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Suppose you are a financial analyst and you have been asked to analyse an ASX listed company. Your task is to make a recommendation as to whether or not this company is an attractive investment opportunity. Before you draw a conclusion, you are required to:

1) Discuss how successful the company has been at maximizing stakeholders value over analysing period. The discussion should be based on appropriate metrics and benchmarks.

2) Analyse the company's share price history and traded volumes over the analysing period, it can be over the past 12 months, 2 years, or 5 years.

3) Calculate the return for investing in the company both short term and long term and indentify the main causes of its volatility in return over the corresponding holding period. The discussion of volatility should consider economic-wide and firm-specific factors.

4) Apply the valuation technique(s) taught in this course and undertake a current valuation of the equity for your company. Based on your calculation, would you recommend a prospective investor to buy, hold or sell this security and why.

5) Evaluate the company's investment projects. Is there a typical project for the company during the analysing period? If so, apply analytical skills relating to the topic taught in this course and evaluate the profitability of the project, the investment horizon whether is a long term or short term project, the cash flow pattern and how the company has financed the project.

6) Analyse the company's dividend policy. Should the company follow a progressive dividend policy? Critically evaluate factors that are affecting corporate dividend policy and how your company's dividend policy may have influenced its capital structure and share price.

7) Estimate the overall cost of capital and analyse the current capital structure. How would you describe the current capital structure for your company and justify with reasons that should potential investors view this company as a favourable investment choice?

8) Based on the attempt to all of above questions conclude whether your company is an attractive investment opportunity. You should clearly explain all of your assumptions used in the valuations and estimations; for the technique(s) and model(s) adopted state why you think they are appropriate for your company; attempt to reconcile any differences in results/outcomes that you obtain by using different technique(s) and model(s); finally, critical discuss the weaknesses of your analysis and any other risks that may affect investors' decision making.

Stakeholder Value Creation

Rio Tinto Limited is an Anglo-Australian multi-national company which has emerged as one of the world’s largest metals and mining corporations after being operational for 146 years. Rio Tinto is a dual-listed company traded on both London Stock Exchange (LSE), where its securities are traded in FTSE 100 Index and Australian Stock Exchange (ASX), where it is listed in index of ASX200. The company has reported a revenue of $40.030 billion in 2017 while its operating income, net income, total assets and total equity in the same year stood $14.474 billion, 8.851 billion, 95.726 billion and 44.711 billion respectively. The company is also a huge employment generator having 50000 personnel on roll by 2017.

The report is aimed to analyse the company’s financial performance in the context of an investment decision and makes a genuine attempt to analyse and recommend as to whether the company is an attractive investment opportunity (more relevantly to an equity share holder). In order to achieve all the objectives of the report, the report relies on the inputs from following sources:

  • Annual reports of the company;
  • Public domains such as Yahoo Finance and Bloomberg; and
  • Other relevant journals which can help with the direction of the report.

The following areas are analysed in order to ascertain whether or not the company is a good investment option:

  • Value addition to the stakeholders
  • Trend in share prices
  • Return on Investment
  • Theoretical Value of the equity of the company;
  • Dividend policy of the company; and
  • Capital structure of the company

Stakeholder of a company –

Stakeholders are either individuals or groups or both that have an interest in the progression and prosperity of a company.

Stakeholder of a company –

Stakeholders are either individuals or groups or both that have an interest in the progression and prosperity of a company. A stakeholder may be internal or external. Internal stakeholder is one who has invested in the company (say an equity shareholder) or engaged in employment by the company (say employees) while the external stakeholders include business .

Maximisation of Stakeholder Value –

The concept emerges from a management philosophy called ‘stakeholder approach’ that regards maximisation or furtherance of the interest of the stakeholder (either internal or external) as its most important object

The following metrics are used to measure the value of stakeholders. ("5 must-have metrics for value investors", n.d.)

