Adjusted Month-End Closing Stock Prices - Case Study Example

FINANCE ASSIGNMENT PART 2 by: Presented to: Course/ Class: University: City and state: Due date: Adjusted month-end closing stock Prices The three companies that were chosen for purposes of completing the first part of the assignment are the Virgin Australia Holdings Limited, the BHP Billiton Limited, and the Australia and New Zealand Bank limited. The identified public companies are currently listed on the ASX that have been trading for the past five years. The adjusted month-end closing stock prices of the companies for the past 61 months ending 31st December 2013 were obtained from DatAnalysis to aid in computing various financial variables indicated in subsequent sections (Morningstar, 2014). a) The individual monthly returns was obtained by finding the percentage change in adjusted month-end closing stock prices for the respective companies over the past 61 months ending 31st December 2013. The average monthly returns for each of the three companies were calculated by finding the mean using excel functions. To measure the spread of returns from the mean, variance was evaluated. The resulting value of variance was deployed in calculation of standard deviation. Satchell (2011) asserts that standard deviation gives the dispersion of a set of returns from the mean. Individual returns, average monthly returns, variance, and standard deviation for three companies attached in excel file. b) The attached excel calculations clearly shows that the stock with the highest expected return is Virgin Australia Holdings Limited with expected return of 1.81% compared with -3.57% of BHP Billiton Limited and -14.90% of Australia and New Zealand Bank Limited. Stock with the highest highest total risk is Virgin Australia with a standard deviation of 0.1528 compared with 0.0578 of BHP Billiton Limited and 0.0678 of Australia and New Zealand Bank Limited. Standard deviation was used as a measure of risk because it measures the spread of distribution about the mean consequently giving the variability (Cheng-Few and John, 2010). A decreasing standard deviation implies that most returns fall within a narrow band. This fact contributed to the conclusion that Virgin Australia Limited is a stock with the highest total risk. A stock that has the highest expected return per unit of total risk is Virgin Australia Holdings Ltd with a value of 1.81% compared with -3.57% of BHP Billiton Limited and -14.90% of Australia and New Zealand Bank. These values were obtained by dividing the expected return by total risk as shown in appendix 1. c) The stock with the highest total risk does not necessarily mean that it is the riskiest of the stocks. The reason lies with the deficiencies of using standard deviation as a measure of risk. The standard deviation is not a relative measure hence lacks a benchmark. Concisely, standard deviation measures variability and when applied to investment returns, standard deviation quantifies volatility of the returns. The measure just gives numbers and do not have a benchmark such as the market. Adjusted month-end closing value of AORD The adjusted month-end closing value of ASX All Ordinaries Index for the past 61 months ending 31 December 2013 was obtained from Yahoo Finance (Yahoo Finance, 2014). However, the process began by obtaining data readings as per Yahoo Finance then comparing the data for the ending days with the ones captured by DatAnalysis. This was intended to give accurate estimate of beta for the period under review. d) Individual monthly returns on the market index The calculations is shown in attached excel file. However, a summary of descriptive statistics is shown in appendix 2. e) Beta estimation process as per the CAPM uses the ordinary least squares estimator. According to Jones (2009), the market model that is used in estimating beta is expressed as follows: In order to develop an estimate of the identified market model, the process entails regressing for stock on the corresponding for the market index. The output of the regression is the constant return on a security and the expected increase in a security’s return for a 1% change in market return . A regression line fitted into the data points represents security characteristic line. Damodaran (2010) asserts that the slope gives beta of the stock, hence, is a measure of riskiness of the stock. On the other hand, the intercept measures performance of stock compared with CAPM expectations. Beta for Virgin Australia Company limited, BHP Billiton ltd, and Australia and New Zealand limited was calculated using regression analysis. The output of the regression is shown in the attached excel file. The slope of the regression line attached in appendix 3 gives beta of the stock. The corresponding beta for the companies being analysed is tabulated in a summary table below: Company Beta Virgin Australia 1.7256 BHP Billiton Limited 0.7005 ANZ Limited 1.1194 A beta of 1.7256 shows that Virgin stock is 72.56% more volatile compared with the market. A beta of 0.7005 indicates that BHP Billiton ltd is 29.95% less volatile compared with the market. Finally, s beta of 1.1194 shows that ANZ bank is 11.94 % more volatile compared with the market. Assuming a 4% p.a risk free rate, the expected return on each of the three stocks is as follows: Expected return on Virgin Australia Expected return on BHP Billiton ltd Expected return of ANZ bank f) Impact of changing risk free rate on expected returns. Expected return on Virgin Australia Expected return on BHP Billiton ltd Expected return of ANZ bank Expected return on Virgin Australia Expected return on BHP Billiton ltd Expected return of ANZ bank It is apparent from calculations made above that returns for BHP Billiton