EDF Group and EON SE from an Investor's Perspective - Assignment Example

?Introduction Many companies exist in the present and not all companies perform as well as others. The performance of companies is a critical area for some, mainly the investors who have invested capital amounts into the company. Investors can use a wide variety of tools to measure performance, but mainly focus on financial analysis, including ratio analysis, as well as other finance tools such as the Capital Asset Pricing Model (CAPM). This report entails a detailed analysis on 2 companies EDF Groups and E.ON SE. Both of these are key players globally in the energy business and are large multinationals. The analysis includes a discussion on CAPM (along with its assumptions, mainly efficient market hypothesis theory) and a financial ratio analysis. It is assumed that the reader has basic knowledge of these tools of analysis. Capital Asset Pricing Model (CAPM) According to Rai University: “The CAPM was developed to explain how risky securities are priced…CAPM aims at a more practical approach to stock valuation.” The assumptions of CAPM include: 1. Investors hold diversified portfolios 2. Single-period transaction horizon 3. Investors can borrow and lend at the risk-free rate 4. Perfect capital market (Rai University, 2013) Capm reflects that investors need to be compensated in two ways Time Value Of Money Risk (Investopedia, n.d.) The risk-free (rf) rate in the formula represents the time value of money invested at a minimum rate while the other half of the formula represents market risk applicable to the company. CAPM is in the view that the expected return of a stock is equal to the rate on a risk-free stock plus a risk premium. If the expected return does not match or meet the required return then any such investment is termed to be not feasible and is not to be carried out. The betas calculated in the attached working represent the risk of the specific company in relation to the market. When coupled with the market equity risk premium and the risk free rate, we can establish a minimum rate of return that would be required by the shareholders in relation to risk and returns in the market The calculated ROE of both companies is in the 5%-7% range showing that the companies’ shareholders require a minimum return of 5% as compared to the risk and return level they face in their investment in the company’s stock. CAPM is not an absolute model as it faces many limitations. It assumes markets are information efficient and all investors preferences are the same. These assumptions may not hold true in the actual market place and so, there are other models to calculate required return on equity, such as the gorden growth model or the earnings multiplier model. The major assumption in CAPM relates to perfect capital market and the assumption of all perfect information being available to investors. This introduces the concept of efficient market hypothesis. Efficient Market Hypothesis - EMH Many different theories state that it is simply impossible to beat the market. This is mainly due to the fact that market efficiency leads share prices to reflect all relevant information at any given time. The Efficient Market Hypothesis believes that all the stock traded always hold their fair value hence it is impossible for the buyer to purchase undervalued stocks or for the seller to sell at an overvalued price as stated by Malkiel, 2003. Due to this the only way that any investor may get a higher return is by getting hold of high risk stocks or a balanced portfolio (Pesaran 2010) On the other hand people against the hypothesis highlight the example of Warren Buffet beating the market consistently over fairly long periods (CBS, 2012). “Beating the market” is considered impossible under the efficient market hypothesis. Another aspect highlighted by those against the theory is events of 1987 during which the Dow Jones Industrial Average fell by more than one fifth in a day. This gives proof that the prices of stock may show a deviation from their fair values. Efficient Market Hypothesis relates to the information efficiency of the stock market and how the prices reflect the information available. There are 3 forms: Strong, semi-strong, and weak form (Malkiel, 2003). Historically markets were mainly in the weak form category as much of the recommendations for stock buy and sell was made on the historical performance of the company and stock. However, with the introduction of IT and other sophisticated systems, information barriers lessened and more and more information was readily available for the market (Gu Bin et Hitt Lorin, 2011). This describes the semi strong form in which public information and past information are used to analyse stocks into buy, sell, and hold recommendations. This semi strong form of market efficiency prevails in the modern world today as still some information is kept private in companies. Our analysis on EDF and EON groups