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Running head: INVESTMENT ANALYSIS

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Kerri A. Gentz 7-1 Final Project: Investment Analysis SNHU October 11, 2019

INVESTMENT ANALYSIS

2 Client analysis

Investment refers to the act of committing funds in the present moment in a particular form with an expectation that in future, the act will gain some returns (Gillet & Salaber-Ayton, 2017). Investment has the likelihood of having a variation of the actual return deviating from the expectation from minimum to maximum. The deviation is known as investment risk. Therefore, any investment has risk and return (Meissner, 2018). The type of investment will determine what the investor can earn and how much additional monetary value they can gain in form of financial assets. Financial assets have three main characteristics namely liquidity, risk and return. Return is the gainful reward of an investment, risk is the variation of the return from the expected while liquidity refers to the ease of converting assets into cash. Age of an individual is an important consideration when constructing a portfolio of an individual (Aliu & Dehning, 2017). Different age have different investment strategies. Risk tolerance is another important factor that needs to be consider. Both the future and current needs of capital of an investor and the risk tolerance will determine the investment allocation of the portfolio among various asset class. The risk/return principle trade off applies for the fact that the higher the risk, the huge the return on the investment while lower returns is associated with lower risk. Determining an efficient asset allocation will require a careful analysis of the client’s nature. Ezra, currently at the age of 26 is single and planning to get engaged and she will thus require an engagement ring costing $5000 almost immediately. Ezra also requires $10000$15000 in the next period of 12-24 months that will be used to finance the wedding. Ezra is currently employed and earns $70000 per annum that is expected to cover his normal living expenses and taxes that is approximated to be $4800 and he expects to save $1000 per month as

INVESTMENT ANALYSIS

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savings. At the current moment to date, he has saved at least $15000 using the 401K plan with a cash savings amounting to $20000. Risk tolerance Ezra has a higher risk tolerance because of his young age and because he is employed, investment is not a requirement that it becomes his income source (Gillet & Salaber-Ayton, 2017). The tolerance level of Ezra is moderate to high as indicated by his plan on losing at least 30-40% of capital invested if higher returns are offered. This means that based on the investment he has made, he expects a higher returns. Ezra is not planning for his risk tolerance to adjust after getting married. The liquidity of Ezra is low due to the higher amount of cash he saves and the fact that he does not have so much expense to cover. Therefore, we conclude that Ezra should be classified under the capital and growth preservation category. Ezra is thus classified under the asset preservation category since he is willing to increase his bank savings account just as a precaution of what may happen at his place of work. He is not risk taker since he does not have any plan of investing in equities and stock which are mostly growth investments. Jacob and Rachael are nearing age of retirement and they are probably more concerned about how to protect their asset and getting incomes from their investments in manner that is tax efficient. Rachael and Jacob are aged 52 and 53 and married with four children. The have a responsibility of paying for their two children college fees and also the two high school kids expected to join college whose college fees are expected to be catered for. The parents still live below their means despite doing relatively better for themselves and earning about $190000 per annum. The college expenses for their children need to be covered out of their pocket and they won’t have enough that they could save for themselves in the next 6-8 years. Based on the above information, the clients can thus be classified as having moderate risk tolerance. The clients have

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less cash for savings as evident in their increased expenses of college fees paid from their pockets and hence riskier investment cannot be afforded. The investment to be undertaken should have a higher liquidity that will allow them to be easily be converted to cash when need arises. Jacob and Rachael cannot afford to have a less liquid investment since they have a lot of expenses to cater for. According to the analysis done on the client, Jacob and Rachael do not need a higher returns but instead will prefer investment that would be provide income to them. A moderately aggressive portfolio is what will satisfy Rachael and Jacob’s average risk tolerance while a balance of income and the capital growth would be achieved. The investor would be classified as growth and income categories since they require investment to be a source of income while they are planning to earn income during their period of retirement (Jarrow, 2018). Stock analysis Symbol

IBM ORCL MMM NFLX GE

Estimate

Dividend

Earnings

Sales

Free cash

5 year

Average

Average

Free cash

d beta

s per

per share

per

flows per

dividend

industry

industry

flow

0.86 1.1 0.98 1.57 1.12

share 5.6 0.6 4.505 NONE 0.93

12.38 2.21 8.16 0.43 0.89

share 83.52 9.17 50.44 22.14 13.50

share 13.36 2.86 7.78 -3.61 -0.82

growth 4.6% 21.1% 7.0% N/A 6.3%

PE ratio 23.7 20.5 23.8 52.5 23.8

P/S ratio 1.12 4.45 2.59 6 2.59

growth 2.6% 10% 7% N/A N/A

IBM Value of IBM = Cash flow model of valuation will be used in valuing IBM

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Calculated as free cash flow per share/current market price per share = 13.36/153.83 = 8.68% The method was selected because of the firm’s higher free cash flow per share indicating an outstanding performance The stocks expected return is calculated as 0.75% + (0.86*9%) = 8.49% ORCL The value of ORCL is determined using the model called dividend valuation Dividend valuation model of valuation = Dividends/1+g = 0.6/1.211 = $49.55 The selection of the method was because the firm had a high 5-year dividend growth. The value of the firm will be dependent on the calculation of the dividends since the firm is attractive due to the high dividend level. A low payout ratio makes the method more appropriate Expected return = 0.75% + (1.1*9%) = 10.65% MMM The value of the MMM can be calculated using the free cash flow model of valuation Value of the firm = Free cash flow per share / current market price per share = 7.78/208.19 = 3.74% The method was selected because of the firm’s outstanding performance as indicated by the free cash flow per share.

