Fundamentals of Finance: Caterpillar, Inc - Coursework Example

Fundamentals of Finance: Caterpillar, Inc Executive Summary Caterpillar’s high profitability, management efficiency and acceptable liquidity are indisputably good reasons for investing with the stocks of the company. The high profitability and average efficiency may just help maintain the good liquidity and keep the company stable by eventually reducing its obviously high leverage-position, which is seven times more than the industry average in terms of debt to equity ratio. Its higher PE ratio and higher market to book values than industry average appear may prove the point that the company may just be that the company’s good financial performance in the past and should be telling investors about a further good future and this was further sustained in the seeming undervaluation of the company’s stock using dividend discount model. At a certain point however, the high leverage position may be inconsistent with the high growth in dividends for the past five years. Such high growth rendered the application of constant dividend growth model almost ineffective, had not a lower rate been assumed. The dividend experience is something that investors must watch since this may further increase the leverage position and put the company more risky than the past. 1. Introduction Caterpillar, Inc. (or “Caterpillar”) is engaged in the business of providing construction and mining equipment, diesel and natural gas engines and industrial gas turbines. It therefore belongs under the heavy machinery industry. It has its primary operations under three lines of business of business: Machinery, Engines and Financial Products. The first line of its business, Machinery, Caterpillar provides the design, manufacture, marketing and sales of mining, construction and forestry products while under the second line, Engines, it does the same as the first but this time on electric power generation systems, petroleum, locomotives, marine, industrial, construction, agricultural and other related products. Its Financial Products as the third line would refer to its primary subsidiaries under the name of Caterpillar Financial Services Corporation, Caterpillar Insurance Holdings, Inc and other subsidiaries (MSN, 2010). This paper seeks to evaluate the performance of Caterpillar, Inc, as the chosen US listed company for the purpose of recommending whether or not to invest in the company's shares by looking at the company’s liquidity, solvency position, financial ratios of performance, and its market ratios and dividends conditions for the past five years. The company’s ratios will be evaluated by comparing them against the industry averages. A valuation of the company’s stock based on dividend discount model using weighted cost of capital would be appropriate to determine possible valuation or undervaluation as additional basis for recommendation. 2. Analysis and Discussion 2.1 Financial Analysis Financial analysis requires the use of relevant financial ratios to evaluate the company’s record for the past five years. 2.1.1 Liquidity Caterpillar’s liquidity tells its ability to meet its currently maturing obligations. With liquidity measured using the current ratio and the quick asset ratio, the company showed the following information in Table 1 in relation to Appendix I. Table 1- Summary of liquidity and solvency ratios; Sources: Sources: (Reuters.com 2010a, 2010b). The significance of measures of liquidity becomes clearer by determining how the formulas are meant to be. To have current ratio, one uses current assets need to be divided to current liabilities while to have quick assets ratio is almost the same with current ratio except that the latter is more strict. Under the latter ratio, inventory and prepaid expenses are being removed from the current assets, as used in current ratio, to have a new numerator for dividing with same current liabilities as the denominator. Quick assets are stricter than current assets and normally include only cash, marketable securities, and accounts receivable. This makes quick asset ratio a finer measure of liquidity than that of the current ratio. Caterpillar, in applying formula, would produce current ratio is 1.23 as against industry average of 1.48. Although a little bit lower than industry average, the company’s more 1.0 current ratio is still an indication to good liquidity. Its quick ratio on the other hand, was shown at 0.83 as against industry average of 1.01. Again the company showed lower rate but such a quick ratio is still acceptable in relation to its high current ratio considering the industry where the company operates. Thus, it can be deduced that the company is still generally liquid and is capable to pay or match current liabilities by its current assets. See Table 1 above in relation to Appendix I. 2.1.2 Solvency A financially healthy business should have good solvency position and Caterpillar’s needs such long-term capacity to keep up with its stability over the long term. Measured by the debt to equity ratio, by dividing the total debt of the company’s debt to its total equity, solvency or financial leverage would inform investors whether the company could survive in the long run to recover long-term investments, which takes years to produce the needed returns. The debt to equity ratio of Caterpillar is 6.49 as against industry average of 0.83 or about seven times more than the industry average. This indicates a company weakness as the value the company investments from stockholder is less compared to its creditors. See Table 1 above. As an evidence of a highly leverage capital structure for Caterpillar, the company would be considered perilously able to make further expansions in the future without become more risky than present competitors are. In other words, Caterpillar would it difficult to manage its long terms risk in case of reverses in the economy and that its profitability may not be enough to provide funds to pay currently maturing obligations. This would also limit its capacity to provide good amount of dividends annually to investors. Surprisingly the company was providing an average of 15% growth for its dividends while having a highly leverage position. 