Investments: Analysis and Management - Example

Financial Research Report Investment decisions are based on both fundamental and technical analysis of the selected company financials and its stock performance over a period. In order to make investment recommendations, it is important to determine and assess the investor profile and then select a stock that matches his or her risk and return profile and preference. For a risk-averse investor who would be interested in keeping the risk level low and at the same time be able to obtain capital gains from investment in stocks, the current report makes recommendations for investment in stocks of Google Inc. Google Inc. is a leading internet marketing and application developer company based in the US and its stocks are listed on NYSE. The analysis presented in this report clearly indicated that the company had a strong financial position in the last three years and it was able to sustain its leading position in the web market. The company faces minimal risks i.e. liquidity, credit, interest rate, market and default risks. It makes the company’s stocks suitable for the investor with the given risk and return profile. Table of Contents Abstract 2 Table of Contents 3 Section I 4 Introduction 4 Basis for Selection 4 Section II 5 Investor Profile 5 Company Profile 6 Section III 6 Financial Ratio Analysis 6 Current Ratio 7 Quick Ratio 8 Debt to Equity 8 Earnings Per Share (EPS) 9 Price Earnings Ratio 11 Stock Valuation 12 Risk Analysis 14 Section IV 15 Overall Risk Assessment 15 Section V 16 Recommendation 16 References 17 Financial Research Report Section I Introduction Investment decisions recommended in this report are primarily based on the financial analysis of the selected company’s reported financials. The selection of the company for investment proposal is made after consideration of the investor’s profile. The analysis uses financials of the selected company reported in the last three years financial statements. The report includes values of key financial ratios and their analysis in terms of the trade off between risk and return. Moreover, the current report performs stock price analysis and valuation based on Discounted Cash flow Method (DCM). The intrinsic value of the selected company’s stock along with market indicators is used to form basis for investment recommendation. Furthermore, some of the key financial risks associated with financial instruments and income securities are also covered in this report that could affect the company’s return and increase risks associated investment in the company’s stocks. Basis for Selection Keeping in view the investor profile provided in the following section, the criteria used for selecting a company and its stocks are provided in the following: 1. Strong business model and market position (Whitman, 2000). 2. Weak competition and sustainability of business. 3. High R&D and diversity in the business. 4. Strong financials in terms of assets, revenues, profits, and cash position. 5. Global presence of the company’s network that reduces its dependency on specific markets (Sornette, 2003). 6. Strong potential for business growth. 7. High level of synergy between different business functions. 8. Expanding network of operations and product profile. Section II Investor Profile In order to make recommendations for an investment in the equity market, the investor profile is reviewed. The investor is risk averse who accepts a low level of risk in his investment. The investor aims to reduce his portfolio risk further by investing in a stock that could generate positive returns in terms of capital gains from long-term holding (Deangelo, DeAngelo, & Skinner, 2009). As the investor is not interested in regular income in the form of dividends therefore it is important to select a company’s stock, which has high potential of capital gain (Deangelo, DeAngelo, & Skinner, 2009). Furthermore, the investor would invest in such company that has strong business model and its business is expected to sustain the economic and financial pressures. Moreover, such company should have healthy stream of revenues and profits that could assist in further development and expansion. Company Profile Larry page and Sergey Brin incorporated Google Inc. in the year 1995 when both were studying at Stanford University. The duo worked on a search engine named BackRub in the year 1996, which operated on servers of Stanford University for more than a year and ended up taking too much bandwidth. Google was registered as a domain on September 15, 1997. Google was firstly named as “googol” with 100 zeros by Larry and Sergey to reflect the sign of having infinite information (Company overview - Google, 2014).  