Analysis and evaluation of financial performance may be considered to be one of the most critical aspects of business studies as the process of such evaluation involves consideration of lots of factors that are both internal and external to the business. Stakeholders associated with the business generally put a major emphasis on such evaluation as the same depicts the true operational health of the firm in which their respective stakes are invested. The instant report deals with such evaluation of two companies listed in Australian Stock Exchange (ASX). These two companies are Rio Tinto Limited (hereinafter may be referred to as “Rio Tinto” or the company, as the case may be) and Wesfarmers Limited (hereinafter may be referred to as “Rio Tinto” or the company, as the case may be). These two companies belong to different sectors (the first one being from materials and the second one is from consumer staples) and hence their respective and comparative financial performance analysis will strengthen the recommendations subsequently provided.
At the outset of the study, the capital structure of both the firms has been analysed for a period of last five years followed by an evaluation of their respective weighted average cost of capital (WACC). The researcher analyses the impact of the tax on corresponding WACC of both the companies. At the subsequent part of the report, the paper focuses on the valuation of stocks of those two firms and finally provides a recommendation based on the findings gathered. In this context, it may be noted that the related financial data may be taken from last few five years’ annual reports. Lastly, the researcher wraps up the discussion by way of concluding note.
The section below provides the position of the capital structure of these two companies in brief. However, the detailed calculation is shown in the table in the appendices below. The figure below shows the trend in the D/E for both the companies in the last five years. In this context, it may be noted that the market value of equity has not been calculated because of complexity involved therein in terms of extracting share price for each year end and a number of shares outstanding as on the valuation dates. Rather, the book value of equity has been taken into consideration. Moreover, the industry average has not been traceable in the IBIS World website and hence the same has not been referred to herein.
The business is primarily driven by equity and hence, its D/E for last five years has been averaged at 27%. The major component in the capital structure of the business is share premium and reserve and surplus which clearly establish the fact that the management of the business does not want to take the unnecessary risk of debt and consequent interest costs on the bottom-line (“Annual Report 2017”, 2018).
The management of Wesfarmers holds an almost similar view with that of Rio Tinto. The business runs on equity and average D/E for the last five years stands at 22%. The figure above shows that both the firms have experienced almost similar trend in D/E in terms of rising and fall that may be construed to be in line with the industry benchmarks (“Annual Report 2017”, 2018).
The following sections attempt to analyse the WACC for both the firms with the data of the last five years. The detailed calculation is shown in the table in the appendices below. The table below shows the WACC of the firms considering the capital structure related data of last financial year i.e 2017. While calculating the cost of equity, CAPM has not been considered and simple theory of EPS/Share Price has been applied to compute the overall WACC.
The company has an overall cost of capital of 6% which may be considered to be substantially low. It may be observed that the cost of debt has been marginal and to the extent of 2% only. Though the weight of debt in overall capital structure has been only 25%, the cost of equity has also not been very high (only 7%) and that is the reason the firm has been able to maintain WACC at such lower level.
The company, on the other hand, has marginally higher WACC (9%) than that of Rio Tinto. However, in this case, also, the pattern of the cost of capital reflects an almost similar trend with Rio Tinto. Cost of debt is considerably low (3%) and debt contains less than 20% of the overall capital structure. It may finally be noted that both the firms will have the benefit of expansion as the cost of capital for both the firms will be much lower than the industry players and hence they will be in better position n terms of long-term financing, expansion strategy and costing and budgeting.
Income tax plays an important role in determining the WACC for a firm and hence it would be relevant to discuss the impact of income tax on the WACC of both the companies so computed in the previous sections of the report. Such an impact has been briefly discussed in the sections below.
Since the calculation of the cost of debt considers the impact of the tax, it may be noted that income tax influences WACC to an extent. In the case of Rio Tinto, the tax rate is 31% which may be calculated from profit before tax and income tax expenses. However, the cost of debt is basically multiplied by 69% (i,e, 100%-31%) to arrive at a post-tax cost of debt which is ultimately considered to be the final cost of debt. Had it not been done, the cost of debt would have shown a higher value and consequently the WACC would have been more.
In a similar manner, the Wesfarmers’s WACC may also be stated to be influenced by the respective income tax, which is also eventually 31%. Therefore, it may be finally concluded that the income tax rate helps the firm to reduce its WACC to the extent of benefit of the tax rate. In other words, the taxed part of finance cost is excluded for the computation of WACC as the firm may get the average benefit out of the same and hence does not affect the capital cost for the firm.
