Table of Contents
Question 1
Stock can be valued using different methods. For this analysis, the Gordon model is used to value the stocks of Wal-Mart, Lockheed Martin, Nike, Coca Cola, and Apple Inc. to determine whether they are over or under valued. A stock with greater risk must pay a higher rate of return to encourage investors to buy it. This means that a high risk stock must pay a higher rate of return in order to compensate investors for investing in risky business. When investors buy shares of a company, they expect the firm to pay them compensation for investing their money in high risk business instead of risk free T-bills. The rate of return is determined by the market. However, as a rule, the higher the risk the higher the required rate of return to compensate for the risk (Engsted and Pedersen 264).
The rate of return is used to value stocks by adding the present value of future cash flow in a similar way interest rate is used to value the price of a bond. When calculating the price of a bond, the present value of all future interest payments is discounted using the required rate of return or market interest rate. Similarly, the Gordon dividend discounting model discounts prices of stock by determining the present value of future dividend cash flow using the market required rate of return. The future cash flow of stocks is the dividends payable and price of the stock. The discounted dividend model determines the intrinsic value of a stock. If a firm does not pay dividends, the future value of the stock is the present value of price the stock fetches in the market when the investor sells it.
The intrinsic value of the stock is determined based on the price of the shares of 3rd January 2017. The closing price is used to compare the intrinsic value with the stock price to determine whether the stocks are over or under valued.
Coca Cola
Coca Cola is a company that has paid dividends in the last 50 years (StreetInsider). The company is experiencing zero growth. Therefore, the valuation of the stock is the price the stock will be sold in the market.
Intrinsic value = Annual dividends/required rate of return
$1.4/0.08 = $17.5
As at 3rd January 2017, Coca Cola stocks were trading at $41.80 (StreetInsider). This means that the stock is overvalued. The intrinsic value is the true value of a stock.
Nike Inc.
Nike is a US based manufacturer of footwear. The company is estimated to have a growth rate of 4%. The intrinsic value of the stock is determined by the constant growth model below. In 2016, Nike paid a total dividend of $0.66 (Yahoo Finance (b) par. 2). Therefore, the intrinsic value is
$0.66/0.08-0.04=$16.5
$0.66/0.12-0.04=$8.25
As at 3rd January 2017, Nike share prices were trading at $51.98 (Yahoo Finance). This means the stock is overvalued.
Wal-Mart
Wal-Mart is the largest company in the world by revenue. The company has been experiencing growth over the last five years. This analysis assumes that Wal-Mart has a growth rate of 8%. By the end of 2016, Wal-Mart has paid total dividends amounting to $2 (Morningstar par. 2). The share price on 3rd January 2017 was $68.66.
$2/0.12-0.08=$50
The intrinsic value of Wal-Mart stock is $50; however, the stock has been priced at $68.66. This means the stock is overvalued.
Apple Inc.
Apple Inc. is estimated to have a growth rate of 6%. In 2016, the company paid total dividends amounting to $2.23 (Apple Inc. par. 3). The shares were trading at $116.02 on January 2017.
The intrinsic value is calculated below:
$2.23/0.08-0.06= 111.5
From this analysis, Apple Inc. shares are almost trading at par value. The intrinsic value is $111.5 while the shares were trading at $116.02. Apple stocks were trading slightly overvalued above the intrinsic value.
Lockheed Martin
Lockheed Martin is the largest defense contract in the world. The company is estimated to have a growth rate of 6%. In 2016, the firm paid dividends amounting to $6.77 (Yahoo Finance (a) par. 2). The shares were trading at $253.31 as at 3rd January 2017.
$6.77/0.08-0.06= $338.5
Lockheed Martin stocks are undervalued. The intrinsic value is $338.5 and the stock price is $253.31. Investors can take advantage of this stock to make huge capital gain when the stock will be trading at par value.
Expected return using the CAPM
The expected rate of return can be determined using the capital asset pricing model. The CAPM established the relationship between the expected rate of return and systematic risk for stock. This model is widely used for pricing of risky security particularly stocks when the expected return from those assets is given and their expected cost of capital (Moosa 67). The expected rate of return using the Asset pricing model is given below.