2.1.3 Profitability and Management Efficiency Caterpillar’s average return on equity (ROE) for the last five years at 39% could easily impress many compared to the industry average of 6%. Investors may not allow the average of about 39% return on equity to escape their attention. For every US-$100 investment, the investors can wait for returns of about 39 dollars after a year time. Such high rate of return could be viewed as something extraordinary given the condition of the economy as affected by the global financial crisis. Every serious thinking investor could almost be asking: “What is the secret of the company in generating such high profitability?” See Table 2 below and see Appendix I for more details. Table 2- Summary of profitability and efficiency ratios. Sources: (Reuters.com 2010a, 2010b). How good ROE is in measuring profitability? The ratio uses the formula where net profit is divided by the total stockholders’ equity. It is telling how much one will get in return from making an investment with the company after one year? To determine its magnitude of return, an investor normally compares the return to what he or she would get from another investment that he or she could have made. Doing nothing or just keeping one’s money in the bank without much risk, an investor would earn in the US an average rate of 0.25% using as basis the US base rate of the Federal Reserve Bank (Housepricecrash, 2010). The rate should be a valid benchmark to know what is the present risk-free-rate investment in the US. Compared with Caterpillar’s present ROE of 39%, means getting more than fifty times the said rate. Given the present economic condition, that of Caterpillar must be difficult to find for investors. Aside from profitability, it is also interesting to know whether the company management is efficient. To measure the latter, this paper uses return on assets (ROA). Caterpillar’s ROA for five-year average, the rate of 5% for the company is the same as the industry average of 5%. ROA may indicate profitability measure and may tell as well how efficient management the company had in terms of profits in relation to assets employed in business. ROE on the other hand measures how much management can give back resources invested by stockholders. By comparing the two ratios, it appears that Caterpillar is still more profitable but as efficient as the industry. 2.2 Market ratios After looking at liquidity, profitability, efficiency of the company, there is need to see whether market ratios confirm or not what past performance show. As a publicly listed company in the US, how investors value the company in relation to its earnings and book values should be relevant information. While management tries to maximize the wealth of stockholders (Brigham and Houston, 2002), checking whether such is done is measurable using these ratios. Table 3 summarizes the market ratios of Caterpillar as against is competitors in the industry. Table 3 – Market ratios as against the industry. 2.3 Valuation 2.3.1. Weighted cost of capital for Caterpillar Valuation of the Caterpillar’s involves use of cost of capital that is somewhat related conceptually to opportunity cost in economics, which indicates what could have been earned by investors had they invested their other than that of the company. The same can guide if an investor is earning below or above expectation. Using the said cost of capital as discount rate in discounting dividends for Caterpillar under the dividend discount model, it is possible to determine the intrinsic value of the stocks. To estimate the cost of capital for discounting for the company using the CAPM model (Brigham and Houston, 2002), the formula is: Required (or expected) Return = RF Rate + (Beta * (Market Return - RF Rate)). RF stands for risk free rate and plus a compensation for increased risk or the market risk premium. Using said the formula now for Caterpillar an estimated cost capital of 6.54%% comes up as shown below: Required (or expected) Return = RF Rate + Beta (Market Return - RF Rate) = 0.25% + 1.74 (3.86%- 0.25%) = 6.54% Another way to estimate cost of capital is by using directly the reciprocal of the industry’s price- earnings ratio (P/E) for latest twelve trailing months. . This P/E signifies willingness of investors to buy a share of stock for every level of earnings per share in the industry. Getting the reciprocal of the industry P/E ratio produces an estimated cost of capital of 3.86%, which is computed by dividing 1 by P/E ratio of 25.86 (See Appendix II). 2.3.2 Computing the market value of the Caterpillar using the constant growth model. The constant growth model (Brigham and Houston, 2002) uses the growth rate of the dividend per share of 15% per year as computed. Together with cost of capital estimated at 6.54% using CAPM model and the industry’s PE reciprocal for the latest twelve months, producing two separate market values became a reality. CAPM model resulted in market value per share of $177.31 while under latest quarter industry PE reciprocal, the resulting market value per share should is $172.80. Thus, it was necessary to estimate a lower growth rate of 5.54% under CAPM and 2.86% under P/E reciprocal since if actual 15% average dividend growth is used, the constant growth cannot apply. See Appendix II. The market value per share combined of the following information: Dividend last year Do, expected growth rate in dividends (g), and the discount rate (Brigham and Houston, 2002). The dividend per share paid last year (2009) is given at $1.68 while the expected growth rate was calculated by taking the average increase of the dividend per shares for the prior years was computed at 15% (Appendix II), while the discount factors used could be either under CAPM or PE reciprocal as estimate of WACC. In both methods, Caterpillar’s stock appears to be undervalued at $83.54 per share (Reuters.com, 2010a) . 3. Conclusion Caterpillar’s has high profitability, management efficiency and acceptable liquidity. These are undeniably good reasons of investing with the stocks of the company. The most critical is the high profitability and average efficiency as it may cause other good things like maintaining the good liquidity of the company. This may also keep the company stable by eventually reducing its leverage position, which is very high. The company’s higher PE ratio higher market to book values than industry average, could only confirm the company good financial performance in the past and should be telling investors about a further good future. The results of the valuation using the dividend discount model revealed undervaluation of the company’s stock. Aside from high leverage position the high growth in dividends, which rendered the application of constant dividend growth model, almost ineffective, are something that investors must watch since this may further increase the leverage position and put the company more risky than the past. Investing with Caterpillar’s stocks is highly recommended. Appendices Appendix I -Summary of Financial Data and Ratios; Sources: (Reuters.com, 2010a, 2010b; Caterpillar, Inc, 2010a) Appendix II- Computation of Market Value per share and Dividend Growth per Year; Sources: (Reuters.com, 2010a, 2010b; Caterpillar, 2010a) References: Brigham and Houston. (2002). Fundamentals of Financial Management, Thomson South-Western, London, UK Caterpillar, Inc (2010a). Annual Reports for 2005 through 2009. Retrieved 6 November 2010 from http://ccbn.10kwizard.com/xml/download.php?repo=tenk&ipage=6775740&format=PDF Housepricecrash.co.uk. US Base rate, (2009). Retrieved 6 November 2010 from http://www.housepricecrash.co.uk/base-rates.php MSN (2010). Company Report - Caterpillar. Retrieved 6 November 2010 from http://moneycentral.msn.com/companyreport?Symbol=US%3aCAT Reuters (2010b). Financial Statements 2005 to 2009. Retrieved 6 November 2010 from http://www.reuters.com/finance/stocks/incomeStatement/detail?perType=ANN&symbol=CAT Reuters.com (2010a). Industry ratios. Retrieved 6 November 2010 from http://www.reuters.com/finance/stocks/financialHighlights?symbol=CAT Read More