2013

2014

2015

2016

2017

a

Price of share

68.18

58.00

44.71

59.90

75.81

b

Earnings per share

1.98

3.53

0.48

2.57

4.90

c

Total Assets (in millions)

111025.00

107827.00

91564.00

89263.00

95726.00

d

Total Liabilities (in millions)

57523.00

53233.00

47436.00

43533.00

44611.00

e

Book Value (in millions) = c - d

53502.00

54594.00

44128.00

45730.00

51115.00

f

Debt (in millions)

57523.00

53233.00

47436.00

43533.00

44611.00

g

Equity (in millions)

53502.00

54594.00

44128.00

45730.00

51115.00

h

No. of Shares O/s

1861.14

1861.14

1808.19

1772.69

1763.41

i

Earnings Growth

78%

-113%

641%

91%

j

Net Profit (in millions)

      1,079

6499

-1719

4776

8851

k

P/E Ratio = a/b

34.36

16.43

94.13

23.32

15.46

l

Book Value per share = e/h

28.75

29.33

24.40

25.80

28.99

m

PEG Ratio = a/i

21.07

82.97

3.64

17.01

n

Return on Assets = j/c

0.97%

6.03%

-1.88%

5.35%

9.25%

o

Return on Equity = j/g

2.02%

11.90%

-3.90%

10.44%

17.32%

p

P / BV per share = a/l

2.37

1.98

1.83

2.32

2.62

q

Debt to Equity Ratio = f/g

1.08

0.98

1.07

0.95

0.87

The inputs were obtained from Annual Reports of Rio Tinto (2017 Annual Report, 2018); (2016 Annual Report, 2017); (2015 Annual Report, 2016); (2014 Annual Report, 2015); (2013 Annual Report, 2014); ("Price Earnings Ratio - Formula, Examples and Guide to P/E Ratio", n.d.)

If we plot the metrics in a graph to determine performance bench mark, we will get the following result:


In the above table it can be seen that the P/E Ratio has recovered from negative in 2015 to positive. The main reason for such a steep downfall in P/E ratio in 2015 is negative EPS. Further the PEG Ratio has decreased from 82.97 in 2015 to 17.06 in 2017 which is a positive sign since higher PEG Ratio would mean that the share is expensive. Further, we can also see that the BV / Share is consistent within the range of 1.8 to 2.3 and there are no wide fluctuations indicating that the share is consistently valued in the market when compared to its accounting value ("Book Value per Share Definition", n.d.). Further, if we look at the Debt-Equity Ratio, we find that the ratio is in a decreasing trend from the past couple of years and it indicates that the ownership of shareholders on the overall assets is increasing. Therefore the company is doing reasonably well in maximising the value of shareholders. If we focus on value maximization for other stakeholders, let us compare the trend of Return on Assets (ROA). The return on assets after fall in 2015 has increased to 9.25%. It indicates that the company has increased its operational efficiency thereby increasing the profit generated by the assets. By increasing operational efficiency as evident in the increase in ROA, the company has maximized value to not only the shareholders but also the debt holders and the financers of the company. The ROA of the industry as a whole in Australia is 4.43% only which is less than the ROA of the Company. The ROE of the company is 17.32% against the industrial average of 6.78%. Therefore the company is performing reasonably well in maximization of value of stakeholders.

Share Price History and Trading Volumes

Trend of Market Price of the Shares:

Volume Traded

In the above graphs we can observe that share price fluctuated between the range of 70 – 86 and we can see that the fluctuations are not wide. However we can see huge fluctuations in the traded volume of the shares in the market. By comparing the both, we can safely conclude that the shares of the company are not widely affected by the traded volume which indicates that the share prices are not extremely sensitive to the demand in the market.

Note: The data for analysis was taken from Yahoo Finance ("RIO ASX - Historical Data", 2019), Share prices were considered for past 12 months [i.e., 29/01/2018 to 28/01/2019]

Computation of Return on Investment (short-term)

2017

2016

2015

2014

2013

a

Closing Price

          78.17

75.25

60.39

44.65

58.1

b

Opening Price

          75.85

60.28

44.75

57.5

68.5

c

Difference = a - b

           2.32

          14.97

       15.64

      -12.85

      -10.40

d

Dividend

           2.90

           1.70

         2.27

         2.05

         1.78

e

Return = c + d

           5.22

          16.67

       17.91

      -10.81

        -8.62

f

Investment

          75.85

          60.28

       44.75

       57.50

       68.50

g

Return on Investment = e / f

7%

28%

40%

-19%

-13%

Return on Investment (Long-term)

a

Closing Price

          78.17

b

Opening Price

          68.50

c

Difference = a - b

           9.67

d

Dividend

          10.69

e

Total Return = c + d

          20.36

f

Rate of Return = e / b

30%

g

Annualized Rate of Return = f/5

6%

The Beta of Rio Tinto is 0.97 (Editorial, n.d.). On the other hand the beta of BHP, its peer is 1.06. It means the company is less risky than the market portfolio. Therefore the variance in long term and short term return on investment is not attributable to economic-wide factors. They must be firm related factors.

