Finance Investment and Performance Analysis - Research Paper Example

Finance investment and performance analysis Table of Contents PART1- a- John Lewis Partnership Plc ranks among the top ten retail stores in UK dealing in general supermarket merchandise like fruits, packed fruit, vegetables and groceries to items ranging from toys to beauty products; electrical to clothing etc. The operating profit margin of the company peaked in 2008 to approximately 5.99 percent but declined thereafter to less than 5 percent in the following year. The financial performance of the business is measured in terms of returns generated by the business on the capital invested. Higher the return higher is its appeal towards the investors. The Return on Capital employed (ROCE) is measured as- = Earnings before Interest and Tax (EBIT) / Capital. The capital comprises of equity share capital & reserves and long term debts of the business. ROCE of John Lewis for the year 2009 is calculated as 10.6 percent. This has steadily moved up over the last three years. For 2007 ROCE was 7.7 percent and it marginally increased to 7.99 percent in 2008. The successive rise in ROCE indicates that the company has managed to use its capital base effectively. By doing this it has managed to create wealth for its shareholders. Economic Value Added (EVA) uses residual income or economic profits to measure the value of the business. As per this method value is generated by adopting strategies whose returns are higher than the cost of capital (Schon, 2007, pp.22). EVA of John Lewis is -£37 million in 2009 which is the lowest in the last three year period. It indicates that the costs incurred on capital outweigh the return generated from the use of the same. Shareholder Value Added or SVA uses discounting techniques to predicted cash flows which are driven by growth in sales, operating margins; and from this the investments made in the year is subtracted (Rappaport, n.d. pp.7). John Lewis has a SVA of £968.25 million, as the Residual value of year 5 including the present value of the net futures cash flows is more than the Residual value in the base year. This indicates improved performance by the company which in turn has raised the value to the shareholders. b- Retail Industry- Carrefour is a leading retailer in Europe with operations spread across 31 countries. The ROCE of the company was 16.4 percent on 2007 and declined to 11.9 percent in the following year due to a fall in the profits. It ranks third amongst its peers Wal-Mart and Tesco in terms of ROCE. EVA of the company was €390 million in 2007 and this fell marginally in the following year to €360.3 million. SVA of the company for 2008 was €15913.05 million. J Sainsbury Plc is a retailer in UK with ROCE of approximately 8.19% and 8.52% for 2008 and 2007 respectively. EVA of the company was -£169.49 million in 2008 and SVA of the company was £1307 million. Sears Holdings the fourth largest retailer in US reported a ROCE of 2.7% in 2008 which is far behind its business competitor Wal-Mart. EVA of the company is also deficit at US$1302 million. SVA of the company is US$2367 million. Wal-Mart is the leading retailer in general merchandise and food items across the globe. The ROCE of the company has remained more or less steady over the last five years. This fell marginally in 2006 to 20.7% despite a rise in the EBIT from $17091 million in 2005 to $18530 million in the following year. In terms of peer performance the company is placed at the top in terms of ROCE as compared to Tesco, Carrefour etc. EVA of the company has also moved up from $5908 million in 2005 to $6151 million in 2006. SVA of the company is $124039 million which is indicative of sound performance in the future. Aviation- Lufthansa is an aviation company with worldwide operations. ROCE declined from 13% in 2007 to 7% in 2008 owing to a fall in the profits. EVA of the company rose from € 2132 million in 2007 to € 1351 million in 2008. SVA of the company is € 2827.64 million. Qantas is an Australian based airline company ranking among the top five airlines in the world. ROCE of the company was 8.47% in 2005; this dropped to 6.46% in the following year and bounced back to 9.85% in the year 2007. The EVA of the airlines is negative at $244.986 million marking an improvement over the previous year’s deficit of $784.4162 million. SVA of the company is $3512.7 million indicating that the company is capable of generating value for its shareholders. Like its Australian counterpart Singapore Airlines has maintained a positive ROCE of 18.65% in the year 2007. EVA of the airlines in 2006 dropped to $839.26 million. SVA of Singapore Airlines is $1173 million indicating that it is capable