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04Dec

FINC 2011 Corporate Finance

This report is deal with the investment assignment and a important part of corporate finance subject.  It will help you in understand the various investment technique for financial markets.

Introduction

Investment in financial markets is a blend of the risk taking capability and the proportionate reward for the same. A positive stimulus to earn more from a stock is directly responded in form of increased investment in the same. The investment in the risky equity instruments of stock market are accorded by way of the payment of dividend i.e. the part of the organisation’s earning to the shareholder or the owner in the real sense. Thus, the real test always is about investing in a positive and prosperous organization which may ensure a sound and a sustainable return (Brigham and Houston, 2007). The report underneath is an attempt to practically analyze the financial performance of the stock of an organisation listed on Australian stock exchange (ASX) using various popular and scientific techniques of investment and equity analysis by the use of the financial management tools and techniques like Capital assets pricing model (CAPM), Dividend discount model (DDM) etc.

Background of the Chosen Organisation

For the purpose of analysis of the tools and techniques of valuation, has been chosen Ansell Limited, an Australian Stock Exchange (ASX) listed organisation.

Ansell is one of the leading healthcare equipment supplies company in Australia. The organisation has been trading on the Australian Stock Exchange since 22/08/1985 and has a market capitalization of $2,875 million and has a issued share capital base of 152.9 million shares. The company conducts the development, manufacturing and sourcing, distribution and sale of gloves and protective products in the B2B as well as B2C markets. It is renowned for its sexual health and wellness products range all across the globe.

Analysis

For the purpose of framing a specialized learning base of the techniques of stock and organisation’s valuation, the historical data of the Ansell’s stock’s prices for a period of 60 months have been used. The adjusted closing value of the stock prices have been extracted and used for the purpose of the analysis (Appendix 1).

Beta Valuation of Ansell’s Stock

 The valuation of stock is fairly impossible without understanding the integrated risk potent of the stock and the market as well. This has led to development of several valuation measurement tools and techniques amongst which the Capital asset pricing model holds the maximum relevance. The CAPM model values the co-variance of the asset return and the market portfolio (Krause, 2009). The typical measure of the riskiness of asset is beta that is the co-variance between the assets return and the market return. Beta is defined as, the slope of characteristic line, beta denotes the riskiness of stock return to the market return and in order to compute the same any of the following two methods are usually adapted.

  1. Finding slope of market index and the monthly return of the stock. The slope value shall be the beta. Or,
  2. By computing the co- variance of two arrays divided by the variance of the array of index. This is more simplistic and reliable and hence, the Beta of Ansell has been computed wide this method (Higgins, 2008). This can be presented as,

          Beta = COVAR (Stock’s monthly return, Market’s Return) / VAR (Market’s Return)

This needs to be understood that the basic facet of accurate valuation lies in estimating the risk and CAPM model specifies that the systematic risk can be quantified and defined irrespective of risk aversion. Moreover, the separation in actuality is valid only under the two-factor separating distribution. The financial theorems express systematic risk by a co-variance formula between marginal utility and asset’s return. When the utility function is known the co-variance shall define the ideal beta. The ideal beta is assumed to be the most suitable one for signifying the riskiness of the asset. Once known the ideal beta, enables comparison with the other beta estimators (Ittelson, 2008). The market analysts who undertake the task of analysis of stock valuation on an optimum regular basis do valuate Beta.

In the research conducted for investment assignment. The Beta has been derived for Ansell’s stock and it has been found to be,

Beta of the Ansell Limited Stock (B)
Computed Beta over a period of 60 months 0.51
Beta derived by Morningstar 0.18

There appears to be a clear difference between the derived Beta and the Beta computed by research houses like Morningstar. Now the major reasons for these differences are,

Method of Computation – One of the most prominent reasons is due to the difference in the method of calculation of the Beta as discussed above. A difference in method shall fetch difference in Beta derived. It’s worth being mentioned in the said reference that there doesn’t exist and best recommended way of beta computation.

Time– Moreover the Beta computed in the analysis by the Author is different also because of the factor of time, in choosing time period for beta estimation it becomes essential to determine the trade off involved.