Google is now a Multinational Corporation, which deals in Internet-related services and products. The use of Google has tremendously increased and it is still growing. The corporation has now launched multiple chains of products. Google has Gmail for sending and receiving emails, Google+ for social networking service, use of chrome has increased as it is among one of the first choices for web surfers and so many other reliable products. A result of 2007 has shown that the company controls more than a million data servers across the globe in its data centers. Alexa has listed Google as one of the most visited websites in the world. Google also has taken steps into the communications hardware it is now partner with some big electronic manufacturers. Google Maps are live and they added a satellite view in 2005 giving direction to the people worldwide. Section III Financial Ratio Analysis Google Inc. financial performance as reported in the last three years is evaluated by ascertaining values of key financial ratios. It is an important element of analysis because stakeholders can easily understand the basis of the company’s performance and compare it with other companies and industry. The results of financial ratio analysis are provided in the following table.     2011 2012 2013 Current Ratio Current Assets/Current Liabilities 5.92 4.22 4.58 Quick Ratio Current assets - inventory / current liabilities 5.92 4.22 4.55 Debt to Ratio Total Liabilities/Total Assets 0.20 0.24 0.21 Earnings Per Share Net Earnings/ Average Shares Outstanding 30.17 32.81 38.82 Price-Earnings Ratio Share Price/EPS 10.69 10.77 14.42 Source for financial data: (Form 10-K (2013): Google Inc., 2014) Current Ratio From an investor’s perspective, it is important that the company continues to remain profitable and is able to generate cash to fund its operations. The company needs to have ample liquidity to ensure that any business decisions that are in favor of the company’s investors could be undertaken. Therefore, there is a trade off between risk of having too much cash tied up in current assets such as accounts receivables, inventory, etc. and return that the company could earn for its shareholders (Downes & Goodman, 2003). The current ratio is, therefore, an indicator of the company’s funding liquidity risk. It is calculated as the proportion of current assets to current liabilities. In the last three years of reported financials, Google Inc. had current ratio values of more than one. It suggests that the company faced low levels of liquidity risk in these three years. An area of concern that could be highlighted is the increase in the company’s accounts receivables by 12.64% in 2013. It could create problems for the company’s liquidity if it fails to realize all of its receivables and recognizes high level of bad debts in its income statement that could lower its net earnings. It could be noted that the company’s bad debt provision also increased significantly in the last three years. Therefore, there is a trade off between liquidity risk and return of the company. Quick Ratio The quick ratio is another measure of the company’s liquidity position and risks associated with the business operations. It excludes the company’s inventories from its current assets. The company’s inventories are less liquid as compared to other current assets as they are difficult to be sold upon liquidation. Google Inc. had low levels of inventories in the last three years. It suggested that the company did not have large cash tied up in its inventories and it had low level of funding liquidity risk. The quick ratio values were almost same as the current ratio values. The nature of the company’s business implies that the company is less likely to have high inventories. Therefore, it could be stated that the company’s liquidity risk is minimal. Debt to Equity Every business has different stakeholders and they are prioritized according to their interests in the business. Debt-holders obtain stake in the business by providing funds at a predetermined interest charge. The repayment of principal loan amount and interest amount are crucial for the business and they have to be made before any funds could be distributed to shareholders. The repayment of principal amount has implications for the company’s cash flow from financing activities. Moreover, the interest payment is deducted from the company’s operating profits before determining net profits attributable to shareholders. It could, therefore, be suggested that the company could face credit risk related to its inability to meet its financial obligations. Shareholders need to be concerned if the company is highly leveraged (McMenamin, 2005). Google Inc. maintained a low level of leverage in the last three years. The debt to equity ratio values indicated that equity rather than external borrowing majorly financed the company’s operations and investment projects. The company raised external borrowing by issuing long-term bonds in the debt market. The total amount borrowed was $3,000 million with maturities falling in the next ten years. The nearest maturity is due in 