Investment Analysis of Two Companies - Case Study Example

Comparison of two companies from FTSE 100 listed on the London Stock Exchange with regard how they are financed and which shares would be better to invest in. Introduction In this paper I would like to elaborate on the investment analysis of two companies, open a space of possibilities in discourse and practices in order to determine which of the two companies to invest in. The paper will commence with a brief overview of the two companies that are being considered. Then, key assumptions and author’s analysis method are presented. The latter part of the paper will explain and critique the financial position of the two companies and also the strategy and structure of the organisation. For this purpose different financial tools will be used. The conclusion will be description and reasons for the company chosen to invest. In this paper I have chosen Prudential and BHP Billiton as two multinationals from FTSE 100 firms. I have chosen these companies because they are very reputable in their industries and I want to use investment analysis to compare and to make an investment decision based on this analysis. Companies Overview Prudential PLC Prudential is an international financial services group providing retail financial products and services including insurance, fund management and banking products. The company primarily operates in the UK. It is headquartered in London, the UK. Prudential is a holding company. Through its subsidiaries, Co. is engaged in the provision of financial services in the U.K., the U.S. and Asia. Co. operates through five brand names: Prudential, M&G, Egg plc, Jackson National Life and Prudential Corporation Asia. Prudential is a life and pensions providers provider in the United Kingdom. The group recorded revenues of £41,125 million during the fiscal year ended December 2005, an increase of 21.3% over 2004. The net profit was £760 million in fiscal year 2005, an increase of 47.3% over 2004. (Prudential, 2006) BHP Billiton BHP Billiton is the world's largest resources group primarily engaged in mineral exploration and production. The group's primary focus areas include carbon steel raw materials, energy coal, nickel, copper concentrate, petroleum and diamonds. It operates globally with more than 100 operating bases in 25 countries. BHP Billiton is a 'dual listed company' comprising BHP Billiton Limited and BHP Billiton Plc. The two entities continue to exist as separate companies, but operate as a combined group known as BHP Billiton. (Billiton, 2006) The global headquarters of the combined BHP Billiton Group are located in Melbourne, Australia. The group employs about 37,000 people. (Billiton, 2006) The group recorded revenues of $32,153 million during the fiscal year ended June 2006, an increase of 20.3% over 2005. The operating profit of the group was $14,671 million during fiscal year 2006, an increase of 58.2% over 2005. The net profit was $10,534 million in fiscal year 2006, an increase of 58.9% over 2005. (Billiton, 2006) Assumptions and Analysis Method In my perspective to do investment analysis on the assumption that the past will not be predictive and the market can over or under value shares as markets are weak in efficiency and in my view I don’t belief in technical analysis because share prices cannot be predictive at least in the short-run and I don’t believe efficient market hypothesis that market will incorporate all information on a timely basis because of asymmetric information and there fore I don’t believe in Efficient market hypothesis. Therefore, I apply fundamental analysis of these companies in determining in comparing capital structure and in the analysis of determining which is a better buy given the specific factors and financial viability and strength of these companies and risk profile to make an investment decision. Methodology of Analysis of Fundamental Analysis The fundamental analysis uses the financial and other information to determine a firms strength in operational and financial terms its risks, return, capital structure, financial strength profitability, recent growth rates, price earning ratio, earnings per share. Performance compared with a similar firm or with the industry and also examine recent trend for at lest 3 years to value its shares whether it is under or over valued so that to make an informed decision based on the above analysis and the assumptions of market behaviour as mentioned above. Financial ratios are indicators of an entity’s performance and financial