of generating value for its investors. Automobile Industry- Audi Ag, German car manufacturing company belongs to Volkswagen Group. In the year 2007 the company generated a return of 23.1% on capital employed in the business, an increase of nearly 5% over 18.5% in the previous year. EVA of the company also moved up by 51 percent from € 1200 million in 2006 to €1814 million in 2007. The SVA of the company is also positive at €8567 million indicating value creation for the shareholders. Toyota ranks among the largest automobile manufacturers in the world. ROCE of the company has moved up steadily over the years with the company reporting a return of 5.95% in 2008. EVA of the company has also moved up from 27887 million Yen in 2007 to 45607 million Yen in the following year. Toyota has a SVA of 850922 million Yen. BMW Group is headquartered in Munich and reported a ROCE of 13.19% in 2005 that moved up to 15.02% in 2006. EVA of the company moved up from €1433.94 million in 2005 to €1806.17 million in 2006. SVA of the company is also negative at €23051 million. This implies huge debt burden for the company. The best industry to invest in these times is “retail”. With the markets conditions’ getting back to normalcy this industry is expected to perform strongly in the future. c- The Return on Capital employed (ROCE) helps in evaluating the financial performance of the companies and facilitates inter-company comparison. Higher the ROCE higher is the profitability of the company. This method is simple to interpret where the Earning before Interest and taxes (EBIT) is divided by the capital employed in the business i.e. Total Assets less non-interest bearing liabilities. It helps in assessing how effectively the company is utilizing the capital resources. Compared to ROCE, Economic Value Added (EVA) is a critical measure of evaluating business performance. Under this method the profit is termed as “economic profit” that is obtained by deducting all the costs relating to debt as well as equity capital. As per the financial analyst this profit is termed as “Economic Value Added (EVA)”. The underlying concept of this method is not ascertainment of business profitability but whether this profit is adequate to meet the cost of equity invested in the business and if there is any surplus revenue after meeting the costs of resources employed in the business. Source: (Boehlje, n.d.). A positive EVA indicates that the business is earning a return on capital exceeding the direct costs like interest and opportunity cost relating to capital investment. However a negative EVA indicates that the business is unable to generate adequate returns for covering the costs relating to debt and equity. A falling EVA, even though positive, means that the financial performance of the company is deteriorating with time. A continuation of this trend can make EVA negative and result in undesired performance. A negative EVA means that the business is unable to compensate its capital resources and calls for corrective actions. With regard to this the business can improve its operating profit margins or raise the turnover ratios for generating more revenue without increasing the capital base. The unutilized assets in the business can be disposed off. This will lower the capital charges due to lowered debt and equity investment. The capital investment can be shifted from the current projects to the high yielding projects. Lastly if the business is not heavily leveraged the capital composition can be changed by substituting high cost equity with low cost debt (Boehlje, n.d.). Shareholder Value Analysis (SVA) is an alternative method of measuring value. This method is based on “value drivers” and calculates the value by assembling all the related business variables. Drivers like growth rate in sales, rate of tax, profit margin are used for calculating the firm’s operating cash flow. Incremental investments relating working capital and fixed assets form the investment cost. Free Cash flow is the excess of operating cash flow over investment costs. The present value of the benefit is computed based on the planning period and discounting rate. “Company value” is calculated by adding together the terminal value or residual value and market value relating to temporary investments. From this the external financing is deducted to obtain the shareholder value. By combining data from the Income Statement and Balance Sheet SVA determines surplus returns to the capital holders. By using the concept of WACC SVA looks into the risk aspect and expectations of the shareholders (Department of Treasury and Finance, 1999, pp.3). Of all these techniques ROCE is the simplest one and is commonly used by the investors