The theoretical value of share is computed using the comparable approach to valuation of equity shares

P/E Approach:

As per this approach the value of equity share is computed as under (2015 Annual Report, 2016):

Value of ordinary share = P/E Ratio of 2018 x Estimated Earnings per share for 2019

Particulars

Result

P/E Ratio of 2018

      34.36

Estimated Earnings per share for 2019

   Current Earnings

        1.98

   Estimated Growth

0.38%

Estimated Earnings per share for 2019

        1.99

Price of the share

68.44

The estimated growth rate is obtained from Yahoo Finance ("RIO AX Analysis", 2019)

Since the theoretical price of the share is 68.44, when compared to the actual price of 83.53 as on date, the price of the share is slightly over-valued. Since the shares are over-valued, it is being sold in market for a price which is more than its intrinsic value. So depending upon this analysis a marginal investor should not acquire this share and the existing shareholder should sell the share.

The dividend policy of the company was adopted in the year 2016 in which the company decided that at the end of each financial period, the board will determine the appropriate level of dividend per share to be proposed. Therefore it is clear that the company has adopted residual pay-out policy. The board expects a total cash return to shareholders over the longer term to be in a range of 40 to 60%. The same is evident from the following table where the company maintained a dividend pay-out ratio within the range of 50-70% in order to maximize the total cash return to shareholder. The dividend pay-out ratio of another company in same industry BHP Billiton is 77.06% ("BHP AUX", n.d.) (greater than pay-out of the company) which indicates that the company can adopt better pay-out ratio.

2017

2016

2015

2014

2013

Dividend per share

        2.90

1.7

2.265

2.045

1.78

Earnings per share

        4.90

2.57

-0.475

3.512

1.973

Dividend Pay-out Ratio

59%

66%

NA

58%

90%

Short-term and Long-term Return and Volatility

Further the company also displayed increase in dividend per share which indicates that the company has adopted incremental growth policy of dividend. Further as per the annual report of 2017, the company is also confident to maintain the total cash return between 40% and 60%. This clearly bears a positive sign in the minds of the shareholder and have a positive impact on the share price. Apart from distributing cash dividends, the company has also adopted buy-back of shares in 2015. The company announced a buy-back of $2.0 billion and further it has announced a buy-back of shares worth $2.5 billion during 2017. Buy-back is also viewed as favourable since it shows that the company is generating more money than it currently needs.  However, pay-out of more than 50% of residual earnings to the shareholders in the form of dividend prevented the increase the total ownership of equity holders on asset, making it stable. However the company has maintained at least 50% of the ownership of total assets in the hands of shareholders of the company.

Cost of Capital

Cost of Debt

a

Interest Expense

        897.00

b

Interest Bearing Debt

    15,176.00

c

Cost of Debt

6%

Cost of Equity (Levered)

a

Dividend Per Share

           2.90

b

Market Price per Share

          83.53

c

Cost of Equity = a/b

3%

d

Cost of Equity - Cost of Debt

           0.02

e

Debt-Equity Ratio

           0.87

f

Tax Rate

           0.31

g

Cost of Equity = (c ) + [(d)x(e )x (1 - f)]

4%

 

 Equity

Debt

Total

Cost of Capital

a

Required Rate of Return = a x b

4.05%

5.91%

b

Component of Capital

    51,115.00

15176

 66,291.00

c

Weight of Component

           0.77

           0.23

d

Weights x Required Rate of Return

3.12%

1.35%

4.47%

The weighted average cost of capital is 4.47% (Ward, 1999). On the other hand, the WACC of BHP is 5.21% ("BHP AUX", n.d.). This indicates that the company has better borrowing power than its peer BHP since the company ended up borrowing capital at lesser cost than its peer. This is because the company is largely dependent upon the share capital of the company which has relatively lesser required rate of return than the debt of the company.