2016 is of $1,000 million with YTM of 0.49%. The company also pays fixed coupon of 2.125%-3.625% to its debt holders (Google Inc Class C, 2014). From the company’s financial reports, it could be highlighted that the company had a strong net cash position in the last three years and there are no immediate threats that could affect the company’s ability to repay this borrowed amount. It could be inferred that the company has low levels of credit risk. Earnings Per Share (EPS) Shareholders are interested in the return on their investment in the business. EPS is an indicator of net profits attributable to shareholders. It is determined by dividing the company’s net profits by the number of outstanding shares. The results indicate an increase in the company’s EPS in the last three years. The company’s main business that is web marketing and advertisements indicated major success. The company’s revenues went by 21% and 20% in 2012 and 2013 respectively, which suggested no slow down in the company’s business and it resilience to compete with other web browsers and Facebook. In 2014, the company reported 5% decline in its profits resulting from high costs of real estate and also rising costs of hardware (BBC, 2014). Keeping in view, the company’s Android application and launch of new products such as Google Glass, it is expected that the company will achieve its revenues targets from its advertising business. The company’s innovation process is on going and it has announced several new products in 2014 that would yield positive impact on the company’s revenues and profits. Although the company did not pay any dividends in the last three years, shareholders of the company can expect an increase in their wealth as the value of the company’s stock is expected to increase. In order to assess the impact of risks associated with the company’s inability to maintain its current growth rate, the following table summarizes results of the scenario analysis that predicts EPS under pessimistic, neutral, and optimistic views of the company’s future performance. In Millions of USD (except for per share items) Pessimistic Neutral Optimistic   -5% 19.2% 30% Revenue 56,834 71,331 77,773 Total Revenue 56,834 71,330.95 77,772.50 Cost of Revenue, Total 24,533 30,790.65 33,571.20 Gross Profit 32,301 40,540.31 44,201.30 Selling/General/Admin. Expenses, Total 11,402 14,310.31 15,602.60 Research & Development 7,515 9,431.31 10,283.00 Unusual Expense (Income) 117 146.66 159.90 Total Operating Expense 19,033 23,888 26,046 Operating Income 13,268 16,652 18,156 Gain (Loss) on Sale of Assets (54) -67.96 -74.10 Other, Net 60 75.12 81.90 Income Before Tax 13,273 16,659 18,164 Income After Tax 11,189 14,044 15,312 Net Income 11,189 14,044 15,312 EPS 16.53 20.75 22.62 The table above reflects changes in EPS under three scenarios considered. It clearly implies that the company’s financial position does not have any immediate challenges and it could be sustained in any suggested scenario if faced by the company. Price Earnings Ratio The price earnings ratio (P/E) is an indicator of the equity market’s sentiments regarding the company and its share price. If shares are trading at a price that is at higher multiple of EPS then it implies that the equity market expects further increase in the company’s share price. Additional investment in the company’s shares could yield capital gains from holding. The findings presented in the table above indicate that the shares of Google were trading at high multiple of 14.42 times its EPS in 2013 (as of December 2013). In 2011 and 2012, the company’s shares were trading at 10.69x and 10.77x and a significant increase in the share price was recorded in both years. The current P/E of the company is 13.68 (as of December 3, 2014) that is still supportive of the expected increase in its share price. Therefore, it could be stated that investment in the company’s stocks would yield positive returns. Stock Price Performance The company’s shares are listed on the New York Stock Exchange and its symbol is GOOG. The company was listed on the NYSE in the year 2004 at a share price of $85 (Russolillo, 2013). Current Price $531.32 (as of December 3, 2014) 52 week $512.54 (as of December 4, 2013) Stock Price Growth 3-Year 73.31% 2-Year 52.99% 1-Year 0.99% 1-Month -3.96% 1-Week -1.47% Source: (Google Inc. (GOOG), 2014) The data summary indicates that investors earned high returns from holding their investments in the company’s stocks. The company’s stock prices have significantly increased over the last three-year period and it implies that shareholders can make capital gains in the absence of dividends. However, there were fluctuations recorded in the company’s stock price during the analysis period. Stock Valuation It is also useful to perform valuation of the company’s stock value based on its historical financial performance. It allows ascertaining the intrinsic value of the