in assessing investment opportunities. Compared to this the SVA method is based on subjective assumptions. PART 2- a- i. Top-down analysis is a method involving an analysis of the “overall picture” and then breaking it down to smaller components. Like an investor can analyse the macroeconomic trend before narrowing down the analysis to prospective companies. Top-down analysis is based on the idea of selecting a company and then analyse the important factors that can affect the firm. This includes information relating to economic scenario. legislation, demographics and other such factors that play a crucial role in the determination of a company’s growth potential (Thomas & Gup, 2009, pp.1). The economic condition is slowly improving and this will have a positive impact on the performance across various industries. Company profitability, credit access etc are showing positive signs. With most of the companies reporting a rise in their quarterly profits over the corresponding period last year the market conditions are finally showing signs of improvement. The companies across the industries have initiated their investment revamp that they had halted during the recessionary period. This will create new employment opportunities and spur market demand. With the earnings back to normalcy and improved market demand the retail industry looks very promising as the retail market in UK is expected to increase by nearly 15 percent over the coming five years (Prospects, n.d.). The retail market has already improved in countries like Britain. Retail sector in the country showed an impressive performance in December last year with sales growth of December breaching the records of the last seven years (Prosser, 2010). Company Analysis- Wal-Mart is the leading retailer in US with operations spread across various countries. The net profit margin of the company is 3.7 percent which is higher than the industry standards of 3.5 percent (MSN Money-a, 2010). Wal-Mart has generated a positive return for its investors as is evident from the Return on Equity of the company of 21.2 percent which is higher than the industry average of 19.4 percent (MSN Money-b, 2010). In terms of ROCE the company has bypassed its global peers like Tesco and Carrefour making it an attractive investment. EVA of the company is also positive at $6151 million. SVA of the company is $124039 million which is the highest of all the companies analysed in the retail sector. This indicates that the company holds good prospects for its shareholders. The quarterly sales growth of the company is 4.50 percent which is close to the industry average of 5.30 percent. Moreover the annual average dividend of Wal-Mart is 15.95 percent which again is higher than the industry average of 15.79 percent over the same period. The leverage position of the company is also reasonable with a debt-equity ratio of 0.58 (MSN Money-c, 2010). This indicates that the company has balanced its position fairly so as to avail the maximum benefit without exerting a pressure on its financials. Limited use of debt ensures that the credit rating of the company is good which facilitates the easy access of credit on favourable terms. A highly leveraged company is considered to be risky by the rating agencies and therefore it is assigned a low credit rating signifying higher default risk. But the situation is in favour of Wal-Mart as the ideal use of debt will ensure that the company does not face any problems in raising finance for its expansionary programs. This will enable the company to make use of the growth opportunities. Moreover the low costs associated with funding will result in significant surpluses for the investors. Due to all these factors like profitability, leverage, EVA, shareholder wealth maximization and market position Wal-Mart has emerged as the market leader in retail sector. For this reason the company has been chosen for investment. Impact on the risk and return of portfolio- The portfolio comprises of various stocks belonging to varying sectors. However the retail industry is not prominently represented in this portfolio. The inclusion of Wal-Mart in the portfolio will diversify the portfolio further. The beta of all the stocks in the portfolio is less than 1 except in the case of BP Plc. However the beta of Wal-Mart is 0.25 making it a defensive bet (Yahoo Finance, 2010). High beta means high market risk. In the current uncertain times it is better to invest in the defensive stocks. In the event of any unprecedented market movements the value of the portfolio will not be much impacted. Currently, the portfolio consists primarily of British companies and by investing in US based Wal-Mart the portfolio will acquire