Economy – Industry – Company Analysis

You are an investment analyst for a large broking firm. A client, Johnnie Carter, has just contacted you, asking for advice on an appropriate stock to invest in.
Client’s financial position:
Johnnie has just retired from his Australian public life (albeit a bit bitter about the whole affair!) and was entitled to a privileged superannuation package. So, he is still very thankful to Australia for this.
Johnnie currently owns a diversified portfolio, consisting mostly of stocks in companies which are run by his ‘used-to-be’ mates and a smaller amount invested in bonds. The total portfolio is worth $2,000,000. In addition, he has just got his book published and the publisher has kindly given him a $30,000 royalty. He would like to put this money into his investment fund as well. Johnnie likes to invest his funds in high dividend stocks if they appear to be undervalued. His investment horizon is ten years and he has no near-term liquidity requirements.
Undertake a top-down, economy-industry-company analysis to identify an appropriate stock for Johnnie to purchase. You will first need to analyse economic and industry information to identify an industry which you expect to perform well in the future. Once the industry is selected you will need to identify a firm operating in that industry which is fairly priced or undervalued.
Calculation of intrinsic value:
Intrinsic value should be estimated using both the dividend growth model and the P/E ratio. Remember to consider whether the forecast short-term growth rate is sustainable. Web sources such as the ASX, Tradingroom and Yahoo finance (see unit outline for addresses) will provide you with information such as current share price, past and estimated future earnings, dividends and growth rates. Databases accessible from the Murdoch library, such as Factiva and FinAnalysis (see over for instructions) also provide company information including financial ratios, growth forecasts and betas.
You will need to use the CAPM to estimate the required return on equity: ke = rf + ? (Rm – rf). To estimate the risk-free rate you need to use the rate offered on a security that has minimal risk. No security is totally risk free, and there is no agreement in practice or in the literature as to which traded security provprovides the best proxy for the true risk free rate. Therefore, you must justify your choice(s). Several securities with a close to risk free return are reported in the financial press.
The return on the market portfolio is not observable. Return on an equity market index is commonly used as a proxy for the market return. You must justify your choice. Remember that the market return includes both capital growth and return from dividends. Therefore, in principle you should use an accumulation index, not a price index. The accumulation index can be obtained from the database of the Reserve Bank of Australia. Remember that you are using historical returns to estimate future returns. You are also required to use the latest data in your analysis.
Write a professional looking report for Johnnie, detailing your recommendation.
Your report should include an analysis of the current economic fundamentals and a justification for your choice of industry given the economic indicators. This should address both the positive aspects and any potential threats to potential performance.
You should then justify your choice of stock. Include a brief outline the firm’s operations and its expected performance given expected economic and industry conditions. The actual calculation of intrinsic value should be included in an appendix, along with justification of assumptions made when estimating the intrinsic value.
The report should not exceed 2,000 words plus a two page appendix. The body of the report should be self-contained, while the appendix should provide further detail for interested readers.
The appendix should include one page detailing any difficulties / assumptions plus one page of data, including your calculation of the cost of equity and intrinsic value.
The page of difficulties / assumptions is required because real-world data often appears to be contradictory. Where this is the case you need to decide which data to use in your analysis. Alternatively, you can undertake the analysis using alternative sets of data, depending on which course of action is appropriate in the circumstances. I do not expect every group to use the same assumptions. I do expect your assumptions to be reasonable and for you to justify them.
The company chosen has to be undervalued