position. Ratios are calculated from information provided by the financial statements. The ratios can be used to analyze trends and to compare the firm’s financial position to those of other firms and in some cases; ratios can predict a future bankruptcy (Hossari & Rahman, 2005). Comparison of Prudential with BHP Billiton on How They Are Financed One of the main indicators is capital structure analysis ratios or debt to equity ratio. So-called ‘gearing ratios’ are related with the ‘financial structure of the company’ (Tyran, 1992, p. 186). Companies fund their operations by borrowing from other companies and banks as well as by means of investment by their owners. Gearing refers to the ratio of debt and equity in a company’s financial structure. Debt and borrowing affect risk and return. Debt increases financial risk and causes shareholders to demand a higher return on their investment. A corporation, which is highly geared, is a corporation, which has a high ratio of debt relative to its equity. A low-geared business has a low ratio of debt relative to its equity. (Jones, 2004) Table 1. Capital structure of Prudential plc for 2003 – 2006 Period 2003 2004 2005 2006 latest Qtr Debt/Equity 2.40 2.35 0.09 0.09 (Source: http://quicktake.morningstar.com/Stock/FinancialHealth10.asp?Country=USA&Symbol=PUK&stocktab=keyratio) Table 2. The Capital Structure of BHP Billiton Period 2003 2004 2005 2006 Debt/Equity 0.59 0.45 0.57 0.37 Source: (http://moneycentral.msn.com/investor/invsub/results/compare.asp?Page=TenYearSummary&Symbol=BHP) As indicated above the debt to equity ratio differs for the Prudential plc and BHP Billiton. This is because they are different in terms of their Asset structure and in their operations and they are indifferent industry. The gearing ratio different in accordance with the nature of operations and its Asset structure and their risk profiles. In addition one can see from the table above the debt to equity ratio also differs in different periods that reflects different economic, social and political conditions as well as on the management’s view of appropriate debt to equity structure in different periods and there fore reflects in the debt to equity ratio. The proportions clearly illustrate that Prudential plc has a lower gearing than BHP Billiton. The distinction between the companies is due to BHP Billiton receiving a better return on equity and also Prudential plc don’t have any preference shares in issue. ‘The higher the gearing a company has’ (Dyson, 1997, p.326) the higher their return if commerce are going well, but the bigger the risk to shareholders in poor economic environment. As BHP Billiton have a higher gearing it as a result has a higher ratio of debt relative to its equity and in comparison to Prudential plc. Nevertheless, low levels of debt to equity ratios for both companies indicate that financial risk is comparatively low. Furthermore, in these two companies one can see the debt to equity ratio is reduced consistently. That means the Assets and operations are financed by equity rather than debts. If the debt to equity ratio is less than 1 it shows it will face less financial risks in the future to meet. Interest payments and variation in interest payments and less risk of insolvency problems in the future. (Jones, 2004) There fore the two companies financing of its business is consistent with their nature of business and not excessively exposed to financial risks. There fore it can be said the two companies capital structure is fairly sound in recent times than in earlier periods. Fundamental Analysis of Prudential plc and Evaluation Whether its Stocks are Over/Under Valued Comparison of Profitability Rations from 2002 –2006 Another aspect to be looked into while assessing the firm's financial position is the profitability. Every firm operated with an aim to earn profit. For an investor it is very important that the organization earn profit as the more the profit the more the return that the shareholder gets in the form of dividend. The firm also increases its value by earning profit and increasing its customer base. (Jones, 2004) Table 3. Comparison of Profitability rations from 2002 –2006 Ratios 2002 2003 2004 2005 2006 EBT margin (25.1%) 5.6% 4.5% 5.2% 5.2% Net margin (8.64%) 3.92% 0.41% 1.85% 1.85% Return on Assets (0.23%) 0.41% 0.05% 0.40% 0.40% Return on Equity (6.50%) 12.77% 1.62% 13.89% 13.89% (Source: http://quicktake.morningstar.com/Stock/Profitability10.asp?Country=USA&Symbol=PUK&stocktab=keyratio) As indicated above the profitability ratios