865965 Observations 60 ANOVA   df SS MS F Significance F Regression 1 631.5316 631.5316 18.35339 7E-05 Residual 58 1995.754 34.40954 Total 59 2627.285         Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept -0.3235 0.7724 -0.41882 0.676891 -1.86963 1.222626 -1.86963 1.222626 X Variable 1 0.898405 0.209707 4.284085 7E-05 0.47863 1.318179 0.47863 1.318179 Read More