The paper 'Stock Analysis and Risk Evaluation' is a worthy example of a research paper on finance and accounting.
The research below explores the main methods of stock analysis and risk evaluation. Risk analysis is related to the risks of investments in particular stocks. Three models are considered in the research – DCF, comparative valuation, and Gordon growth model. The last model has been applied to three firms (Walt Disney, Wal-Mart and McDonalds) to define a fair price for their stocks. The most undervalued company has been identified as the best option for investments at the moment.
Literature review on stock analysis and risk evaluation
The task of the research paper is to analyze the performance of stocks of the following companies – McDonald's, Walt Disney and Wal-Mart. The task can be divided into tactical objectives. First of all, the dynamics of the companies shares for the last years should be monitored. Second of all, the price for the stock should be determined, using the different valuation techniques. These techniques are going to be the following: DCF, comparative valuation, and the Gordon growth model. The main question that has to be answered in the research is the following: whether investors should continue investing in the companies’ shares. In general, a fair price for the companies’ shares must be defined. Basing on this fair price, it will be possible to judge whether the price is overvalued or undervalued. In turn, this should be the basis of whether an investor should invest in such shares. If the share is undervalued, it is an indicator of making effective investments.
That is why some theoretical definitions and concepts should be provided. First of all, we have to define the term “fair price”. In our opinion, one of the most appropriate definitions of this term is the following. It is the price of a company’s common stock that represents the real value of the company (assets, financial assets, etc) and future cash flows from the company’s performance.
There are a lot of methods to calculate the fair price of a company’s stock. Two of them will be used in this research paper: discounted cash flow (DCF) and peer (comparative valuation) methods. These are the most popular and widespread methods of evaluation of fair prices for shares. A formal definition of the DCF method may be the following.
“DCF method is a valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one” (DCF Definition).
Thus, the DCF method reflects the essence of the fair price of a company’s stock – a reflection of the range of future cash flows from a company’s performance. This method is more difficult for calculations, but it reflects a company’s fair price more precisely.
“Comparative valuation technique is a valuation theory based on the idea that similar assets sell at similar prices. This assumes that a ratio comparing the value to some firm-specific variable (operating margins, cash flow, etc.) is the same across similar firms” (Comparative Valuation Definition).
The second method is based on the principle that a company should have the same market capitalization as similar companies. That is why financial indicators of these companies are compared and then a fair price is calculated. The most difficult task, in this case, is to choose the right peers.
All the mentioned techniques are used to define a fair price for a company’s shares. However, they need a lot of information to reach a goal. That is why the Gordon growth model is going to be used in the case under consideration. The explanation of this model will be provided in more detail later. Now, it is time to explain the risks, associated with investments in stocks.
The main risk of investments in stocks is the risks that these stocks may be overvalued. It means that they cost more than their fair value. Usually, such a situation is caused by significant and speculative demand for shares. However, in the end, the market will eliminate such a situation and the price will fall. Thus, investors may lose their money. Also, there is a risk of bad timing. It means that an investor chooses the wrong moment to buy a stock. As a rule, it happens, when a stock reaches the peak of its price. The following dynamics will be associated only with a decline. Therefore, it will be impossible to gain some profits in such a situation. Thus, it is very important to choose the right moment, when to enter a market.
The next task will be to analyze the overall dynamics of the companies’ shares. Information about the dynamics can be got from the public and readily available sources. Also, such information is provided in the companies’ financial statements. The dynamics of Walt Disney’s shares are provided on the following graph.
The company has been demonstrated really positive dynamics of shares for the last 10 years. It is a reflection of the positive financial results of the company. Investors monitor such positive financial results and trust their money to the company. In turn, growing trust even increases the prices for shares. Therefore, it is an interdependent process. The dynamics of McDonalds’ shares are presented in the graph below. This company also has been demonstrated positive dynamics. However, the degree of growth is less.
Finally, the dynamics of Wal-Mart’s shares should be analyzed. These dynamics are practically similar to the previous company. Both previous have been demonstrated stable dynamics for the last ten years. The risks associated with investments in them are low. This opinion is going to be proved by further calculations below.
The dynamics of the company’s shares have been considered in the previous question. In order to evaluate the degree of attractiveness of investments in each share, their fair value and Beta coefficient must be calculated. It is also important to define their correlation with the overall market. This correlation can be calculated, using the instruments of Excel. S&P 500 is going to be used as an indicator of the overall dynamics of the market.
Finally, a fair price for the company’s shares must be calculated, using the Gordon growth model. This model defines a fair price for a share, taking into account the expected return on equity and dividends. The formula for calculation of a price, according to Gordon growth model is the following:
P = D/(k-g), where D is expected dividend per share a year from now, k – required rate of return and g is a growth rate of dividends. All the calculations have been conducted in the previous parts of the research. They are provided in the Excel file.
The degree of correlation of Walt Disney with the market is 0.78, McDonalds – 0.5, Wal-Mart – 0.3. Therefore, all the companies are characterized by a relatively low degree of correlation with the market. It is important to calculate the so-called Beta-coefficient. Beta demonstrates the shares’ reaction to the overall dynamics of the market. For instance, if the beta is 1.2, it means that a share will demonstrate a higher pace of growth than a market and vice versa. The Beta coefficient can be also calculated, using instruments of Excel.
Thus, the beta for Walt Disney is 1.15, for McDonalds – 0.51, Wal-Mart – 0.33. Thus, Walt Disney is the riskiest share.on the other hand, these shares can bring significant capital gains in the case of growth. The two other companies are more conservative. Investment in these shares are characterized by lower risks, but the lower potential rate of return in turn.
According to the Gordon growth model, a fair price for McDonald's is $97.84, Walt Disney - $107.94, Wal-Mart - $78.11. The current prices of all the shares are lower. It means that all the companies are currently undervalued. The most undervalued company is Walt Disney. The potential for the price’s growth is more than 300%.
Conclusions and recommendationsAll the shares are currently undervalued. Therefore, it is possible to gain capital gains via investing in all the companies. However, the Walt Disney company is characterized by the highest potential for growth – more than 300%. On the other hand, this company is also really risky for investments. It can bring significant losses for an investor in the case of decline. Two other shares are more conservative. However, they are characterized by a lower possible return. The best investment strategy would be to combine investments in all the companies for the purpose of balancing the risks and potential returns. The greatest share of investments must be invested in Walt Disney’s shares. We believe that proportion is going to be about 50%, 25%, and 25%. Such a proportion is going to minimize risks and maximize potential returns.
Comparative Valuation Definition. Retrieved April 24, 2015, from http://www.investopedia.com/terms/m/multiplesapproach.asp#axzz2DRucPQxw
DCF Definition. April 24, 2015, from http://www.investopedia.com/terms/d/dcf.asp#axzz2DRucPQxw