Technical Report Analysis
Introduction
Most of the companies and firms are utilizing the financial market in determining and predicting the status as well as the progress of specific firm. The most common of these approaches is the fundamental analysis which involves the evaluation of stock by examining the company’s financial and operation conditions (Edwards, 2007) Nevertheless, there is the technical analysis that has also the significance effects and sometimes used by the financial analyst. Primarily, the goal of this paper is to analyze the case study and to determine whether Bill Miller can still be considered by other investors.
Overview of the Case
The case study was about the remarkable performance record of Value Trust which is a mutual fund managed by William H. "Bill" Miller III at Legg Mason, Inc. Herein, the case has been able to describe the investment style of Miller, whose record with Value Trust has been able to beat the S&P 500 14 consecutive years. It can be said that Miller’s approach to financial management has enabled Value trust to meet and reach its organizational objectives. One of the most renowned professional fund managers is Bill Miller. Such can be proven on the outgrowing of the Value Trust against its benchmark index, S&P 500. 14 years of gaining positive result has marked the longest competitive streak of success among all the managers in the mutual-fund industry.
The case shows that in the mid-2005, Value Trust has been noted to be worth .2-billion. The approach of Bill miller to managing investments was considered to be research-intensive as well as highly concentrated. For example, nearly 50% of Value Trust’s assets have been invested in just 10 large-capitalization firms. On the other hand, most of the investments of Miller were noted as value stocks, and he was not reluctant in considering large positions in the stocks of growth industries. In this regard, it can be said that the investing style of Miller is considered as iconoclastic. Mutual fund is known to be an investment tool which pooled the funds of specific investors to purchase portfolio of securities, bonds, stocks as well as money-market instruments to achieve the objectives of specific investors. Herein, the investors owned a pro rata share of the entire investment portfolio (Bruner, 2007). With this, the different investments included in portfolios of the funds are being handled by professional money managers in tamers of the stated investment policy of the fund. The work of Miller focused on this approach to reach competitive advantage in the mutual-fund industry.
Valuation approaches
For the investors to choose the company that will be worthy of the investment, the investors may use the Payback approach or payback period. The payback period is the number of years needed to return the original investment from the net cash flows (net operating income after taxes plus depreciation). This is where the considerations of two investment propositions; Value Trust A (for the first investment option) and Value Trust B (for the second option) will take place with the computed cost of capital or the hurdle rate which is 12%.
If the investor has the policy of employing payback period, which means that, which ever Value Trust has the minimum years of having the investment or the cost of capital back, that Value Trust will be accepted for investments. The advantages of the payback period are that, it is easy to calculate, however wrong calculations may lead to wrong decisions. The output of this approach will determine the number of years the capital investment will be returned that will be the basis of the investor’s decisions. Another advantage of this approach is, it put more emphasis to quick return of the invested fund so that this fund may be used again in other places or for meeting other needs; moreover this approach is easy to apply and simple to understand.
However, the approach does not consider post-payback cash flows and does not include the time value of money which is also essential in decision making. Moreover, another disadvantage of this approach is, it does not explicitly consider risk and the "acceptable" time period is just arbitrary. Without these things, the investor might make wrong decision that may pull their business or stocks back from scratches.
Financial valuation
In choosing the most appropriate investment approach that would enable the investors to gain profit, it is also essential to give consideration to evaluate a company’s financial status. The ideal financial valuation approach should include all cash flows that occur during the life of the Value Trust, consider the time value of money, and incorporate the required rate of return on the Value Trust. Thus, the rate of return or the hurdle rate is required in order for a Value Trust to be acceptable. The hurdle rate is the most appropriate to use when evaluating financial investments. More often than not, the hurdle rate is the opportunity cost of investment capital, known to be the rate of return that can be earned on the next best alternative investments. Hence, acceptable Value Trust should be able to hurdle over, that is, be higher than the accepted rate.
