Financial Instruments and Markets - Assignment Example

Part A: Equity Markets

Question One

Secondary offering leads to share price fall. Theoretically, the issue of new ordinary shares dilutes the ownership stake of the existing shareholders. This means that they have diminished influence over major events. Increased shareholding threatens to slow the growth of the earnings. A Higher number of shares reduces the earnings-per-share (EPS). Earning-per-share is considered by investors as a proxy for stock performance. While the issue of new shares brings more capital to the capital which can facilitate growth and encourage more income generation, investors focus on returns that they get from each individual shares that they hold. The increase in the capital base of the company dilutes, the earning of the company by spreading them among a high number of investors. Without having a strong case for boosting or maintaining EPS, the sentiment of the investor for a stock, which is subject to the prospective dilutive event will be negative. Therefore, the prospect of the share dilution, following the issue of new shares were expected to hurt the stock price of the Santos (STO).

Chart 1.0 indicates the actual effect of the issue of new shares by Santos

The performance of Santos Limited is contrary to my expectation. The company share price increased on the announcement day instead of decreasing. This could have been caused by good news about the company which overshadowed negative perception of the new issue. The company hired new CEO (Kevin Gallagher), there was management shakeup, and share price of the company was considered highly undervalued considering it had dropped significantly following continued fall in oil prices. The prospect for share price turnaround could have made the made the stock price to be high despite a theoretical expectation of low performance following new issue or ordinary shares.

Question Two

Currently, the ordinary common share price in Fortescue Metal Group (FMG) as at 5th Mya 2016 is $3.03. Chart 2.0 below shows the performance of the Fortescue Metal Group compared to the ASX200 market index

Chart 2.0 FMG and ASX 200 performance between January 2011 and May 2016

The graph indicates that the share price of Fortescue Metals Group Ltd has been very volatile over the period (from 2011 to 2016) compared to the ASX200. The price started at $5.4 in January 2011 which fell to $3.03 by 2016 representing a 43.89% fall. This was a dismal performance when compared to ASX200, which was trading at $4644.8 in January 2011, and was trading at $4931.5 on May 2016, representing 9.06% growth. While the ASX 200 price was stable between 20th January 2012 and 30th March 2012, the price of Fortescue Metals Group Ltd increased considerably which could have been caused by the good financial year 2011 financial report release. The stock price volatility started on 39TH January 2013 and until now the share price has not been able to get back to normal price. On the same period, the price of the ASX 200 has been considerably stable indicating that the mining industry (in which Fortescue Metals Group Ltd) operates has been relatively volatile compared to other industries.

Fortescue Metals Group Ltd cost of capital is 7.45%. 2015 dividend growth = 7.14% (0.04-0.03)/ 0.03). Using discounted dividend model (DDM) the value of the company’s stock would be:

DDM = D/ (r – dg) (where D is the dividend, r is the discounting rate, and dg is the dividend growth rate).

= 3.03 / (7.455 – 7.14%)

= $9.77

This shows that currently the stock price of Fortescue Metals Group Ltd is undervalued.

Question Three

The historical trend on Fortescue Metals Group stock indicates that the trend is rising. The stock hit its lowest price on 27th January 2016, where it was trading at $1.4. From this day until 6th of May 2016 the stock had appreciated by $1.73 to trade at $3.13, which represent a 123.5% growth over five months. The Average Directional Index (ADX) for the Fortescue Metals Group is 23.16 from March to May 2016. This shows that the strong has an average strength in its trend. The strength of the company’s trend indicates that it is more likely to be sustained to the end of the year 2016. The monthly Plus Direction Indicator (DI+) for the company is 31.64 while the monthly Minus Direction Indicator (DI-) for the company is 0.194. Given that the Plus Direction Indicator (DI+) of the Fortescue Metals Group is above the Minus Direction Indicator (DI-), it indicates that the current price momentum of the Fortescue Metals Group stock is up.

The moderate uptrend strength for the Fortescue Metals Group stock is an indication that its stock will have a higher price than it is currently traded at the end of 2016. The Monthly Slow Stochastic is 78.44 while the fast stochastic movement is Monthly Fast Stochastic is 75.79. a general concept of Monthly Fast Stochastic is that the K line and the D line should move between 80 and 20 where moving above indicates upward bearish momentum a trend that is moving from below 20 indicates an upside bullish momentum. In the case of Fortescue Metals Group, the trend is moving up and thus it is in an upside bullish momentum, and it is approaching the “overbought” point (80) which is expected to reach by the end of 2016. Using the technical analysis (mainly the trend line), I would expect the Fortescue Metals Group to close the year 2016 trading at $4.03. I would recommend buying the stock of Fortescue Metals Group. The recommendation means that the stock price will react all the insider and publicly available information in line with the market efficiency theory.