2013

2014

2015

2016

2017

Capital Structure

  Owner's equity

    53,502.00

    54,594.00

 44,128.00

 45,730.00

 51,115.00

  Interest bearing debt

18,055.00

12,495.00

13,783.00

9,587.00

15,176.00

Total Capital Structure

    71,557.00

    67,089.00

 57,911.00

 55,317.00

 69,170.00

Debt Ratio

  Total liabilities

    57,523.00

    53,233.00

 47,436.00

 43,533.00

 44,611.00

  Total Assets

 1,11,025.00

 1,07,827.00

 91,564.00

 89,263.00

 95,726.00

Debt Ratio

           0.52

           0.49

         0.52

         0.49

         0.47

Debt-Equity ratio

           1.08

           0.98

         1.07

         0.95

         0.87

The above capital analysis gives us an insight on capital structure of the company. As we can look at the capital structure, the company is substantially dependent on the share capital for financing its assets rather than the debt funds. The Shareholders of the company are going to have maximum share of the assets as the debt ratio is following a declining trend. The prospects of the share capital of the company is showing positive sign since the company is providing a ROE of 17.32% and a dividend pay-out of more than 50%.

Conclusion:

The company overall scores better as far as shareholders are concerned and hence the company’s share capital turns out to be an attractive investment. However the company is dependent more upon the share capital than debt as evident in the debt-equity ratio and hence the shareholders are extremely susceptible to the factors like negative returns, decline in market value of assets, etc. While the report made a genuine attempt in finding out the attractiveness of the investment in the company, the report may have been more effective if the theoretical price of share is computed using the DDM approach. But owing to lack of information on the growth prospects of the dividend and the lack of trend in growth of dividend, the same cannot be made. However the analysis of theoretical price of the shares was concluded using P/E approach since the data regarding earnings growth was readily available in the public domain. Further, the report didn’t focus on the latest projects on which the company has invested and the effectiveness and profitability of the same since the company did not have such standalone projects with readily available data regarding the cash flows. However, after thorough analysis of aforementioned criteria, the investment in the company seems attractive.

References

RIO AX Analysis. (2019). Retrieved from https://in.finance.yahoo.com/quote/RIO.AX/analysis?p=RIO.AX

Rio Tinto. (2018). 2017 Annual Report. Melbourne.

Rio Tinto. (2017). 2016 Annual Report. Melbourne.

Rio Tinto. (2016). 2015 Annual Report. Melbourne.

Rio Tinto. (2015). 2014 Annual Report. Melbourne.

Rio Tinto. (2014). 2013 Annual Report. Melbourne.

Book Value per Share Definition. Retrieved from https://ycharts.com/glossary/terms/book_value_per_share

RIO ASX - Historical Data. (2019). Retrieved from https://in.finance.yahoo.com/quote/RIO.AX/history?p=RIO.AX

Price Earnings Ratio - Formula, Examples and Guide to P/E Ratio. Retrieved from https://corporatefinanceinstitute.com/resources/knowledge/valuation/price-earnings-ratio/

5 must-have metrics for value investors. Retrieved from https://www.investopedia.com/articles/fundamental-analysis/09/five-must-have-metrics-value-investors.asp

Using the P/E Ratio to Value a Stock. Retrieved from https://www.thebalance.com/using-price-to-earnings-356427

Ward, C. (1999). Estimating the cost of capital. Journal Of Corporate Real Estate, 1(3), 287-293. doi: 10.1108/14630019910811088

Editorial, R. ${Instrument_CompanyName} ${Instrument_Ric} Quote| Reuters.com. Retrieved from https://www.reuters.com/finance/stocks/overview/RIO.AX

BHP AUX. Retrieved from https://in.finance.yahoo.com/quote/BHP.AX/key-statistics?p=BHP.AX

BHP AUX. Retrieved from https://in.finance.yahoo.com/quote/BHP.AX/financials?p=BHP.AX

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