and their relevant indexes proves the application of the semi strong form of market efficiency to these companies. The strong form of market efficiency states that even non-public internal information is available and reflected in the stock price of any particular stock. This form is not yet applicable in any of the exchanges around the world, however with new further innovations in IT, this could be achieved in a given time period of 10-20 years. The DAX and Euronext are both considered to be in the semi strong form of market efficiency. In the past these have been considered as weak form, especially the DAX. The impact of the global financial crises in 2008-2009 was a prime example given, but this event affected all exchanges and stocks around the world, as summarized by Ball, (2009). Better measures have been taken to ensure the markets perform to a minimum extent of market efficiency so that they can safeguard against the massive losses as seen in the global financial crisis. The relevant indexes and the stages of semi-strong market efficiency can be analysed in the case of EDF and EON groups. Certain changes in the information and its availability can be seen to mirror the changes in share prices of EDF and EON groups, among their index. A minute change effects the share prices as does a massive change. If EDF group receives a small contract which may have future potential for it to have capitalising opportunities in the future, based on the judgement of the market of this contract, the share price can be seen to move up accordingly. The same can be said for adverse information such as a meltdown at one of its nuclear plants, or an accident which ensues the company into litigation. These actions have an adverse impact on the share price. RATIO ANALYSIS Profitability ratios reflect the overall efficiency and performance of a company. They analysis of the profitability ratios is in two categories Margins Operating Profit Margin Net Profit Margin Returns Return on Equity Cash Return on Assets Figure 1 - Operating Profit Margin   EDF EON Name of Ratio 2006 2007 2011 2012 2006 2007 2011 2012 Operating Profit margin 15.88% 16.75% 12.94% 11.34% 9.90% 15.21% -0.67% 3.56% Net Profit Margin 9.80% 9.71% 5.19% 4.89% 9.49% 11.24% -1.65% 2.00% Return on Capital Employed 6.97% 7.26% 4.67% 4.30% 6.46% 9.72% -0.65% 4.99% Return on Equity 23.30% 20.12% 10.37% 11.58% 11.87% 14.01% -4.70% 6.80% The table above shows the comparison of profitability ratios over 4 fiscal periods in 2 different time frames, 2006/2007 and 2011/2012. 2006-2007 The Operating and Net profit margins of both companies can be observed to be rising during this period. This is common as both groups were growing drastically and maximizing profits using the available resources and energy opportunities, mainly focusing on smaller markets which they can earn higher profits with higher bargaining power. The ROCE also increased for both companies, but the ROE only increased for EON group. It fell with EDF group due to a higher amount of total equity within EDF group. 2011-2012 The Operating and Net profit margins of both companies paint a totally different picture in these years. The OPM and NPM of EDF group declined on average by 4-5% as compared to 2006-2007 values. This was mainly due to the financial crisis of 2008/2009 which took its toll on the profitability of both companies. This is also observed in EON group which had adverse negative margins in 2011 which subsequently recovered in 2012, but still remained less than half of the values of comparison with 2006. ROE and CAPM The ROE of both companies has been higher than the calculated CAPM in the years 2006,2007. This is due to the fact that the CAPM calculated uses the market index and company share price fluctuations starting from 2006 to 2013. Due to this the ROE of 2006 or 2007 is not comparable. The ROE of 2012 of EDF is higher than the CAPM calculated. This shows that the actual return generated by the company is higher than what an investor would require, based on the assumptions of CAPM listed in the above sections. The ROE and CAPM comparison of EON groups shows that the CAPM is slightly higher than the ROE of 2012. This may have further adverse effects on the share price of EON group as investors are not earning a worthwhile return on the index. They may prefer to invest in a different company that EON which may give higher returns that the index. Liquidity ratios indicate the liquidity of the company in determining the need to meet its near term finances which can be measured through several ratios such as current ratio, quick ratio, cash ratio. The cash ratio is the best indicator of a company’s liquidity and steady liquidity ratio of all. It only measures the firm's cash, along with investments that can easily be converted into cash, to pay its short-term finances. Along with the quick ratio, a higher cash ratio usually means the company has sound financial standing in the market. The quick ratio excludes stock but still includes other questionable items such as debtors. The current ratio includes all current asses and is most biased.   