geographical diversification. This will reduce the country specific risk of the portfolio making it immune from any downward movements in a particular country. Therefore the inclusion of Wal-Mart will lower the portfolio risk. The return prospect from the company’s stock is also good which will improve the returns of the existing portfolio. ii. The calculation of intrinsic value of equity is a part of fundamental analysis. This involves analyzing the economy, industry and company fundamentals to identify the stocks that are mispriced. If the market value of the stock is more than the intrinsic value it indicates that the stock is overpriced. To make a gain out of this the investor can short the stock. Similarly if the market value of the stock is less than the intrinsic value it indicates that the stock is underpriced and to exploit this investor can initiate a long position in the stock. This analysis is based on the fundamentals of the company. Investment experts often use this technique to identify the stocks that are temporarily mispriced. There are two models of equity valuation- Absolute Valuation model and Relative Valuation model. The former model uses the discounting cash flow (DCF) technique for calculating the value of equity. Depending on the cash flows that are discounted there can be Dividend Discount Model (DDM) and Free Cash Flow Approach. DDM is best suited for companies with a track record of dividend but for companies that do not have a dividend record the FCFF approach can be used. Dividend discount model (DDM)- This is the simplest method of valuing equity which discounts the future dividend streams using the required rate of return on equity or Re. For the valuation of Wal-Mart the DDM technique has been used. Wal-Mart reported an Earning per share (EPS) of US$3.77 for the year 2010. In this year the company declared a Dividend per share (DPS) of US$ 1.09. In 2008 the company declared a DPS of US$ 0.88. From this the compounded growth rate in dividend (CAGR) over the last three year is calculated to be 5.49 percent. This is then adjusted with the current dividend to anticipate the dividend in the next year. The dividend forecast (DPS 1) for the next year is US$ 1.14 (MSN Money-e, 2010).     (US$) DPS (2008)   0.88 DPS (2010)   1.09 CAGR   0.05496 DPS 1   1.14991 The risk-free rate of return (Rf) has been taken as 3 percent. Beta of Wal-Mart is 0.25. The required rate of return on equity (Re) is expressed as- Re = Rf + (Rm – Rf)*β Rm is the market rate of return. For calculating the market rate of return we have taken the return generated by S&P 500 in the year 2009. Based on this the market returns or Rm is calculated to be 19.67 percent.     S&P 500 31/12/2009   1115.1 2/1/2009   931.8 Annual Return (Rm)   19.6716 From this the required rate of return on equity is calculated as 7.16 percent. Rm 19.6716 Rf % 3 Beta 0.25 Re 7.1679 For valuing the shares of equity Constant Growth DDM has been used. This is expressed as- Value of equity = DPS1 / (Re – g) DPS1 is the expected dividend in the next year. Re is the required rate of return ‘g’ is the growth rate in dividend From this the value of equity is calculated as- Po = 1.14991 / (0.0716- .0549) = US$69.1046 The current market price of Wal-Mart is US$ 52.58. This is less than the intrinsic value calculated as per DDM model. It indicates that the stock of the company is underpriced. One can make a gain by buying the shares of the company (MSN Money-d, 2010). Relative Valuation approach- This model of valuation is based on the principle that similar assets having identical fundamentals must be priced similarly. In this approach the price earning ratio, price to cash flow ratio, price to sales ratio of the company is compared with the other firms in the industry. The average of these ratios is found by computing an average of the comparable firms. Here the PE ratio of the stock is compared with the other firms in the industry. The industry average PE ratio is multiplied with the EPS of the company to obtain the value of company’s equity. The current PE ratio of Wal-Mart is 14.3 and the average PE ratio of the industry is 15.9. EPS 3.77 Industry PE ratio 15.9 Value(US$) 59.943 As per this approach also the market value of the share is underpriced. Currently the shares of the company are trading at US$52.58 which is less than the value of equity as per this approach signifying that the scrip has not been correctly priced by the market. If an individual enters into a long position in this stock he can make profits. iii. From the above analysis the intrinsic value of the equity of Wal-Mart as per Discounting technique is US$ 69.10 and the same as per Relative valuation approach is US$ 