The Key Aspects of Investment & Performance Management - Essay Example

Investment & Performance Management Name Course Lecturer Date Table of Contents Part 1 3 1.A review of the ‘top-down’ analysis that led to the focus of a particular company. 3 1.1 Economic Analysis 3 1.2 Industry analysis 5 1.3 Firm analysis 6 2.DCF Technique 6 2.1 Discounted Cash Flow (DCF Projected) 7 2.2 Net Current Asset Value 9 3.0 The DCF Analysis 11 3.1 Advantages 11 3.2 Disadvantages 12 Part 2 12 1.Evaluation of the current performance of Microsoft Corp 12 1.1 Using ROCE 12 1.2 Using Return on Investment 14 1.3 Using Economic Value Added 14 1.4 Using Shareholder Value Added 15 2.Critically evaluate: the usefulness of ROCE, EVA and SVA in assessing company performance 17 2.1 Return on Capital Employed 17 2.2 Economic Value Added 18 2.3 Shareholder Value Added 19 References 20 Part 1 1. A review of the ‘top-down’ analysis that led to the focus of a particular company. Top-down investment analysis begins with a broader economic analysis. This focuses the attention on the economy of a particular region. This can include business cycle, government policy, indicators, trade, public attitudes, legislation, inflation and GDP growth. The analysis then moves to industry analysis, which focuses on the industry within which a certain company operates. Analysis of the industry may include the industry structure, supply-demand relationships, quality and cost elements, government regulation, financial norms and standards, etc. Finally, this process moves to the analysis of the individual company. The attention in this area is focused on the forecasts of the firm, the balance sheet analysis, income statement analysis, flow-of-funds analysis, accounting policy and footnotes, management, research, return and risk analysis. The baseline of the top-down analysis is that the effect of each sector of the analysis will have varied impact on the individual firm, that is, the happenings in the overall economy will have a heavier impact on the firm than what happens in the industry within which the firm operates. For an individual who owns several companies in his diversified portfolio, it does not mean each individual company is a top performing company. Thus the success of the companies will depend on the industry diversification and the overall economic approach. 1.1 Economic Analysis There is need to develop an economic analysis outlook: Fiscal and monetary policy: involves what goes on with the government fiscal programs. This is related to government spending, interest rates, taxing policy, monetary policy e.g. in 2011, the U.S federal reserve went out buying a lot of bonds in order to help keep interest rates down and put money into the economy. GDP growth: most of the developed countries’ economies are growing at relatively lower rate. This can affect the overall market i.e. a rapidly growing economy will mean much more profits than slowly growing economy. Employment: the more people are employed; there is more purchasing power which can increase sales for corporations. On the other hand, when employment is too strong, this can hurt companies’ bottom line due to very high labor cost. This may end up affecting the economy negatively. Inflation: an increase in inflation may increase the production cost and this will lead to the manufacturers passing the cost to the final consumer. This may in turn lead to higher interest rates. Leading economic indicators: these may include productivity, consumer sentiments, productivity which helps in get in economic outlook. The state of the economy in the near future can also factor in the analysis. Stronger economic outlook may lead to an increase in the value of stock. There is also need to determine the Baseline Required Returns: This is the need to be aware of risk free rate as well as the market risk premium. Higher economic outlook is likely to translate to a higher risk premium while a lower economic outlook translates to a lower risk premium. Economic analysis can also be used to determine Asset Allocation: This is used to determine the equity exposure. If the economy is going to get stronger than the market consensus, then there may be need to increase exposure to stock. If the economy may turn out to be weaker than market consensus, then exposure to stock is reduced due to the risk involved. Economic Analysis can as well be used to identify the industries likely to do better or worse under the economic outlook: This is the situation where the investor will determine the industries