from 2003 – 2006 is not increasing consistently. And the profitability for this period is volatile. This means the operations are affected severely by the market conditions on a global basis and there is likely it will not fluctuate in the future. It may be exposed to more risks than the industry and one has to be aware of this in buying this stock based on the profitability analysis. Comparison of Valuation Ratios of Prudential plc with Industry Comparing the above valuation ratios one can see some ratios are lower and some ratios are higher. The dividend yield is more it means that compared to industry Prudential has less growth potential because it is paying dividends more than the industry and not using the profits because of its expected growth in the future. The industry price/earning ratio is less than the price/earning ratio of the prudential stock. The same applies to price/book ratio for the prudential stock. Table 4. Comparison of valuation ratios of Prudential plc with Industry Ratios Stock Industry Price/Earnings 22.5 21.5 Price/Book 3.5 2.6 Price/Sales 0.4 1.7 Dividend yield 2.3 1.8 (Source: http://quicktake.morningstar.com/Stock/StockValuation.asp?Country=USA&Symbol=PUK&stocktab=valuatio This means on the basis of price to book value compared to industry it seems the company can add value more than the industry and can be a valuable investment. However the price/earnings ratio must be equal or below the Industry to have a decision to buy the stock. In this instance the Prudential plc may have been over valued because the P/E ratio is more than the Industry P/E ratio. Fundamental Analysis of BHP Billition and Evaluation Whether its Stocks are Over/Under Valued Comparison of Profitability ratios from 2002 – 2006 As per profitability in Table 5 it is obvious BHP Billition has increased its profitability ration consistently from 2003 –2006. This shows it has considerable growth potential and it has increased its margin because of its cost consciousness, which is vital in a competitive resource market globally. Table 5. Comparison of Profitability ratios of BHP Billiton from 2002 – 2006 Ratios 2002 2003 2004 2005 2006 Net Profit Margin % 7.3 9.6 11.6 23.9 30.4 Return on Equity% 9.7 12.6 18.0 36.3 40.4 Return on Assets 4.2 5.5 8.7 15.3 20.2 (Source: http://moneycentral.msn.com/investor/invsub/results/compare.asp?Page=TenYearSummary&Symbol=BHP) As well it shows that it has used its assets efficiently and it has earned return on investment over this period and has grown. Shows this efficiency its use of assets to generate adequate return for the risk it takes. On the profitability BHP Billiton is a far more attractive investment opportunity compared to Prudential plc as Prudential has not improved profitability consistently compared to BHP. Comparison of valuation ratios Of BHP Billiton with Industry As indicated in the table 6 except price/cash flow ratio and price/ sales ratio all other valuation ratios are higher. In these ratios the P/E ratio is the most important because it measures the price of stock in relation to earnings. As BHP Billiton stock P/E ratio is more than the industry P/E ratio this indicates that the BHP Billiton stocks are over valued. Table 6. Comparison of valuation ratios Of BHP Billiton with Industry Ratios Stock Industry Current P/E ratio 11.6 8.7 P/E Ratio 5-year High 76.3 65.8 P/E Ratio 5-year Low 22.8 17.8 Price/Sales ratio 3.72 19.42 Price/Book value 4.94 2.96 Price/Cash flow Ratio 9.40 13.30 (Source: http://moneycentral.msn.com/investor/invsub/results/compare.asp?Page=PriceRatios&Symbol=BHP) Compared to prudential the over valuation of the BHP stock is substantial. That is compared to its productive capacity the price is excessive than the Prudential even though Prudential also has a P/E ratio more than the Industry but approximately equal. As well Prudential compared to BHP has less risk in its market than BHP. However Prudential has some growth problems compared to BHP and it use of assets and profitability as mentioned above. Taking the overall fundamental analysis of quantifiable information and non-quantifiable information one has to be cautious to invest in either the company. Overall Fundamental Analysis of Prudential plc and BHP Billiton As discussed above the two companies have considerable market risk as per the Annual report of Prudential in 2006 and the Annual report of BHP Billiton. How ever they have diversified operation globally to manage their risks. However they cannot escape from market risks. In terms of growth and use of resources BHP