company’s shares. If the intrinsic value of the firm’s stock is greater than the company’s current share price then, it could be suggested that there is a potential of higher return on investment (Jones, 2009). In this report, Google’s intrinsic value has been determined using the Discounted Cash Flow Method (DCF). The table below provides details of the calculations carried out which indicate that the company’s intrinsic value per share is $774.30. The intrinsic value of the company is greater than its current stock price of $531.2 (as of December 3, 2014). It indicates that the investor can expect an increase in the company’s share price in the coming periods and he can attain capital gains from holding his investment in the company’s stocks. It is important consideration as the company did not pay any dividends to its shareholders and, therefore, the investor cannot expect to receive any income from dividends in the next period. Cost of Equity Risk-free rate: Rf: 2.25% Return on Market: Rm: 15.55% Beta: 1.172 Sources: (Treasury securities, 2014; S&P 500, 2014) Using CAPM, the cost of equity is determined to be 17.84% Ke = 2.25% + 1.172 x (15.55% - 2.25%) Cost of Debt Interest: $ 530 Total Debt: $ 5,245 Kd: 530 / 5,245 =10.10% Source of Data: (Form 10-K (2013): Google Inc., 2014) Based on the company’s financial information, Weighted Average Cost of Capital (WACC) is calculated as follows: Effective Tax Rate: T: 15.70% Debt: D: $5,245 Equity: E: 25,922 Cost of Equity: Ke: 17.84% Tax Adjusted Cost of Debt: Kd(1-T): 8.52% WACC:16.27% (Brigham, 2013). Free Cash Flow (FCF) EBIT 13,966.00 Depreciation 2,781.00 CAPEX (7,358.00) Working Capital 630.00 FCF 10,019.00 Intrinsic Value Using V = FCF / (WACC – g) V = 216,715.08 Number of Outstanding Shares: 279.88 mn Value per Share: $774.30 Risk Analysis The company indicated various risks that its business faced in 2013. Some of the financial risks that have implications for the company’s financial position are presented in the following. Time Value of Financial Investments The company hedges its position in foreign currency transactions by entering into foreign exchange contracts. The changes in the intrinsic and time value of these foreign currency contracts are recorded in the company’s income statement. There are risks associated with these currency contracts if there is an unfavorable movement in the value of US Dollars. In such situations, the company records expenses as net interest and other income in its consolidated income statement. It is deducted from the company’s operating income and, therefore, implies lower returns for common shareholders (Baker & Powell, 2009). Fair Value of Fixed Income Securities The company invests in various fixed income securities to make efficient use of its free capital and ensure availability of liquidity. The company minimizes its interest rate risks by investing into government securities. However, an increase in the interest rate could affect the market value of such fixed income securities (Veronesi, 2010). In regards to this, the company recognized unrealized losses in its income statement. The company estimated a loss of $1 billion if there is 100 basis points increase in interest rates. Moreover, floating income securities generates less income for the company in case of declining interest rates. These could, therefore, have an impact on the income attributable to common shareholders. Similarly, the company enters into interest rate swaps to hedge its position in different securities. The fair value of these swaps could also be affected by a decrease in interest rates. Therefore, it could be stated that there is a tradeoff between risk and return of the company. Section IV Overall Risk Assessment Google Inc. has a strong business model and position in the web and mobile markets. There are no immediate threats that could affect the business continuity and the company position in the industry. However, there are certain issues that could affect its revenue source i.e. advertisement is the emergence of social media websites and technologies that could block Google’s marketing business. Moreover, the company’s business highly depends on the leadership and entrepreneurship of its founders, which could be affected if any of them leaves the business for any reason (Form 10-K (2013): Google Inc., 2014). The company’s revenues were increasing in the last three years. However, its profit margin declined, which suggests high operating and administrative costs incurred by the company. The declining profits could raise challenges for the company to sustain its huge network. The financial ratio analysis indicates no weaknesses. The company faces minimum level of liquidity risk, credit risk, and interest rate risk. The stock prices experienced volatile movements in the last three years. However, overall the growth in the stock value was significant and positive. The standard deviation