which may do well in harsh economic situations. The investor will most likely transfer the investment into an industry which can still generate profit even when the economy is not performing well. 1.2 Industry analysis Can be looked at in the following aspects: Industry life cycle: whether in the development stage, growth stage, maturity stage or decline stage. Competitive structure: the more competitive an industry is, the less profitable it becomes, and hence the less valuable the industry is. Supply and demand conditions: in some industries, the supply of the commodities may not be able to keep up with the demand. This leads to a steady increase in the prices of that particular product. Legal and regulatory issues: the more the regulatory issues, the less profit a company will be able to generate. 1.3 Firm analysis Forecast earnings and cash flows-involve checking how many products the company has introduced into the market, how fast the products are moving and how much the company can make from sale of the product. Risk factors: this means how well a company can handle competition and remain relevant in the industry. Financial structure: whether there is enough debt or if the debt is too much and how effectively the company can handle the debt. Management and strategic issues: how good the management is and how relevant the strategies of the company are. 2. DCF Technique Fully explained/justified calculation of the current intrinsic value of the company-established using one DCF technique and one relative valuation technique(all figures employed including growth projections to be explained/justified and performance comparisons within industries and/or between countries explained. 2.1 Discounted Cash Flow (DCF Projected) Since the intrinsic value based on Discounted Cash Flow Intrinsic Value (DCF), cannot be applied to companies without consistent revenue, then a valuation model based on normalized Discounted Cash Flow and Book Value of the company is used. This method smooth out the free cash flow over the past 6-7 years, multiplies the result by a growth multiple, and adds a portion of total equity. Value=((Growth multiplier)*Free cash flow(6 year average) +0.8*Total Equity (most recent))/Shares Outstanding There are situations where negative equity is involved. This prompts the use of the formula below: Value=((Growth Multiplier)*Free Cash Flow (6 year average) +Total equity (Most Recent)/0.8)/Shares Outstanding To-date, Microsoft Corp’s DCF intrinsic value is $40.94, the stock price is $39.64, and therefore, Microsoft Corp’s price to intrinsic value ratio of today is 1.0 For the previous 13 years, the highest Price to Intrinsic Value (DCF projected) of Microsoft Corp was 5.29. The lowest was 0.64, and the median was 1.20. Calculation Microsoft Corp Quarterly Data 201112 201203 201206 201209 201212 201303 201306 201309 201312 201403 Total_freecashflow 5,364 8,845 7,055 7,881 3,850 8,736 4,109 6,974 2,681 8,907 200906 200909 200912 201003 201006 201009 201012 201003 201106 201109 Total_freecashflow 2,974 5,672 4,593 6,985 4,846 7,630 3,695 8,014 5,300 8,057 200806 200809 200812 200903 Total_freecashflow 2,867 2,592 4,940 5,412 Adding all the Free Cash Flow together and divide 6 will get Microsoft Corp’s FCF(6 year average)=$22,996.50 The projected Intrinsic Value of Microsoft Corp today is calculated as: Intrinsic Value = (Growth Multiple*Free Cash Flow (6 years average) + Total Equity (March 14) * 0.8 /Shares Outstanding = (11.8545928257 * 22996.5 + 87242 * 0.8 / 8367.000 = 40.94 *All numbers are in millions except for per sale data and ratio. All numbers are in their currency. Explanation The growth multiple is capped between 8.35 and 17.74. Total equity weighting is more art than science and it should always be revisited in more detail when researching a company. Weightings from 0%-100% to more than 100% are possible. 80% was chosen as a happy medium after taking the above ideas into consideration. Microsoft Corp’s Price to DCF Projected Intrinsic Value Ratio for today is calculated as: Price to DCF Projected IntrinsicValue = Share Price / DCF Projected Intrinsic Value = 39.64 / 40.9409996313 =0.97 *All numbers are in millions except for per share data ratio. All numbers are in their currency. 