Principles of Financial Markets - BHP Billiton Corporation - Case Study Example

Running Head: Principles of Financial Markets Principles of Financial Markets Name Tutor Institution Course Date Principles of Financial Markets Risk profile, research approach, selection criteria and investment strategy Before one decides to make an investment portfolio, he should take into consideration several factors. To begin with, he should consider the riskiness of the assets in the portfolio. Risk is directly related to the expected return. According to the capital asset pricing model (CAPM), a rational investor definitely invests in the portfolio that comprises high returns as much as it is risky, (Philips, 2004). To expand on these, there are two types of risks, the diversifiable and non-diversifiable risk. The diversifiable risk is the one that has been minimized as a result of investing in so many small assets in a portfolio regardless of the small returns. On the other hand, the non-diversifiable risk is the risk that cannot be diversified and the investor will only consider a portfolio that is risky but gives high returns. Capital asset pricing model only deals with the non-diversifiable risk commonly known as the market risk. The risk is measured by using beta. There are several assumptions associated with the capital asset pricing model which are highly criticized. First it assumes that the markets are perfect but in the real world this is not true. This is because the stock market securities are wrongly priced. Another assumption of capital asset pricing model (CAPM) is that investors have diversified their investment but in the real practice investors are afraid of doing so because they would rather invest in one company that will give a higher rate of return as compared to many which will give fewer returns. The fact that investors can not borrow at risk free rate because the risk associated with individual borrowing is much higher than that associated with the government, means that in real life getting the funds will be much more demanding and thus getting more risky. For our analysis purposes in considering how to invest the $15,000 we are therefore going to assess the returns and riskiness of the companies to be chosen. Also an assessment on the Australian stock exchange indices will be used. For investment purpose we will invest in BHP Billiton and Rio Tinto companies. Company information a) BHP Billiton Corporation BHP Billiton is a global company operating in over 25 countries but it is headquartered in Melbourne, Australia. The company has a diversified range of products stretching from mining, metal operations, minerals, gas, oil and steel. BHP Billiton resulted from a merger of two companies which are BHP and Billiton in the year 2001. The company has several takeovers. In the year 2005, it took over WMC Resources a company dealing with gold, copper, Uranium, nickel and fertilizer. Another take over bid was placed in 2007 on Rio Tinto a competitor though it was not accepted as the global financial recession had already started (Financial times, 2008). The offer was 3.34 shares of BHP Billiton stock for every share in Rio Tinto. In the year 2010, 1st January the company bought Athabasca Potash for a price of $320 million. Again in august 2010, BHP Billiton made a hostile take over on a potash corporation of Saskatchewan worth $40 billion. This bid was seen as undervaluing the other company therefore it was rejected. This particular bid also reflects BHP Billiton’s strategic move to expand its business through diversification. The reason why we chose to invest in this company is because its revenue has increased by 25% from the year 2007. The dividends have also increased significantly by 150% over the last three year. Its profits have also set a record over the last seven consecutive years. For the year ended 30th June 2010, the shareholders attributable profit was up by 16%, the earnings per share being $224 cents and a strong gearing ratio of 6%. What makes this company successful is its outstanding balance sheet, good managements of costs and its well diversified portfolio. Therefore, investing in such a company would be prudent as the growth is justified. There are other non-financial matters that are taken into consideration by the company in order to ensure its success. For instance, BHP Billiton has in place the customer sector groups which are designed to support and deal with customers so as to ensure customer satisfaction (Financial times, 2008). This is because for every company to be successful, customer satisfaction should be part of the main organizational goals. Here, customer satisfaction means meeting the expectations of the customers needs and it is used as a marketing strategy by almost all companies. The other non-financial aspect is that the company places its interest highly on attainable and sustainable development in order to ensure improved performance. The share performance in the stock exchange is also tremendous as the stocks are highly trade. According to the latest Google news the share rose 0.8% to two months high of 41.33. Currently, the company has shares totaling 3,358,310, a market capitalization of 216,140,200, a return on equity of 28.75, dividend yield of3.29 