In this section of the report, the stocks of both the companies have been valued using a discounted cash flow approach using dividend discount model (DDM) and relative valuation approach using P/E ratio. In this context, it is to be noted that such valuation has been undertaken only on the basis of 2017 share price related data.
Share value under DDM comes out to be AUD 102.79 whereas the share price as on 31st December 2017 stands at AUD 72.04. In other words, the share of Rio Tinto is also construed to be undervalued with high potential of subsequent growth in future. In terms of P/E, the same for the firm is 14.69 that have been discussed subsequently (ASX, 2018).
Share valuation under DDM shows that the company’s share is currently undervalued to the extent of AUD 2.40 (i.e AUD 28.04 – AUD 25.64). In other words, the share price is expected to increase by AUD 2.40 in coming days (ASX, 2018). As far as P/E is concerned, the same for the firm is computed to be 10.07 which is lesser than Rio Tinto suggesting lesser growth prospect in the market than that of Rio Tinto.
Based on the valuation so obtained in the preceding sections of the paper, necessary recommendations have been provided herein. Since both the share is asserted to be undervalued in the market, t may be advised to invest in both the shares. However, an analysis into the P/E of both may reveal that Rio Tinto is more attractive to the investors with higher P/E and therefore, it may be recommended to invest in Rio Tinto for the time being.
Though the quantitative factors like cost and return play a major role in the investment decisions of the prospective investors, however, the qualitative factors like risk and testes and preferences also critical determinant in the situation. The investors assess the risk of investment as well by referring to the volatility of the stock with the market which may be best explained through beta. On the other hand, the deviation of return of the stock from a standard benchmark within the return stream of the stock itself may be another way of assessing the risk. The said process assumes a standard deviation of the stock in rendering the assessment about the deviation. It is needless to mention that market end and choice and preference framework of the considers will also be significant in terms of movement of stock price in near future and fall of top-line of the firm because of bad reputation and brand failure.
As mentioned herein, the standard deviation measures the volatility of the stock with reference to its return for a specific period. On the other hand, beta measures the stock volatility with reference to the market. In other words, the degree of movement of stock for the movement of market index is captured in beta, whereas, standard deviation considers the fluctuation of the stock price in a certain time period (Yahoo Finance, 2018). It does not refer to the market data and hence may not be convincing enough for the investors as this may lack current scenario in the stock market. Hence, beta may be considered to be a comparatively better measure of risk than the standard deviation (Basil, 2016).
Conclusion
The analysis and discussion performed in the report compel the researcher to come to a concluding statement that the financial statement analysis is a critical operation in terms of consideration of lots of variables. Though there has been a number of options and approaches available for the researchers and stakeholders as well to evaluate the financial performance of the company, there lies the inherent limitations of these methods as well. c most of the techniques or approaches are based on the financial data reflected in the annual reports which are by nature, historical and therefore, may not provide the current picture in terms of inflation or recession or even the present market trend or psyche of the investors. In addition, it may also be observed that financial data does not consider the non-financial elements like the significance of human resources, industry trends, customers’ choice and preferences and Government regulations etc. Therefore, the analysis and recommendation based on financial data only may not provide a complete solution for the firm in the long-term. However, considering the importance of such analysis, it may be construed that the same surely gives a platform for the managers to decide on the issues, concerns, inefficiencies and act accordingly. Finally, it may be concluded that a well-thought business strategy coupled with the consideration of both financial and non-financial elements of the firm will surely contribute towards the organizational goal of attainment of sustainability in the industry in the long-run.
References
Annual Report 2017. (2018). Retrieved from https://www.riotinto.com/documents/RT_2017_Annual_Report.pdf
Annual Report 2017. (2018). Retrieved from https://www.wesfarmers.com.au/docs/default-source/reports/j000901-ar17_interactive_final.pdf?sfvrsn=4
ASX. (2018). Retrieved from https://www.asx.com.au/asx/share-price-research/company/RIO
ASX. (2018). Retrieved from https://www.asx.com.au/asx/share-price-research/company/WES
Basil, S. (2016). STOCK VALUATION BY USING PRICE EARNING RATIO (PER) IN STOCK INDEX LQ45. Adbispreneur, 1(2). doi: 10.24198/adbispreneur.v1i2.10236
Yahoo Finance. (2018). Retrieved from https://finance.yahoo.com/quote/RIO.AX/history?p=RIO.AX
Yahoo Finance. (2018). Retrieved from https://finance.yahoo.com/quote/WES.AX/history?period1=1479839400&period2=1511375400&interval=1d&filter=history&frequency=1d
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