The rate must take into account with two key factors. First, a base profit to compensate for investing money in the Value Trust. Money can have a variety of opportunities to be useful which means that money can be used in many ways, for example; cash can be used to pay bills or vendors, make additional capital investments or earn interest income if invested in safe short-term investments. The second element concerns risk. Any time we enter a new investment; there is risk is always at stake. Perhaps the Value Trust might not work out exactly as expected. The Value Trust may turn out to be a failure. Through this, the investor has to be paid for being willing to undertake these risks. The two elements taken together determine our hurdle rate.
Determining the hurdle rate is very essential for investors depending on how they perceive it. The hurdle rate for an investment can also be called the firm’s cost of capital. The cost of capital for a company should reflect the financing mix that it uses to finance its investments. Firms finance their investments by raising funds from creditors and equity investors. In addition, managers can also use hurdle rate to evaluate potential investment opportunities and to reevaluate at regular intervals the company’s existing investments. Also, by knowing its cost of capital a firm can explore various ways on financing a Value Trust. The estimation of a firm’s cost of capital must be forward-looking and must be useful to reduce future cash flows.
The company’s cost of capital must belong to weighted-average of all sources of capital since free cash flows are available to all providers of capital. Furthermore, it must be calculated on an after-tax basis since the free cash flows are nevertheless, after taxes. The company’s cost of capital must be adjusted also for the systematic risk that each provider of capital bears, given that they expect to be compensated for taking that risk.
Suppose, that the Value trust has a maximum capital budget of 0, 000 for the coming year which is assumed to utilize 12% hurdle. Considering purchasing a new assault course training, there are two options that under consideration Value Trust A which offers an estimated cost of 0, 000 and Value Trust B offering an estimated capital cost of 0, 000. As we look at the capital, it is quite amusing to purchase at first option since the capital cost is lesser than the capital cost of the second option.
However, to come up with the right decision the two options were set into different test as for the forecasting of which best to invest. Using the hurdle rate, we come up with the result that in the second option the capital cost can easily be reached if the hurdle rate each year will be 12%. As presented in the result, at the first year of the second option, as it reaches the hurdle rate of 12% that year, the calculated investment is 6, 800.00 that is above the capital cost. On the other hand, for Value Trust A, it gained 8, 000 which is also above the capital cost for that Value Trust. Analysis also shows that in first option, the investors. has to wait for more than 4 years first, in order to reach the maximum budget capital, unlike on the second investment option. Numerically, it can be seen that when the investors chooses to invest in the second option, it can reached the maximum budget capital or even higher than that for just a year.
Using the payback approach, if the investors have set 6 years of limit for each Value Trust, analysis shows that both Value Trusts will tend to fail. It was shown that the payback period for Value Trust A is 7.6 years that is almost 8 years. On the other hand, on Value Trust B, the payback period is 6.9 years or almost 7 years of payback. Both Value Trusts have exceeded the given limit of payback.
Recommendation
Having a year payback period approach is good. Through this, investors can easily determine if the investment to make is acceptable or not. The investors to Value trust which use this approach will be able compare the payback calculation to some standards, set by the firm itself. In addition, if senior management had set cutoff years for Value Trusts, this will be a useful base for a good decision making. Based on the findings, it is better to choose Value Trust B in investing for the new assault training equipment. With the hurdle rate of 12%, Value Trust B, will be able to return the capital cost easily. Although, Value Trust B didn’t passed the 6 years payback period, still it has the minimum payback period that is close to 6 years.
Every business must assess where to invest its funds and regularly reevaluate the quality and risk of its existing investments. Investment theory specifies that firms should invest in assets only if they expect them to earn more than their risk-adjusted hurdle rates. Knowing a business’ cost of capital allows a comparison of different ways of financing its operations. For example, increasing the proportion of debt may allow a company to lower its cost of capital and accept more investments.
Moreover, it is also significant to know the cost of capital so that a company will be able to determine its value of operations and evaluate the effects of alternative approaches. In value-based management, a business’ current value of operations is calculated as the present value of the expected future free cash flows discounted at the cost of capital. This analysis is useful as a guide in decision making as well as for Value Trusting future financing and investing needs. Furthermore, the cost of capital is also used in the computation of economic value added. Economic value added is useful to the managers of the company as well as to external financial analysts. It is the measure of the economic value created by a company in a single year. EVA is computed by subtracting a capital charge (operating invested capital multiplied by weighted average cost of capital) from after-tax operating income.