2.2 Net Current Asset Value In calculating the Net Current Asset Value (NCAV), Benjamin Graham assumed that a company’s accounts receivable is only 75% its value, its inventory is only worth 50% of its value, but its liabilities have to be paid in full. This is a conservative way of estimating the company’s value. Microsoft Corp’s net current asset value per share for the quarter that ended in Mar. 2014 was $3.73. The Net current Asset Value (NCAV) per share of Microsoft Corp for the year that ended in Jun. 2013 is calculated as: Net Current Asset Value; = (Cash and Cash Equivalents – Total Liabilities + 0.75 * Account Receivable + 0.5 * Inventory) / Shares Outstanding = (77022 – 63487 + 0.75 * 17486 + 0.5 * 1938) / 8328.00 = 3.32 Microsoft Corp’s Net Current Asset Value (NCAV) per share for the quarter that ended in Mar. 2014 is calculated as: Net Current Asset Value = (Cash and Equivalents – Total Liabilities + 0.75 * Account Receivable + 0.5 * Inventory) / Shares Outstanding = (88425 – 68695 + 0.75 * 13497 + 0.5 * 1920) / 8260.00 = 3.73 *All numbers are in millions except for per share data and ratio. All numbers are in their own currency. Explanation One research covering the years 1970 through 1983 showed that portfolios picked at the beginning of each year, and held one for year, returned 29.4%, on average, over 13 year period, compared to 11.5% for the S$P 500 Index. Other studies of Graham’s strategy produced similar results. As the methods employed in (ii) above are likely to result in different valuations, you are required to provide an academic justification of valuation method(s) you will rely upon As defined earlier, intrinsic value of a company is the value of the cash that can be taken out of a business during its remaining life (Warren Buffet, 2012). Considering Microsoft Corp’s performance for the last 10 years, we can rely on the book value, earnings per share and the dividend paid to calculate and find the intrinsic value per share. Justification of the method to use can be examined by determining the strengths and weaknesses of each of the above methods. 3.0 The DCF Analysis 3.1 Advantages This method produces the closest value to an intrinsic stock value. The alternatives to this method are relative valuation measures which use multiples to compare stocks within a sector. Whereas relative valuation metrics like price-earnings (PE), EV/EBITDA and price-to-sales ratios are relatively simple to calculate, they are of little or no use if an entire sector is over or undervalued. A DCF which is carefully designed, however, should help investors to avoid companies that look inexpensive against expensive peers. DCF relies on Free Cash Flows, unlike standard valuation tools like PE ratio. Generally, Free Cash Flow is trustworthy measure that cuts through much of the arbitrariness and estimates involved in reported earnings. Regardless of whether a cash outlay is counted as an expense or turned into an asset on the balance sheet, free cash flow tracks the money left over for investors. DCF model can also be applied for confirmation purposes. Rather than trying to come up with fair value of stock price, the company’s current stock price can simply be substituted into the DCF model, and by working backwards, the rate at which the company needs to grow its cash flows to achieve the stock price can be calculated. DCF analysis can help investors identify where the company’s value is coming from and whether or not its current share price is justified. 3.2 Disadvantages DCF valuations can fluctuate widely. If the inputs are far from accurate, then the fair value generated will be very inaccurate and won’t be useful when assessing stock prices. DCF may pose a problem if the future of a company is highly uncertain. The investor’s ability to make forward-looking projections is critical; and that is why this method is susceptible to error. This model is not suited to short-term investing; rather, it focuses on long-term value. DCF may make an investor miss on short term price run ups which may be profitable. Generally, as much as DCF may be with so much uncertainty, it is a rigorous valuation approach that can focus on the right issues. It also helps an investor see the risk and thus separate winning stocks from losers. Thus it comes as an important tool for investors since the most profitable strategies are of the long-term. Part 2 1. Evaluation of the current performance of Microsoft Corp 1.1 Using ROCE Return on Capital Employed is defined as EBIT divided by the total of net fixed assets and net working capital, (Joel. G. The Little Book). Microsoft Corps annualized return on capital for the quarter that ended in March 2014 was 237.00%. During the past 13 years, Microsoft Corp’s highest return on capital was 623.40%. The lowest was 74.37%. And the median was 