of daily returns was low at 1.3% in the last one-year period. The company’s beta value is 1.172 that suggests higher sensitivity in the stock price of Google Inc. to market changes (Kevin, 2006). It is because the company’s main stream of revenues is dependent upon other businesses placing their adverisements (Form 10-K (2013): Google Inc., 2014). In order to address risks associated with the volatility in stock prices, trading in the company stocks for short-term capital gains is not advisable. The investor must invest in the company’s stock with a medium or long-term investment plan rather than seeking quick returns from trading. Section V Recommendation Based on the analysis provided in this report, investment in Google Inc. stocks (GOOG) is recommended. Investment in stocks is riskier and less liquid as compared to fixed income government securities. However, the investor may allocate funds to stock investment in order to diversify his portfolio (Amihud, 2002). Keeping in view, risk and return profile of the investor, Google’s stocks offer considerable opportunity for achieving capital gains in the long run. The investment should be made for long-term holding in order to attain capital gain as the company has no record of paying dividends to its shareholders. It must be understood that companies do not pay dividends as it may affect the stock price and signal negative news about their current financial position (Baker, 1989). Google Inc. has a strong financial position and there are no immediate threats that could affect its business in the coming periods. Therefore, dividend payout could signal weakness in the company’s position, which is not the case. Short-term trading in the company’s stock is not recommended as its value is highly sensitive and quick positions could result in a loss as suggested by (De Long, Shleifer, Summers, & Waldmann, 1989). Therefore, keeping in view the investor profile it is recommended that investment with a long-term perspective should be made in the company’s stocks to avoid such risks. References Agar, C. F. (2005). Capital Investment & Financing: a practical guide to financial evaluation. New York: Butterworth-Heinemann. Amihud, Y. (2002). Illiquidity and stock returns: cross-section and time-series effects. Journal of Financial Markets, 5 (1), 31–56. Baker, H. K. (1989). Why Companies Pay No Dividends . Akron Business and Economic Review, 2(2). Baker, ‎K., & Powell, G. (2009). Understanding Financial Management: A Practical Guide. New York: John Wiley & Sons. BBC. (2014, October 16). Google profits slide 5%, missing analyst estimates. Retrieved from http://www.bbc.com/news/business-29651815 Brigham, E. F. (2013). Financial Management: Theory & Practice. Mason, OH: Cengage Learning. Company overview - Google. (2014). Retrieved from https://www.google.com/about/company/ De Long, J. B., Shleifer, A., Summers, L. H., & Waldmann, R. J. (1989). The Size and Incidence of the Losses from Noise Trading. The Journal of Finance , 44 (3), 681–696. Deangelo, H., DeAngelo, L., & Skinner, D. J. (2009). Corporate Payout Policy. Hanover: Now Publishers Inc. . Downes, J., & Goodman, ‎. E. (2003). Finance and Investment Handbook. New York: Barrons Educational Series. Form 10-K (2013): Google Inc. (2014). Mountain View, CA: Google Inc. Google Inc (NASDAQ:GOOG). (2014). Retrieved from https://www.google.com/finance?q=NASDAQ:GOOG&fstype=ii Google Inc Class C. (2014). Retrieved from http://quicktake.morningstar.com/StockNet/bonds.aspx?Symbol=GOOG&Country=usa Google Inc. (GOOG). (2014, December 3). Retrieved from http://finance.yahoo.com/q?s=GOOG Jones, C. P. (2009). Investments: Analysis and Management. New York: John WIley & Sons. Kevin, S. (2006). Security Analysis and Portfolio Management. New Delhi: PHI Learning Pvt. Ltd. McMenamin, J. (2005). Financial Management: An Introduction. New York: Routledge. S&P 500. (2014). Retrieved from https://finance.yahoo.com/q/hp?s=%5EGSPC&a=11&b=3&c=2011&d=11&e=3&f=2014&g=d Sornette, D. (2003). Why Stock Markets Crash: Critical Events in Complex Financial Systems. New Jersey: Princeton University Press. Russolillo, S. (2013, August 19). Google’s IPO, Nine Years Later: Only Nine Stocks Beat It. Retrieved from http://blogs.wsj.com/moneybeat/2013/08/19/googles-ipo-nine-years-later-only-nine-stocks-beat-it/ Treasury securities. (2014). Retrieved from http://www.bankrate.com/rates/interest-rates/treasury.aspx?ec_id=m1022523&s_kwcid=AL!1325!3!41196774128!b!!g!!us%20treasury%20interest%20rate&ef_id=UpOW1gAAACvlDdrQ:20141205122732:s&MSA= Whitman, M. J. (2000). Value Investing: A Balanced Approach. New York: John Wiley & Sons. Veronesi, P. (2010). Fixed Income Securities: Valuation, Risk, and Risk Management. New York: John Wiley & Sons. Appendix: Stock Price Summary Source: (Google Inc. (GOOG), 2014) Source: (Google Inc (NASDAQ:GOOG), 2014) Source: (Google Inc (NASDAQ:GOOG), 2014) Analyst Opinion Read More