and a relative dividend yield of 0.83. The beta of BHP Billiton is 1.4 which is a true reflection that the risk is very high. Normally, the market risk is assumed to be one according to the capital asset pricing model (CAPM). The price earnings ratio is 17.84 and the relative price earnings ratio is 0.9. The yearly expected rate of return is 12.2%. b) Rio Tinto Group Rio Tinto is a leading international business specializing in minerals and metals. It is headquartered in Melbourne Australia. In the year 2008, it did set a record for iron ore, alumina and bauxite. It also had a net capital expenditure of $8.5 billion which increased by 71% over 2007. Since 2007, the company has achieved a significant growth that has been reflected by the earnings before interest, taxes, depreciation and amortization. For instance in the year 2008, the earnings were 75 per cent higher than those of 2007 (Financial times, 2008). The table below represents the group’s revenues and earnings which have substantially grown between years 2003 and 2009. Reason for such growth is because of the acquisition it made to a company named to as Alcan. What impacts the operating margin most is the market prices of the various commodities produced by Rio Tinto group.       Earnings Data           2003 2004 2005 2006 2007 2008 2009 Gross ales revenue 9,228 14,530 20,742 25,440 33,518 58,065 44,036 underlying profit before tax 1,968 3,017 7,094 9,719 9,947 15,977 7,860 underlying net earnings 1,382 2,272 4,955 7,338 7,443 10,303 6,298 cash flow from operations 3,486 4,452 8,257 10,923 12,569 20,668 13,834 operating margin 19% 24% 37% 42% 34% 32% 17% Because of the acquisition made of Alcan by Rio Tinto group, the company’s balance sheet has been adversely affected (Financial times, 2008). The company took a debt so as to finance the acquisition. There are upcoming maturities of $9 billion for 2009 and $10.5 billion by year ending 2010 which are driven the group to seek additional cash through sale of assets and equity floatation. BHP Billiton wanted to take over the group but it rejected as it saw the purchase as a way of being undervalued. The table below shows a summary of the balance sheet.   Summary Balance sheet             2003 2004 2005 2006 2007 2008 Fixed Assets 19,418 20,131 20,848 25,803 75,888 67,651 Net current assets 1,804 2,356 2,587 3,026 11,609 8,469 net debt 5,646 3,809 1,313 2,437 45,191 38,672 other liabilities 5,539 6,801 7,174 8,160 17,534 16,810 shareholders equity 10,037 11,877 14,948 18,232 24,772 20,638 The total shareholders returns on investments in Rio Tinto stocks have grown and outperformed the industry’s benchmark the global mining index by 2% per year since 1990 (Financial times, 2008). On the other hand, the annual dividends have increased from $0.6 per share in the year 2002 to $1.36 per share in 2008. The current amount on dividend for 2010 is US $45c per share. Rio Tinto is a dual listed company trading both the Australian stock exchange and the London stock exchange. On 31st march 2009, Rio Tinto was announced to be the fourth largest publicly trading company by a market capitalization of approximately $34 billion. Its shares are highly traded in the stock exchange and according to Google news on the ASX website the shares of Rio Tinto rose 1.1% to $80.39 being the highest growth since mid April. Let’s take a look at the current financial ratios of Rio Tinto group. The price earnings ratio is 15.2 while the relative P/E ratio is 0.9. The return on equity is 15.11, dividend yield is 1.6, relative dividend yield 0.5 and a beta of 1.38. The beta shows that the riskiness of the investments is very high since it is above one. Selected portfolio details The question on how will my portfolio look like comes in. because the market price of shares of the Rio Tinto group are attractive than those of BHP Billiton, I would invest more shares in Rio Tinto.   Portfolio     company closing price no. of shares investment   $   $ Rio Tinto Group 79.55 113 9,000 BHP Billiton 41.00 146 6,000       15,000 The above table illustrates the how the portfolio looks like. It shows the closing market prices, the number of shares and the total amount invested in each company (Financial times, 2008). Because the two companies stocks are highly traded in the stock exchange, the investor expects that the prices would go up so as to get higher returns. As noted earlier, investing in such companies is also risky as a result of the expected high returns. References ‘BHP Billiton makes a Bid for Rio.’ The Age. Retrieved 2nd February 2008. `Mergers in the fertilizer industry.’ The Economist. Retrieved 21st February 2010. BHP Billiton official website, http// www.bhpbilliton.com/ Australian securities exchange website. www.asx.com.au/ BHP Billiton launches hostile bid for potash.’ BBC. 19th august 2010. `BHP won’t be drawn on a Rio sweetener.’ Financial Times. Retrieved 28th November 2008 Rio Tinto completes acquisition of North limited. Business wire. Retrieved 10th November 2008. Rio Tinto global corporate official website, http// www.riotinto.com/ Rio Tinto completes acquisition of 100% of Alcan.’ Rio Tinto. Retrieved 30th January 2008 Joseph Philips, (2004). CAPM: Certified associate in project management. McGraw- Hill/ Osborne. Read More