The general idea in this model is that investors should be compensated for time value for money and risk exposure. The risk free rate represents the time value of money while the risk free rate is taken as the yield on government bonds. The other part of this formula determines the risk and investors required rate of return based on risk exposure. Risk is measured by market beta which compares the return of the stock and the market value over a given period. Beta shows how risk a stock is compared to the market risk. It measure the volatility of a stock compared the overall market volatility.
When calculating the rate of return, the risk free rate is assumed to be 4%. The market return is 12%.
Apple Inc.
0.04+ 1.102(0.12-0.04) = 12.8%
Nike
0.04+ 0.41(0.12-0.04) = 7.2%
Coca Cola
0.04+ 0.59(0.12-0.04) = 8.72%
Lockheed Martin
0.04+ 59(0.12-0.04) = 8.72%
Wal-Mart
0.04+ 0.05(0.12-0.04) = 4.4%
A critical analysis of the required rate of return proves that investors rate of return is determine by the level of risk exposure. Apple Inc. has the highest beta factors of 1.102 which indicate that the company has a high risk level compared to others stocks. Wal-Mart has the lowest beta (measure of risk) and therefore, the required rate of return is low. The table below shows the movement of ratios from 2015 to 2016.
Question 2
| Apple Inc. | Nike | Lockheed martin | Wal-Mart | Coca cola | |
| Current ratio | 1.11-1.35 | 2.52-2.80 | 7.81-11.22 | 0.97-0.93 | 1.24-1.28 |
| Inventory turnover | 62.82-58.64 | 3.99-3.79 | 10.44-8.76 | 8.11-8.06 | 5.83-5.90 |
| Financial leverage | 2.43-2.51 | 1.7-1.75 | 15.86-31.64 | 2.5-2.5 | 3.53-3.78 |
| Debt to equity | 0.45-0.59 | 0.08-0.16 | 4.61-9.45 | 0.54-0.55 | 1.11-1.29 |
| Profit margin | 22.85-21.19 | 11.61-12.34 | 7.81-11.22 | 3.37-3.05 | 16.60-15.59 |
| Asset turnover | 0.89-0.70 | 1.51-1.54 | 1.07-0.97 | 2.38-2.39 | 0.49-0.47 |
The net profit of Nike has improved from 11.61 in 2015 to 12.34 in 2016. When the profit margin increases, share prices are likely to increase. It is an indicator the business will report high revenues and probability high dividends. The leverage ratio of Lockheed martin in 2015/16 is an indicator the business acquired asset or invested in new market which caused share prices to increase. Lockheed Martin acquired Sikorsky which created a new revenue stream. This acquisition caused shares prices to increase.
- Apple Inc. “Investor Relations – Dividend History – Apple.” Apple. N.p., 2017. Web. 20 Oct. 2017.
- Engsted, Tom, and Thomas Q. Pedersen. “Predicting returns and rent growth in the housing market using the rent-price ratio: Evidence from the OECD countries.” Journal of International Money and Finance 53 (2015): 257-275.
- Morningstar. “WMT Wal-Mart Stores Inc Stock Upcoming and Historical Dividends and Splits.” Performance.morningstar.com. N.p., 2017. Web. 20 Oct. 2017.
- Moosa, Imad A. “The capital asset pricing model (CAPM): the history of a failed revolutionary idea in finance? Comments and extensions.” Abacus 49.S1 (2013): 62-68.
- StreetInsider. “Dividend History for Coca-Cola Co. (KO).” StreetInsider.com. N.p., 2017. Web. 20 Oct. 2017.
- Yahoo Finance (a). “LMT Historical Prices of Lockheed Martin Corporation Stock – Yahoo Finance.” Finance.yahoo.com. N.p., 2017. Web. 20 Oct. 2017.
- Yahoo Finance (b). “NKE Historical Prices of Nike, Inc. Stock – Yahoo Finance.” Finance.yahoo.com. N.p., 2017. Web. 20 Oct. 2017.