is a better company than Prudential. However based on capital structure as discussed above they in par. In terms of profitability also BHP is a better company to consider than prudential plc. However when one analyse the valuation and determine whether they are priced lower than its actual productiveness to create future cash flow is not certain as the P/E ratio is more than the Industry ratio for the two companies. This may indicate that the share price is over valued than its actual value based on its productive capacity to deliver return more than adequate to the risk taken by the two companies. (Jones, 2004) Given this dilemma of contradictory financial and other information it is not prudent to buy at this moment to buy either of the stocks. However given the P/E ratios of the two companies prudential plc is much closer to Industry P/E ratio than BHP Billiton I would like to mention that Prudential's financial position up to year 2006 was still safe; however the reduced profitability of the company in the years after and its weakness to 'turn over' its stock may result to a great reduction of the company's current asset base. Lack of cash inflow from operating activities due to low profit, will make Prudential plc seek for external funds like short term and long-term debt, in order to support its operations and therefore it will increase the current and total liabilities of its balance sheet. Hence causing significant problems for the firm to meet its maturing obligations in the near future. In the case of BHP Billiton the sales have been more or less consistent over the last 5 years thus increasing the cash inflow they were also able to maintain their profit over the years. As discussed above Prudential plc and BHP Billiton have a fairly sound capital structure, which reflects their nature of the business and their risk profile as well they are flexible. In adjusting their capital structure depending on the economic conditions and changes in the risk in a given period. However as discussed above based on fundamental analysis it seems the two stocks are over valued. However the BHP Billiton is over valued more than Prudential plc. But comparing efficiency and growth BHP is far better than Prudential plc. Conclusion Looking into all the details above it is thus seen that BHP Billiton is a better investing choice as compared to Prudential plc. The main reason why BHP Billiton is better is because it has been consistent. Prudential plc has been having rise and falls over a period of time. BHP Billiton is performing better than Prudential plc. Prudential plc in comparison to BHP Billiton takes the advantage of low rent, cheap products, but still had a fall in the profit, is more vulnerable to changing economic trend (high gearing) high fluctuating sales figures. Not to forget the broker sentiments attached to the firms. Therefore based on fundamental analysis either stocks is currently not attractive to buy. However it is better to wait for some time for the market to correct over valuation and invest in BHP Billiton is than Prudential as BHP is more profitable and it has growth potential than Prudential as per the analysis done above. Thus I would like to conclude by stating that it is better to invest in a stable firm like BHP Billiton than a firm that has a fluctuating trend like Prudential plc. References Dyson, T.R. (2003) Accounting for Non-Accounting students, London: Pitman Hossari, G. & Rahman, S. (2005) A Comprehensive Formal Ranking of the Popularity of Financial Ratios in Multivariate Modeling of Corporate Collapse. Journal of American Academy, 6(1), 321-328. Jones, Charles P. (2004) Investments: Analysis and Management, 9th edition, John Wiley & Sons, Inc. Tyran, M. (1992) Business & Financial Ratios, Woodhead Faulkner. BHP Billiton Annual Report. (2006) BHP Billiton web site. Retrieved on 20 Nov 2006 from: http://www.bhpbilliton.com/bbContentRepository/20061012146404/bhpbreview2006.pdf MSN Money (2006) BHP Billiton Limited (ADR): Key Ratios, MSN Money web site/ Retrieved on 20 Nov 2006 from: http://moneycentral.msn.com/investor/invsub/results/compare.asp?Page=PriceRatios&Symbol=BHP Thomson Education Direct. (2006) Prudential plc ADR PUK, Morningstar web site. Retrieved on 20 Nov 2006 from: http://quicktake.morningstar.com/Stock/FinancialHealth10.asp?Country=USA&Symbol=PUK&stocktab=keyratio Prudential PLC, Interim Report (2006) Prudential plc web site. Retrieved on 20 Nov 2006, from: http//www.prudential.co.uk/prudential-plc/investors/financialreports/2006/int2006.pdf Read More