EDF EON Name of Ratio 2006 2007 2011 2012 2006 2007 2011 2012 Current ratio 1.07 1.06 1.33 1.17 1.06 1.06 1.20 1.10 Quick ratio 0.91 0.88 1.07 0.92 0.92 0.93 1.07 1.00 Cash Conversion cycle 66 80 116 109 -17 -10 6 0 The current and quick ratios of both companies have been constant and a evidence of a liquidity crisis is not empirically evident. Both companies differ in the cash conversion cycle and efficiency ratios. EON has a positive plus point with a near 0 or negative cash conversion cycle, suggesting that it cannot face liquidity shortages in the normal operations of its business, as it receives cash a lot quicker than EDF, which, whose cash conversion cycles vary from 2-3 months. Capital Structure Overview Corporations in today’s world overcome their finances through equity, hybrid securities and debts which have their selected share in corporation’s assets. The whole process of financing is called Capital structure ( Top of Form Marks 2005). Bottom of Form A firm may divide the ratio as 20% equity finances and 80% debt finances. Now the debt ratio of total finances stands as firm’s leverages. In reality this composition becomes more complex when finances are meet from sources inside and outside the corporation as loans (Hart 1994). . Modigliani and Miller presented theory of Capital Structure in a perfect market. There are several qualifications for a "perfect market". The two findings made were as follows: The worth of the corporation is independent of its capital structure and The cost of equity for a leveraged firm is same as cost of equity for an unleveraged firm, including financial risk factor too. It is argued perfect market does not exist in real life so, their assumptions are irrelevant, and now the imperfections which exist in the real world must be relevant with capital structure. (Miller, 1988) Trade-off theory states bankruptcy cost exists that financing with debt (the tax benefits of debt) is positive and which has its cost (the bankruptcy costs and the financial distress costs of debt). So there is a trade-off between its benefits and costs. Pecking Order Theory captures the costs of asymmetric information. Gearing Ratio   EDF EON Name of Ratio 2006 2007 2011 2012 2006 2007 2011 2012 Debt/Equity 1.42 1.20 1.70 2.10 0.26 0.39 0.76 0.67 Debt/Debt + Equity 0.20 0.19 0.24 0.26 0.11 0.16 0.20 0.18 The capital structure and Debt/Equity ratio of EDF show that its debt has been consistently higher than that of its equity. However, when we consider total gearing, the total amount of debt does not make up greater than 26% of Total debt and equity. EON’s debit is relatively low compared to its equity amounts. The balance of Debt and Equity of each company depends on the cost of capital it estimates for its total funds. A higher proportion of debt can be beneficial as debt is cheaper than equity, however after a certain point, due to the increased financial risk, the cost of debt and equity rise, and the benefit of using debt vanishes. How to Reduce Gearing There are many methods that may be used for reducing the gearing ratio of a company: Sellimg shares The board may approve the sale of shares of the company that may be helpful to pay out its debt as selling shares provide liquidity. Converting loans Negotiations are carried out with creditors and they are persuaded to swap the amount owed by the company that is their debt for the shares in the company. Reducing working capital. The collection days of accounts receivable collections is increased , inventory levels are decreased, and the days required to pay accounts payable prolonged. Increasing profits. Increasing profits will in return help paying out debts whuch shall lead to a decline in gearing ratio.   EDF EON Name of Ratio 2006 2007 2011 2012 2006 2007 2011 2012 Interest coverage 3.46 3.94 2.24 2.45 6.37 13.54 -0.35 3.38 Debt to Total capital 19.60% 18.55% 23.92% 25.79% 10.56% 15.63% 19.57% 18.48% The interest coverage ratio of EON is superior to that of EDF, but it seems that EON is a relatively higher risk company, as can be seen from this and other ratios. Its performance is not stable, such as that of EDF. The debt to capital ratios of EDF are higher than those of EON, with the highest in year 2012 with approx. 