372.59%. Microsoft Corp’s 3-year average growth rate of return on capital was -4.10%. Microsoft Corp’s annualized return on capital for the fiscal year that ended in Jun. 2013 is calculated as: = (EBIT – Adjusted taxes) / (Book Value of Debt + Book Value of Equity – Cash) = Net Income / (Total Current Assets + Property, Plant and Equipment + Other Current Assets) = 21863 / (101466 + 9991 +5020) =18.77% Microsoft Corp’s annualized return on capital for the quarter ended Mar. 2014 is calculated as: = (EBIT – Adjusted taxes) / (Book Value of Debt + Book Value of Equity – Cash) = Net Income / (Total Current Assets + Property, Plant and Equipment + Other Current Assets) =22640 / (109006 + 11771 + 5164) =17.98% NB: the net income used here is four times the quarterly (Mar. 2014) net income data. *All numbers are in millions except for per share data and ratio. All numbers are in their currency. 1.2 Using Return on Investment Microsoft Corp achieved return on average invested assets of 19.73% in third quarter below company average return on investment. This decreased to previous quarter due to deterioration of net income. Return On Investment (March 31. 2014) III. Quarter (Dec. 31, 2013) II. Quarter (Sep. 30, 2013) I. Quarter (June 30, 2013) IV. Quarter (March 31. 2013) III. Quarter Y / Y Investment Change 19.61 % 23.8 % 19.07 % 18.55 % - Y / Y Net Income Change -6.52 % 2.84 % 17.42 % - 18.54 % Return On Investment (TTM) 19.73 % 21 % 22 % 22.17 % 17.36 % MSFT's Overall Ranking # 23 # 41 # 36 # 38 # 71 Seq. Investment Change 2.02 % 11.21 % 2.58 % 2.78 % 5.58 % Seq. Net Income Change -13.69 % 25.06 % 5.62 % - -5.05 % 1.3 Using Economic Value Added Microsoft Corp first saw $28 per share in 1998 when the company was making a profit of $4.5 billion in profit annually. With the share price remaining the same, the company makes $17 billion. Microsoft was still a growing company in 1998. Today, this has changed and Microsoft Corp’s earnings have thus collapsed. Graph showing Microsoft Corp’s Economic Value Added In the beginning, Microsoft’s EVA was rising rapidly, nearing $5 billion in 2000. That later changed to 3 years of zero EVA. The same scenario is re-occurring now following steep EVA growth from 2004-2011. The dwindling EVA will have a major effect on the company’s earnings multiple and is thus a contributing factor as to why the stock price is trading like its 1998. 1.4 Using Shareholder Value Added The following table reconciles Microsoft Corp’s results reported in accordance with generally accepted accounting principles (GAAP) to non-GAAP financial results for the prior year. Three Months Ended March 31, ($ in millions, except per share amounts) 2013 As Reported (GAAP) Net revenue recognition for Windows Upgrade Offer, Office Deferral, and Video Game Deferral European Commission Fine 2013 As Adjusted (Non-GAAP) 2014 As Reported (GAAP) %Y/Y (GAAP) %Y/Y (Non-GAAP) Revenue $20,489 ($1,658) $18,831 $20,403 (0)% 8% Gross Margin $15,702 ($1,658) $14,044 $14,462 (8)% 3% Operating Income $7,612 ($1,658) $733 $6,687 $6,974 (8)% 4% Diluted EPS $0.72 ($0.16) $0.09 $0.65 $0.68 (6)% 5% This quarter’s results demonstrate the strength of the company as well as the opportunities seen in a mobile-first, cloud-first world. Progress has been made in consumer services like Bing and Office 365 Home. Commercial customers continue to embrace the cloud solutions. Both position the company well for long-term growth. (Satya Nadell, Chief Executive at Microsoft) Devices and consumer revenue grew 12% to $8.30 billion. Products and services continue to deliver differentiated business value to customers, and the company continues to win shares in areas like cloud services, data platform, and infrastructure management (Kevin Turner, Chief Operating Officer, and Microsoft). SQL Server business grew by double digits. 2. Critically evaluate: the usefulness of ROCE, EVA and SVA in assessing company performance 2.1 Return on Capital Employed This can be employed in the investment appraisal of both independent and mutually exclusive projects. A decision is first set in terms of a minimum acceptable level of ROCE, after which the acceptability of an independent project is determined by ROCE at least being equal to the criterion return specified. ROCE uses a concept with which all management is familiar, by evaluating the project on the basis of a percentage rate of return. For instance, being told that a project has a four year payback would not convey the actual attractiveness of the project; but being told that the project has a 35% return on capital would appear more desirable. This method evaluates the project on the basis of its profitability, which many managers believe should be the focus of the appraisal. The performance of managers is usually evaluated by shareholders in terms of the company’s overall return on capital employed. There is therefore seems to be a certain logic in evaluating the specifications of the individual capital investment opportunities on a similar basis. ROCE on the other end ignores the time value of money. 