59.94. This shows that the valuation as per DDM is higher as compared to valuation as per Relative valuation approach. In such situations credibility should be given to Dividend discount model that uses the ‘discounting technique’ for valuing the equity of the company. Compared to DDM, Relative Valuation is a simple method of valuing equity but this is not free from limitations. The basic premise of this approach is that the value of a company must be similar to its peers in the industry. This distorts the value obtained as per this model. It may be possible that the PE ratio of the other players in the industry is overvalued. This means that the PE ratio of the industry when multiplied with the EPS of the company will not give a true picture of the company’s valuation. If the intrinsic value of the company is obtained by multiplying the earnings of the company with this overvalued PE ratio the value of the company will get exaggerated without any sound financial backing. For this reason the Relative Valuation approach cannot give a true value of a company’s equity. The Discounting technique like Dividend discount model or DDM is more reliable as this is based on realistic estimates. Here the growth rate of dividend in the future is based on past figures like retention ratio, return on equity, growth rate in dividend etc. This makes it more representative as compared to the Relative Valuation approach that suffers from overvaluation or undervaluation in industry averages. Under the DDM the growth rate is calculated as per the past dividend record of the company over a three to four year period. This rate of growth is then applied to the current dividend amount to obtain the dividend expected next year. The forecasted dividend is then discounted using the return required by the investors to obtain the equity value. As this valuation is based on past data it is considered to be more dependable. Therefore in the valuation of Wal-Mart obtained using the DDM and Relative valuation approach, preference should be given to DDM and not relative valuation approach. Reference Boehlje, M. No Date. Economic Value Added. Strategic Business Planning for Commercial Producers. Available at: http://www.agecon.purdue.edu/extension/sbpcp/resources/creatingvalue.pdf [Accessed on May 6 2010]. Department of Treasury and Finance. 1999. SHAREHOLDER VALUE ADDED. Available at: http://www.tenders.tas.gov.au/domino/dtf/dtf.nsf/LookupFiles/SVAPaper.PDF/$file/SVAPaper.PDF [Accessed on May 6 2010]. MSN Money-a. 2010. Profit Margins. Wal-Mart Stores Inc: Key Ratios. Available at: http://moneycentral.msn.com/investor/invsub/results/compare.asp?Page=ProfitMargins&Symbol=WMT [Accessed on May 6 2010]. MSN Money-b. 2010.Investment Returns. Wal-Mart Stores Inc: Key Ratios. Available at: http://moneycentral.msn.com/investor/invsub/results/compare.asp?Page=InvestmentReturns&Symbol=WMT [Accessed on May 6 2010]. MSN Money-c. 2010. Financial Condition. Wal-Mart Stores Inc: Key Ratios. Available at: http://moneycentral.msn.com/investor/invsub/results/compare.asp?Page=FinancialCondition&Symbol=WMT [Accessed on May 6 2010]. MSN Money-d. 2010. Latest Price.Wal-Mart Stores Inc: Snapshot. Available at: http://moneycentral.msn.com/investor/research/newsnap.asp?Symbol=US%3aWMT [Accessed on May 6 2010]. MSN Money-e. 2010. Income Statement. Wal-Mart Stores Inc: Financial Statement. Available at: http://moneycentral.msn.com/investor/invsub/results/statemnt.aspx?Symbol=WMT [Accessed on May 6 2010]. Prospects. No Date. Retail: Overview. Overview. Available at: http://www.prospects.ac.uk/cms/ShowPage/Home_page/Industry_insights/Retail/overview/p!egiLLL [Accessed on May 6 2010]. Prosser, D. 2010. Retail sector 'dazzles' in London as December sales hit 7-year high. The Independent. Available at: http://www.independent.co.uk/news/business/news/retail-sector-dazzles-in-london-as-december-sales-hit-7year-high-1871114.html [Accessed on May 6 2010]. Rappaport, A. No Date. Ten Ways to Create Shareholder value. Harvard Business Review. Available at: http://analystreports.som.yale.edu/internal/S2008/tenways.pdf [Accessed on May 6, 2010]. Schon, D. 2007. The Relevance of Discounted Cash Flow (DCF) and Economic Value Added (EVA) for the Valuation of Banks. GRIN Verlag. Thomas, R. Gup, E.B. 2009. The Valuation Handbook: Valuation Techniques from Today's Top Practitioners. John Wiley and Sons. Yahoo Finance. 2010. Stock Price History. Key Statistics. Available at: http://finance.yahoo.com/q/ks?s=WMT+Key+Statistics [Accessed on May 6, 2010]. Bibliography Moody’s Investors Service. 2006. Global Retail Industry. Rating Methodology. Available at: http://www.moodys.com.br/brasil/pdf/Global_Retail_Industry.pdf Appendix- Read More