declined when risk free rate was reduced from 6.5% to 2.5 %. Alternative share valuation methods that do not use CAPM The first alternative share valuation method is the Discounted Cash Flow approach otherwise called the Dividend-Yield-Plus Growth-Rate model. According to Ehrhardt and Brigham (2008), investors anticipate a dividend yield of plus a capital gain of . This is represented by the following model: . The model requires the estimation of current stock price, the current dividend, and the expected return. In the case of growth rate, estimation can be done using historical growth rate, the retention growth model, or the analyst’s forecasts. The Discounted Cash Flow approach is often applied in companies that face a constant growth of dividends. It might not apply to fast paced companies. The second approach is the Bond-Yield-Plus-Risk-Premium approach. It is a simple, ad hoc way of developing cost of retained earnings (Besley and Bringham, 2011). The approach is subjective and requires analysts to add a judged risk of 3 to 5 percent points above the base rate to interest rate on long-term debt of a firm. In this case, . An example is a company whose long-term debt is 7% and risk premium is 4%. The cost of retained earnings for the company using the bond-yield-plus-premium approach is given by Strengths and Weakness of the alternative against CAPM All the three methods of valuation gives divergent results hence have their own advantages and disadvantages. It is therefore critical to identify the strengths and weakness of each model then make a conclusion based on findings. Starting with the discounted Cash Flow, the first strength is that it is easy to understand and use. Secondly, Discounted Cash Flow gives an output that is close to intrinsic stock value. Thirdly, DCF relies on free cash flows, which tracks down money left by investors. The model can also be used to track the company’s history and if the current price of a share were, correct. Conversely, DCF cannot give an accurate result if the inputs in the model are wrong. Secondly, the model might give the wrong results when it is not possible to estimate future cash flows with certainty. Moreover, DCF is sensitive to perpetuity growth rates and discount rate. This implies that a 1% increase in g leads to a 1% increase in cost of equity. Besides its sensitivity to stock price volatility, DCF does not take into account risk. Finally, DCF is not favourable for a company that is growing fast. In the case of Bond-Yield-Plus-Risk-Premium approach, analyst’s subjective view is applied. This means that valuation is fast. The method however is weak in the sense that it is subject to bias. Kent and Powell (2009) are convinced that Bond-Yield-Plus-Risk-Premium approach is useful for companies that are not publicly traded. The model therefore is a restriction on usage. CAPM is advantages over other models because it takes into account systematic risk, a great concern to investors. Secondly, the model gives a theoretical relationship between required return and systematic risk, which has been tested over the years. The third advantage is that it is viewed as a favourable approach by investors because it takes care of systematic risk faced by a company. Finally, the method supersedes WACC in developing discount rate for appraising an investment. One of the disadvantages of CAPM is that it relies on a number of assumptions. These assumptions can be accurate in theory but lacks application in real-life situations where variables keep changing. The expected market risk premium for example varies over time. Furthermore, the model predicts the future using the past. This is not reliable because events keep changing. In conclusion, the choice of a valuation model varies with appropriateness of the model and the strength of model inputs. The discussion above has demonstrated that none of the three models gives accurate results. Kent and Powell (2009, p. 356) confirms that CAPM is often used by large firms despite its shortcomings. The scholars additionally note that DCF is a supplement to CAPM in a firm with a stable dividend growth rate. Given that Bond-Yield-Plus-Risk-Premium approach gives a general estimate of cost of current equity, it fits well with a privately owned company. Concisely, when valuation estimates differ by large values, analysts may require conducting further investigation. Otherwise an average of the output from the different valuation methods is applied (Graham and Harvey, 2002). In summary it is the role of an analyst to exercise good judgment during valuation process and not to rely on a single model. Reference List Besley, S, and Bringham, E 2011, Principles of Finance, Mason, Ohio, Thomson Cengage Learning. Cheng-Few, L, and John, L 2010, Handbook of Quantitative Finance and Risk Management, New York, Springer. Damodaran, A 2010, Applied Corporate Finance, Hoboken, NJ, John Wiley & Sons. Ehrhardt, M, and Brigham, E 2008, Corporate Finance: A Focused Approach, Mason, Ohio, Cengage Learning. Graham, J, and Harvey, C 2002, ‘How Do CFOs Make Capital Budgeting and Capital Structure Decisions?’, Journal of Applied Corporate Finance, vol 15, no 1, p 8-23. Jones, C, P 2009, Investments: Analysis and Management, Hoboken, NJ, John Wiley & Sons. Kent, B, and Powell, G 2009, Understanding Financial Management: A Practical Guide, Hoboken, John Wiley & Sons. Morningstar 2014, DatAnalysis Premium, viewed 22 April 2014, Satchell, S 2011, Forecasting Expected Returns in the Financial Markets, New York, Academic Press. Yahoo Finance 2014, All Ordinaries, . Appendices Appendix 1: Expected return per unit of total risk Appendix 2: Mean, Variance, Standard deviation of AORDS Appendix 3: Regression line fit graphs Read More