26%. The use of debt capital is encouraged as it lowers the Weighted Average Cost of Capital up to a certain extent. The gearing ratios of both companies are not abnormally high as compared to the sector and industry and seem to be stagnant of the financing requirements of both organizations. Dividend Policy Dividend Irrelevance Theory Modigliani and Miller believe that with no bankruptcy cost, a dividend policy is irrelevant. This theory is known as the dividend irrelevance theory and suggests that dividends don’t influence the stock price and capital structure of the company (Frankfurter et all, 2003). Bird-in-the-Hand Theory The bird-in-the-hand theory states that dividends are relevant. The total return (k) equates dividend yield plus capital gains. It is assumed that the total return would decrease as a company's payments increase. So, company increases its expenses ratio, investors become worried about reinvestments Top of Form (Weigand, & Baker 2009).Bottom of Form Tax-Preference Theory Investors worry about taxes and capital gains are taxed at a lower rate than dividends.so, investors will go for capital gains. This is known as the "tax Preference theory".  Beside that capital gains are not paid till investment is actually sold. Investors can overcome capital gains but not the dividend which is in corporation’s control ( Top of FormLease 2000).  Hence, some investors prefer dividends, other prefer capital gains. The preference emphasis here is on the tax effect passed to each investor with the capital gain/or dividend. The preference is based on the current holding of the investor in his diversified portfolio and the return each had foreseen from the company. Bottom of Form The Dividend-Irrelevance Theory and Company Valuation In determining value of a company, dividends are often used. Dividend-irrelevance theory says that financiers may affect their return on a security irrespective of the dividend of the stock/security. Suppose, from an investor's perspective, that a company's dividend is too big. That investor could then buy more stock with the dividend that is over his or her expectations. Likewise, if, from an investor's perspective, a company's dividend is too small, an investor could sell some of the company's stock to replicate the cash flow he or she expected. As such, the dividend is irrelevant to investors, meaning investors care little about a company's dividend policy since they can simulate their own. The Principal Conclusion for Dividend Policy The dividend-irrelevance theory with no taxes or bankruptcy costs assumes that a company's dividend policy is irrelevant. The dividend-irrelevance theory designates that there is no effect from dividends on a company's capital structure.  MM's dividend-irrelevance theory assumes that investors can affect their return on a stock irrespective of the stock's dividend. So, the dividend is irrelevant to an investor. These financial ratios analyse the main rations that all investors consider when investing in a company. As EPS, DPS, and other rations relate directly to the return that the shareholder receives on his investment. Earnings per share and dividend per share are self-explanatory. The dividend cover indicates how many times the net profit can cover the payment of the dividend. This is evidently higher in EON group due to their lower equity and lower number of shares. However the dividend cover of both companies in 2011-2012 is surprising as it seems they have paid the majority of their net profit out in dividends. The P/E ratio is a reciprocal of the Earnings yield and shows the price multiple of the share in comparison to its earnings. Normally the P/E ratio is analysed in terms of growth and mature companies. Higher P/E ratios mean greater share value in comparison to earnings. Higher P/E ratios are common in companies which are expected to have higher future earnings, and lower P/E ratios are common in companies with forecasted lower earnings growth (MORLEY, 1984) These policies and the decision taken by management lead to a signalling effect to shareholders. In both companies case, dividends were at an increasing trend as can be observed in the 2006,2007 financial years, however in 2011,2012 dividends have become stable and fixed. This may be due to a liquidity requirement and the need to retain earnings for capital projects in the future. As a company which skips a dividend in any given year can be viewed as negative, companies usually decide a minimum level of dividend pay out to ensure shareholders have a continued interest in the company and its operations. This can be observed in the case of EON. It incurred losses and a net loss margin of -1.65% in 2011, however it still paid dividends at its minimum defined rate. Going forward, it can be observed that both companies face hurdles in their operations in order to reach a level where dividend payments won’t be considered a burden, and shall be able to be used strategically for the benefit of the company. Weighted Average Cost of Capital (WACC) WACC or the Weighted Average Cost of Capital is used to describe the interest costs for capital in terms of its origin, whether it comes from equity (interest free) or from debt (which comes with a rate of interest attached). It's also called the marginal cost of capital It represents the cost of each additional dollar to the firm The higher the WACC, the higher the breakeven point and the lower the net present value The lower the WACC, the lower the breakeven and higher the net present value. But if a company