2.2 Economic Value Added The economic value added is a strict utility, which incorporate the traditional definition of capital costs contributed by the shareholders in the income statement. It can also be seen as a set of administrative tool that takes into account the gain that should be in the company to recover its investment. Economic value added shows clearly the relationship between the operating margin and intense use of capital, so that it can be used to identify opportunities for improvement and appropriate investment levels to achieve them. On the other hand, economic value added fails to consider the future prospects of the company, other than requiring a lot of adjustments to financial information company. Furthermore, considering the above, the economic value added requires a tradeoff between accuracy and simplicity of calculation, due to the fact that very complicated adjustments resulted in a lack of credibility in the results. 2.3 Shareholder Value Added Shareholder value analysis is sometimes known as value based management. The underlying principle is that the management of a particular company should first consider the shareholder’s interests and gains before taking any other decision, set short-term or even long-term objectives and decide company’s strategy as well. Due to the fact that company’s value is usually calculated based on the value returned to its shareholders, previously had been criticized for being either short-term measured or only based on past figures. SVA takes a longer-term view and it is calculated by estimating the total net value of the company and dividing the figure by the value of shares. Once the value is calculated, the company can then set targets and objectives for improvements and measure also its management performance. In order to succeed in the implementation of shareholder value analysis, managers need first to understand and calculate the organization’s shareholder value and gain top management commitment. Moreover, managers should identify the key drivers of the organization and set performance targets providing a framework together with responsibility assignment to individual managers, reviewing the financial performance of the business and developing strategic plans. The approach should then be communicated to the staff and they must be trained. The creation of sustained value will require permanent monitoring. That is the main reason for the managers to monitor review progress and refine the targets. This method provides a long term financial view on which to base strategic decisions. Furthermore, it provides a universal approach that is not subject to the particular accounting policies that are adopted. It is therefore internationally applicable and can be used across sectors. It however presents a challenge in the estimation of future cash flows which is a key component of SVA. This can then lead to incorrect and misleading figures forming the basis of strategic decisions. Similarly, development and implementation of the system can be long and complex. References Barbara Maria. 1999 Shareholder Value Demystified University of New South Wales Press Reilly, F. K. & Brown, K. C. 2012 Analysis of Investments and Management of Portfolios (10th Edition) or previous edition South-Western Cengage Learning Reilly, F. K. & Brown, K. C. 2012 Analysis of Investments and Management of Portfolios (10th Edition) or previous edition South-Western Cengage Learning Gilman, L.J. & Joehnk, M.D. 2011 Fundamentals of Investing 10th Edn Addison Wesley Pilbeam, K. 2010 Finance and Financial Markets Macmillan Press Penham, S. H. 2012 Financial Statement Analysis and Security Valuation McGraw Hill Rappaport. 1998 Creating Shareholder Value: a guide for managers and investors New York Free Press Rutterford, J. 1998 Financial Strategy: Adding Stakeholder Value J. Wiley & Sons Saunders, A. & Cornett M.M, 2012 Financial Markets &Institutions McGraw Hill Sharpe, W.F., Alexander, G.J. & Bailey, J.V. 2003 Investments Prentice Hall International Read More