Thus, financial theorists agree that using a correct risk-adjusted discount rate is needed to analyze a company’s potential investments and evaluate overall or divisional performance. Risk-adjusted discount rates should incorporate business and operating risk as well as financial risk. Business risk is measured by the nature of the products and services that the business provides (discretionary vs. nondiscretionary), the length of the product’s life cycle (shorter life cycles create more risk), and the size of the company (economies of scale can reduce risk). Operating risk is determined by the cost structure of the firm (higher fixed assets relative to sales increases operating risk). Financial risk is determined by a company’s level of debt. For example, industries that exhibit high operating leverage and short life cycles, and have discretionary products such as technology, have very high beta measurements. Borrowing money will only exaggerate the impact of the risk.
Computation
To compare which Value Trusts options is best suitable for the investors, the hurdle rate for six years and the payback period were used.
Hurdle Rate
6-Year Forecast with the Hurdle Rate of 12%
Year
Value Trust A
Option 1
Value Trust B
Option 2
1
448, 000.0
716, 800.0
2
501, 760.0
802, 816.0
3
561, 971.2
899, 153.9
4
629, 407.7
1, 007, 052.0
5
704, 936.7
1, 127, 899.0
6
789, 529.1
1, 263, 247.0
In order to get the 6-year forecast with the hurdle rate, we multiply the cost of capital to the hurdle rate and added the cost of capital for the previous years. Hence we have the following computation:
Value Trust A
Capital = (400, 000 * 0.12) + 400, 000
= 448, 000
Capital2 = (448, 000 * 0.12) + 448, 000
= 501, 760
Capital3 = (501, 760 * 0.12) + 501, 760
= 561, 971.2
Capital4 = (561, 971.2 * 0.12) + 561, 971.2
= 629, 407.7
Capital5 = (629, 407.7 * 0.12) + 629, 407.7
= 704, 936.7
Capital6 = (704, 936.7 * 0.12) + 704, 936.7
= 789, 529.1
Value Trust B
Capital = (650, 000 * 0.12) + 650, 000
= 716, 800
Capital2 = (716, 800 * 0.12) + 716, 800
= 802, 816.0
Capital3 = (802, 816.0 * 0.12) + 802, 816.0
= 899, 153.9
Capital4 = (899, 153.9 * 0.12) + 899, 153.9
= 1, 007, 052
Capital5 = (1, 007, 052 * 0.12) + 1, 007, 052
= 1, 127, 899
Capital6 = (1, 127, 899 * 0.12) + 1, 127, 899
= 1, 263, 247.0
Payback Approach
Forecast profit / (loss) after depreciation and before taxation
Year
Value Trust A
Value Trust B
0s
0s
1
113
-57
2
73
-57
3
53
43
4
13
93
5
13
213
6
50
323
315
558
Depreciation is charged in equal annual installments over the useful life of the asset
The net cash flow summary was presented in the table and to calculate the payback period we have the following formula:
Payback period = Investment/Annual cash flow
The investment for Value Trust A = 400, 000
The investment for Value Trust B = 640, 000
The annual cash flow for Value Trust A is equal to 315, 000 / 6 = 52, 500
The annual cash flow for Value Trust B is equal to 558, 000 / 6 = 93, 000
Payback period for Value Trust A
Payback period = 400, 000 / 52, 500
= 7.6 years
Payback period for Value Trust B
Payback period = 640, 000 / 93, 000
= 6.9 years
Conclusion
With the 14 streak of outperforming their rivals, it can be concluded that Value trust through Bill Miller is still at par with their competitors, in this regard, it can be said that investments should invest in value trusts. By using different valuation method, and considering options for the investors, the investors can easily choose whether they will invest or not.
Reference
Edwards, R et. al. 2007, Technical Analysis of Stock Trends, CRC Press, United Kingdom.
Credit:ivythesis.typepad.com
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