Valuation of Expected Returns from Ansell’s Stock using CAPM Model

 Every equity share has a varied level of risk integrated. The risk reward relationship is an important variable in the CAPM model which seeks at ascertaining the cost of equity. The Capital assets pricing model (CAPM) is the most recommended and widely used method of evaluating the expected return from the stock of an organization. The logic of calculating of cost of equity through this methodology is that, the investors expect more returns than the risk free return for compensating them for the risk undertaken (Higgins, 2008).

The amount of risk compensation or the market risk premium depends on the volatility of the security. The CAPM model divides the cost of equity into two parts namely risks free return and risk premium for risk undertaking. The market risk premium refers to the differential between the market return and the risk free return. The formula for its computation goes as,

Ke= Rf + β (ER (m) – Rf)

Ke                   = Cost of equity

Rf                           =Risk free Rate of Return

ER (m)                  = Expected Return of market

β                      = Systematic Risk or sensitivity of Company

(ER (m) – Rf)   = Market Risk Premium

The most important feature of this approach lies in the ability to predict the relationship between the risk and expected return of risky asset. The approach provides a very strong basis of decision making for investors by providing them a quantified measure of risk. The CAPM model enables derivation of risk which can’t be eliminated by diversification. Thus, it needs to be understood that, contribution of a single security to risk of a large diversified market depends solely on its systematic risk as represented by Beta of the security (Simon, 2009). Therefore, it can be said that the risk premium of a particular stock is proportional to its beta which denotes that, rise in market risk premium with the rise in beta and vice versa. CAPM approach is highly dependent on efficient market preposition and ignores any transaction cost. The assumption in it is that a well diversified portfolio shall be subject to only systematic market risk is also a matter of testability.

Approach to be followed

  • A company with a stable income and constant dividend policy may use the dividend pricing approach to measure the cost of ordinary share capital.
  • In the case of growth companies where expectation of growth rate is more important, the cost of equity share capital is to be measured by Gordon’s Model.
  • CAPM Model is most preferred in case of stocks where the risk is high and thus, the expectation of return is also high (Taillard, 2012).

The determination of cost of Equity of Ansell limited has been made by CAPM model and it is observed to be,

Beta of the Stock (B) Risk Free Rate (Rf) (Given) Market Return (Rm) Expected Return E(r) as Par CAPM
Ansell Limited 0.51 4% 0.71% 2.32%

Determination of Growth Rate of Ansell’s Stock using DDM Model

 Dividend discount model is another technique of stock valuation. This method assumes that the dividends of an organisation grow in perpetuity at a constant growth rate. The model is a simple and powerful tool to valuate equity and it works on an assumption that the rate at which the dividends would grow would be constant and stable. This model theoretically appears to be sound but it needs to be noted that market behavior towards a given stock can never be expected to be constant and thus the intrinsic value generated by Gordon Model may give misleading results. The annualised constant growth rate may be derived by the formula,

               Dividend current year = Dividend Base year * (1+g) ^ (n-1)

The computation of annualized growth rate from the available data of Ansell’s stock is made henceforth,

             Er = 2.32% (As par CAPM Model)

         Dividend Current Year = 17 (Appendix 2)

         Dividend Base Year = 16 (Appendix 2

         N = 5 years

         Hence, g = 10.17%

References

  •  Brigham & Houston, (2007), Fundamentals of Financial Management, 5th edition Thomson South-western.
  • Higgins, R. (2008), Analysis for Financial Management, 9th edition, Mc-Graw Hill Irwin.
  • Krause, A., (2009), An overview of asset pricing models, University of Bath, school of management.
  • Ittelson, T.R., (2009), Financial Statements: A step by step guide to understanding of financial statements, Career Pr Inc.
  • Tija, J., (2009), Building Financial Models, 2nd edition, Mc-Graw Hill.
  • Taillard, M., (2012), Corporate Finance for Dummies, For Dummies.
  • Simon, B., (2008), Financial Modeling, MIT Press