has a higher WACC, it won't go for the project if it forecasts a negative net present value While a company with a low WACC can take on many projects as most will be profitable. By determining the percentage that WACC allocates to capital for each year for both EDF and E.ON it can give a potential investor an indication of what extra costs will be attributed to the capital they are planning on investing. Year EDF EON 2006 3.00% 9% 2007 10.13% 9.1% 2011 4.30% 6.1% 2012 3.8% 5.6% As seen from the table, EDF has usually had a lower WACC of EON. The only year in which its WACC rises is the year of 2007, just before the acquisition of EDF by the British Synergy. It may also been seen that since that the WACC of EON has also declined. The decline of 2012 as compared to 2011 in WACC is, 11.6% by EDF and 8.2% by EON. There is a difference of 1.8% in 2012 in the WACC of both companies and surprisingly the difference in WACC between both of the companies was the same, that is, 1.8%. This may suggest that EDF is more preferably to be invested into but as much doesn’t part both the companies investing in one company solely and neglecting the other, may never be a good neither a feasible option. Secondly, as mentioned earlier it is also important that the value of WACC for both companies should be also compared with their respective net present values and further analysed. This may help is making a more viable and profitable decision along with helping in the allocation of assets accordingly. Also it is to be noted that more risk usually does bring more gain. BETA Every investors before he even thinks of investing has a set a parameters which he looks upon before making a decision. These parameters include, earning growth rate, PE ratios, EPS and ROIC along with plenty of others. With the help of these parameters it is comparatively easy to assess a company’s position at that moment which in return increases and maximises the return on investment. An easy to calculate and also easy to apply parameter with respect to investing in stocks in known as Beta or Stock’s Beta. Volatility and Risk: They are two types of volatilities noticed when investing in and assessing stocks. The risks that are faced and are industry specific in nature are known as unsystematic risks. These includes competition from competitors, project delay, management change along with many others. Systematic risk refers to the risk due to the market sentiment. Stock prices move in relation to the market sentiment. The relation of each stock varies. Some stock may more proportionately then others, some may move inversely and other may move in tandem with respect to the market sentiment. Unsystematic risk can be reduced and diversified, mainly thru portfolio management; however Systematic risk cannot be reduced or diversified. Calculations & Analysis of Beta: Beta or Stock Beta may be said to be one of the most important and useful measure of volatility, stock risk and the relationship of the stock with the market sentiment. It provides an in depth insight about the relations of stock with the movement of the market . Although volatilities may also be monitored through technical charts Beta Stock is the most preferred measure. Beta Stock is also known as financial elasticity. With the help of Beta stock an investor happens to understand how volatile a stock has been recently. A decision keeping the value of Beta stock increases profit hence enhancing the performance of one’s portfolio. Although calculating Beta Is relatively easy, it is usually published in reports that investment firm publish. Two set of data are required to calculate stock beta. The first constitutes of the closing stock prices that are under examination while the second is of the closing prices for the index chosen as a proxy. Beta has been calculated here by obtaining daily share price data of each company from 1 January 2006 onwards and comparing this with its relevant Stock Index daily fluctuation. Relationships are established between the two and correlation and covariance are mathematically calculated (Vuolteenaho & Campbell 2003). . Then the following formula is used to calculate the Beta of the company in relation to its Index: Interpretation of Beta: The growth opportunities of companies act as a significant factor in determining their beta value. Usually the more growth opportunities a company has the more higher its betas as the expected growth is related to risk and uncertainty coupled with higher return opportunity. How to use Beta? How we use beta for investment in stocks is very much dependent on our risk appetite. Like I said, beta measures a stock’s association with market movements and represents volatility and thus risk associated with that stock. Choosing company which has beta more than 1 means we are selecting more volatile stock. For example, an early-stage technology company’s stock will have a beta greater than 1. This company’s stock price will bounce up