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Expected return = 0.75% + (0.98*9%) = 9.57% NFLX Value of the company was calculated using the price multiples Value of the firm = price / sales per share = 149.41/22.14 = 6.74 This method is appropriate for the company because of the company’s negative free cash flows and therefore, the company could have been undervalued had the free cash flow method of valuation had been used. The capital of the firm expenditure are higher than the firms operating cash flow. PORTFOLIO DEVELOPMENT A 0.2 value of similar weights for the investments would be assumed. The portfolio of Ezra is as follows:

Symbol

NFLX

Estimate

Standard

Weight

d Beta

Deviation

1.57

42%

0.2

IWM

1.15

16.50%

0.2

EFA

1.03

15%

0.2

EEM

1.09

20%

0.2

ORCL

1.1

15%

0.2

Expected return = Risk free rate + (Beta * market risk premium)

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Market return = 9% Risk free rate = 0.75% Expected return = [14.88% + 0.75% + (1.15*9%) + 0.75% + (1.03*9%) + 0.75% + (1.09*9%)]/4 = (14.88%+11.10%+10.02%+10.56%+10.65%)/5 Expected return=11.44% Standard deviation of the portfolio = ω1×σ1 + ω2×σ2+ …..ωn×σn =21.7% Portfolio of Rachael and Jacob

Symbol

Estimate

Standard

d Beta

Deviation

IBM

0.86

18%

SPY

1

13%

MMM

0.98

16%

LQD

-0.02

5.25%

HYG

0.38

7.50%

Expected return = Risk free rate + (Beta*market risk premium) Market return = 9% Risk free rate = 0.75%

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Expected return = [8.49% + 0.75% +(1*9%)+ 0.75%+(0.98*9%)+ 0.75%+(-0.02*9%) +0.75% +(0.38*9%)]/5 = (8.49%+9.75%+3.74%+0.57%+4.17%)/5 Expected return=5.34% Standard deviation of the portfolio = ω1×σ1 + ω2×σ2+ …..ωn×σn =11.95% Performance of the portfolio Based on the analysis provided, I recommend that recommendations should be based on the beta of the assets. A security having a beta of more than 1.0 means that the security has a higher risk compared to the market and hence higher returns are expected. Lower return securities are expected to generate a relatively lower returns. The portfolio of Ezra have a higher risk and hence higher returns should be expected while portfolio of Rachael and Jacobs have lesser risks.

Portfolio of Ezra

Symbol

Return

Standard Deviation

NFLX IWM

18% 14%

45% 18%

INVESTMENT ANALYSIS EFA

9%

15%

EEM

-1%

19%

ORCL

2%

16%

Standard deviation of the portfolio = 22.6% Average return = 8% Rachael and Jacob’s portfolio

Symbol

Returns

Standard Deviation

IBM

8%

20%

SPY

9%

11%

MMM

6%

14%

LQD

7%

6%

HYG

8%

8%

Average = 8% Standard deviation of the portfolio = 11.80% Portfolio standard deviation=11.80%

Portfolio of Ezra = 8%/22.6%= 0.354

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INVESTMENT ANALYSIS

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Portfolio of Rachel and Jacob =8%/11.80%= 0.678

Benchmarks

Return

Standard Deviation

Growth

9.6%

13.1%

0.733

Income

8.1%

10.2%

0.794

Capital Preservation

5.8%

7.2%

0.806

Treynor ratio=

Average return− Average risk free rate Beta

Portfolio of Ezra = (8%-0.75%)/22.6%=0.321 Portfolio of Rachel and Jacob = (8%-0.75%)/11.80%=0.614 The Jensen’s measure is used to determine the excess return in Alpha and it is measured as actual return less expected returns Portfolio of Ezra = 8%-11.4%=-3.4% Portfolio of Rachel and Jacob = 8%-5.34%=2.66

INVESTMENT ANALYSIS

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References Aliu, F., Pavelkova, D., & Dehning, B. (2017). „Portfolio risk-return analysis: The case of the automotive industry in the Czech Republic “. Journal of International Studies, 10(4), 7283. Gillet, P., & Salaber-Ayton, J. (2017). The recent development and performance of ethical investments. Routledge. Jarrow, R. A. (2018). Portfolio Optimization. In Continuous-Time Asset Pricing Theory (pp. 409423). Springer, Cham. Meissner, G. (2018). A Correlation-Based Portfolio Performance Measure. The Journal of Investing, 28(6), 19-26.

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