Question Four

• Brief Industry And Company Analysis

Some of the strengths of the Woodside Petroleum include it is the largest liquefied natural gas producer in Australia, has most active exploration initiatives in deep-sea, extensive expertise and experience in design engineering, has quality assets for oil and gas in some of the oil and gas basins, and it has a leading market in Australia with strong competitive position. However the company is facing legal challenges reading acquisition of land for the Browse natural gas, it has faced protests over its plan to establish James Price Point gas industry complex in Kimberley region, and encountered a failure of its oil mist detector in the Wood Side Petroleum’s Vincent oilfield.

Oil and gas industry is shrinking following fall of oil prices in international market. The company is facing increasing competition from such companies as ROC Oil Company and Sinopec. There is an increase in oil production from Shale plays destabilizing the oil price in Australia. On addition to this, there is a range of natural disasters experienced in Australia including floods, bushfires and cyclones that severely affect exploration activities. As such, the oil exploration industry is relatively volatile.

• Theoretical Price For The Woodside Petroleum Share

Dividend per share in 2015 = $1.3154

Dividend per share in 2014 = $ 2.63365

Dividend growth rate = (Divided 2015 – Dividend 2014/ Dividend 214) %

= ($1.3154 - $ 2.63365)/ $ 2.63365

= - 50.05%

Discount rate = RF + b (Mp)

(Where RF risk free rate (RBA cash rate), b is the beta for the Woodside Petroleum and Mp is the market premium).

RBA cash rate as at May 2016 = 2%

Woodside Petroleum beta (WPL.AX and ASX 200 returns slope) =

Market premium = 5%

Discount Rate = 2% + (1.21 * 5%)

= 8.05%

DDM = D/ (r – dg)

= $1.3154/ (8.05- - 50.05%)

= $ 22.64

• Investing in Woodside Petroleum share

Using the theoretical price as the fair value for the stock of the Woodside Petroleum Company, I would not consider investing in the company’s ordinary share. Currently, the share price of the company is $26.96. The discounted dividend model share price is $22.64 which is lower than the prevailing market price. This insinuates that the market price is overvalued. An overvalued share is good for making sell-decision as opposed to buy-decision. This is because it is more likely to fall in price to reach the fair value when the market stabilizes. The market share of the Woodside Petroleum indicates that there is noise in the market, or some events have influenced the company’s share to trade above its value, and as the news become irreverent in the market, the price will tend to normalize. This will be indicated by a downward trend that is expected for the Woodside Petroleum share. As buying the share of the Woodside Petroleum would lead to a loss of capital as the price is more likely to go down to its normal value ($22.64).

On addition to overvaluation, the current oil and gas exploration and energy industry is shrinking and is very volatile following the oil price volatility in the international market. There is the overproduction of oil spurred by American oil companies increased production, removal of Iran international trade barriers, and high level of exploration in many countries. Failure by OPEC members to agree on a benchmark price of crude oil further escalates the industrial performance. This means that companies operating in the oil and gas industry, such as the Woodside Petroleum, are not worthwhile to invest in. This is likely to affect the income generation of the Woodside Petroleum negatively. Low income will lead to low share price as many investors dispose it (causing low EPS) and cause a low appropriation of dividend per share. This means that the share will not have positive or considerable returns. As such, given the prevailing volatile and shrinking international and national oil market and prices, and overvaluation of the Woodside Petroleum share price I would not invest in the ordinary shares of the company.

Part B – Ethics

Volkswagen (VW) Emission Scandal

Volkswagen (VW) intentionally programmed controls in its TDI (turbocharged direct injection) diesel engines such that they made controlled emission during emission which was less than 40 times the normal emission of the vehicle. The control made the vehicle models with this cheating program to produce nitrogen dioxide that meets sets standards in European and the USA during the laboratory test but during the normal drive, the vehicles released more than 40 times more nitrogen oxide. The programming was installed in more than eleven million cars that were sold between the 2009 and 2015 model years.

Ethical business practices call for the management to exercise a duty of care and to ensure that the products offered on the market meet the description that they give. In the automobile industry, management is supposed to ensure that the fuel consumption, emission, security measures and all other vehicle features that are described by the manufacturer do not have any deviation from the real condition of the vehicle model that they concern. For the Volkswagen management, it was unethical to release vehicles with a cheating program that allowed them to emit more than 40 times the volume of nitrogen dioxide compared to the stated emission level by the company.

The installation of a cheating program might have been motivated by the raising concerns about environment protection ‘going green’. The management wanted to increase their sales level by offering a product that purports to meet the set environmental standards. I would prevent this from happening in the future by ensuring that the company has a strong research and development department that will facilitate production of environmentally friendly vehicles. On addition, I would require the management to abide by the company’s ethics standards and ensure that they release a truthful information regarding all the products of the company to prevent denting the image.

The stock price of Volkswagen fell by more than a third in immediate days following the new release. This indicates the bearish market sentiment for the stock of the Volkswagen. The Company’s scandal news is a negative news to the market, which negatively impacts on the prices of the company’s stock. The value of the firm may change by more than the cost of the recall to correct the issue because of the bearish market sentiment instigated by the scandal. More investors are likely to sell the stock of the company, making its price fall much further thereby, negatively affecting the value of the company which may be higher than the value of the funds used to get back (and correct the problem) the vehicles from the worldwide market.