and down more than the market. Definitely these kinds of companies will be riskier than, say; utility industry stocks which have low beta or beta close to 1. Of course, here risk also implies return. Stocks with a high beta usually give a higher return than the market. A risk-averse investor may like to look for companies which have beta 1 or very close to 1. Generally most blue chip companies have beta close to 1 or lower than 1. And because of this these companies are considered as safe bets in a volatile market. Limitations: Beta value of a stock relies on price movements that are historic in nature and we all know that assessing history may not always lead to a reliable and accurate prediction of the future. It does not account for any sudden change in stock price. Taking decision on the basis of beta is no doubt a good practice but at the same time it is important to assess the fundamentals. In no case is beta an alternative to fundamental analysis. Beta is basically a add on tools which helps one to make a better and more secure decision. Beta and Failure analysis Weibull Distribution helps calculating the failure of a company. This is based on specific variables. The input variables being the slope ?, ? and the data sets to generate the respective output values of median, mode, mean, variance along with standard deviation. Its interpretation is: When ? < 1.0 it reflects that the company has a decreasing failure rate. When ? = 1.0 it reflects a constant failure rate. The ? > 1.0 it reflects an increasing failure rate. Conclusion Both the companies seem to be feasible when it comes to investment, however EDF is clearly the better choice based on its returns and margins. Both companies have had their high and lows during the past five years. An in depth analysis would suggest that Electricte de France (EDF) is a much better option that E.ON. Many factors are in the favour of EDF such as its consistency of profitability over the period and comparatively less decrease in EPS and profitability during it times of economic turndown. Being an investor, one should look forward to diversify its portfolio. Although EDF may seem to stand out in many aspects such as EPS, DPS and Dividend cover it is also to be considered that before the economic downturn E.ON was living a dream with an EPS as high as 11.06 during 2007 when EDF was sitting on only 3.08. EON at the present moment also leads EDF in P/E ratio and Dividend yield. Considering the recent events and performance EDF remains a comparatively better and stable investment as compared to EON but a diversification of portfolio is recommended with a 70/30 holding to EDF. References Top of Form PESARAN, M. H. (2010). Predictability of asset returns and the efficient market hypothesis. Munich, Univ., Center for Economic Studies. Top of Form BARNES, P. (2009). Stock market efficiency, insider dealing and market abuse. Farnham, Surrey, England, Gower. http://site.ebrary.com/id/10362150. Top of Form FRIDSON, M. S., & ALVAREZ, F. (2002). Financial statement analysis a practitioner's guide. New York, John Wiley & Sons. Top of Form MARKS, K. H. (2005). The handbook of financing growth: strategies and capital structure. Hoboken, N.J., Wiley. Top of Form HART, O. (1994). Capital structure decisions of a public company. Roma, Banca d'Italia. Top of Form TIMMONS, J. A., SPINELLI, S., & ZACHARAKIS, A. (2005). How to raise capital: techniques and strategies for financing and valuing your small business. New York, McGraw-Hill. Top of Form FRANKFURTER, G. M., WOOD, B. G., & WANSLEY, J. W. (2003). Dividend policy theory and practice. Amsterdam, Boston. http://www.books24x7.com/marc.asp?bookid=6491. 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Princeton University, Available at: http://www.vixek.com/Efficient%20Market%20Hypothesis%20and%20its%20Critics%20-%20Malkiel.pdf [Accessed 11 July 2013]Bottom of Form GU BIN, HITT LORIN (2011) Transaction costs and Market Efficiency, Wharton Times, Available at: http://opim.wharton.upenn.edu/~lhitt/tcme.pdf [Accessed 16 July 2013]Bottom of Form BALL, RAY (2009) The Global Financial Crisis and the Efficient Market Hypothesis: What Have We Learned? Journal of Applied Corporate Finance •Volume 21 Number 4, 11-13Bottom of Form CBS (2012) How Warren Buffett beats the market. CBS Money Watch. Available at: http://www.cbsnews.com/8301-505123_162-57524029/how-warren-buffett-beats-the-market/ [Accessed 11 July 2013]. Bottom of Form INVESTOPEDIA (N.D.) The Capital Asset Pricing Model: An Overview. INVESTOPEDIA Available at: http://www.investopedia.com/articles/06/capm.asp [Accessed 10 July 2013]Bottom of Form Miller, M. H. (1988). The Modigliani-Miller Proposition after Thirty Years. Journal of Economic Perspectives, 2, 99-120. Top of Form MORLEY, M. F. (1984). Ratio analysis. Berkshire, England, Published for the Institute of Chartered Accountants of Scotland by Gee & Co. Bottom of Form Bottom of Form Bottom of Form Bottom of Form Read More