HA1022 Principals of Financial Markets : Qualitative and Quantitative

Answer:

Introduction

This report has been developed for demonstrating the importance of conducting fundamental analysis for developing knowledge relating to the stocks performances for investment purposes. The fundamental analysis aims to predict the capital gains that can be realized from investing in a particular stock through evaluating the economic, financial, qualitative and quantitative factors. The fundamental analysis is carried out through the adoption of two approaches that are, bottom-up and top-down analysis. The report presents a top-down and bottom-up analysis of the energy industry in Australia for identifying the economic factors that impacts its performance. The companies selected for the purpose are two ASX listed energy companies in Australia that are, AGL Energy Ltd and Origin Energy. The fundamental analysis examines the underlying economic forces that impact the stock valuation of companies within a selected industry. The top-down analysis examines the macro-economic forces impacting the performance of the selected industry whereas micro-economic factors are examined under the bottom-up analysis.

Top-Down Analysis

The top-down analysis begins with primarily analyzing the global economic environment conditions before selecting the particular securities for investing. As such, the analysis starts with analyzing the broader economic environment and then narrowing down its approach to examining the industry and the individual companies’ performance. The macro-economic policies impacting the economic growth and development of a particular selected country is examined first during top-down analysis. This is followed by identifying the best performance industries and then looking for excellent security to invest in under the selected industrial sector. The different macro-environment factors examine under the top-down analysis is interest rate, inflation rate, foreign exchange rate and the GDP value. The examination of all these macro-economic factors helps the investors to select a specific industry based on their expectations. The industry selection is followed by the analysis of securities that is performing well under the present economic conditions.

Australia Macro-Economic Environment Analysis

The Australia in the recent years have maintained a stabilized economic growth through better creation of job opportunities, creation of wealth and developing high standard of living of people. The current value of GDP (Gross Domestic Product) of the country is AUD $ 1.7 trillion as of the year 2017. The GDP value indicates the overall monetary value of the goods and services produced under a given period of time. The GDP value of the country is recording an increase of 0.5 per cent since the past few years with rise in per capita income of the people of the country. The increase in per capita income is strong supported by the commodity boom that has significantly increased the export volume of the country.

The strong monetary policy of the country developed by the Reserve Bank of Australia is also responsible for its sustainable economic growth. The monetary policy involves developed an effective interest and inflation rate in the country that helps in promoting of its economic growth. The interest rate is determined by the interaction between the supply and demand forces in the capital market. The changes in interest rate have major impact on the spending power of consumers through affecting their savings. The RBA has currently maintained a low interest rate of 0.5 per cent in order to support the economic growth of the country through proving easy loans from banks. The lower interest rate is also supporting the increase in consumer spending thus leading to rise in GDP of the country. The RBA is currently pursuing the strategy of maintaining the sustainable economic growth attained by the country through achieving an inflation rate between 2-3%. As per the Consumer Price Index (CPI), the current inflation rate in the country is 2.6% that fits well within the pre-determined range of RBA. The country has maintained a low inflation rate for encouraging the economic growth by raising the per capita income of the people of the country and encouraging the foreign investment. The Australian economy has enhanced its economic growth by 8% per annum through maintain an effective balance between its interest and inflation rates.

The RBA has also maintained an effective exchange rate policy that is responsible for its string economic growth during the period of global financial crisis. The exchange rate policy helps in determination of the value of $ AUD in comparison to the value of other country currencies. The value of Australian dollar is mainly determined by the interaction of the market forces. The value of Australian dollar has experienced strong rise during the period of commodity boom through enhancing the purchasing power of the country population group. However, its value has currently decreased in order to improve the competitiveness of Australia export in the foreign market. The depreciated value of AUD has helped in increasing the export demand from foreign countries such as China. The current value of Australian dollar has reached to its lowest level since the year 2009t o 0.69 per USD in the year 2016. As such, its value has reported an annual degradation of 25.9% and has reached a stabilized value of 0.71 USD per AUD in the year 2017. The weakening currency has helped RBA to promote the economic growth by improving the export demands from China and thereby increasing the trade revenue.

The strong economic growth attained by Australia in the current years is on account of its strong industrial production as indicated by increase in its GDP value in the recent years. The strong financial performance of its mining, agriculture and service sector has improved the economic conditions in the country. The large-scale production and export of coal from Australia has promotes strong growth in its energy sector as well. It is estimated by the financial analysts in the country that the energy market of the country is expected to record an increase of 8.7% from its present value till the end of the year 2022. As such, the presence of high-quality energy resources within the country provides a positive sign of future growth in the energy sector of the country. The country is recognized to be accounting for 2.5% of the total energy produced across the world and contributes strongly to its economic growth. The price of energy products is on increase in the country with its large-scale domestic use. The use of energy by the domestic population of the country is on increase in the recent years with the growth in population.

The natural gas and electricity represents high usage of about 24 % and 22% of the overall energy use in the country. The government of the country is also placing strong focus on promoting the growth of the energy industry of the country also plays a vital role in improving its GDP. The government is incorporating the use of modern technological measures for reducing the pollution from the energy sector of the country. This is done mainly to promote the development of clean energy technologies that does not have any impact on the environment quality. This is done for ensuring the long-term growth of the energy sector of the country by ensuring the industry compliance with the standard guidelines provided under Kyoto Protocol. Also, the government is emphasizing on the production of energy products from renewable sources such as hydro and wind with the exhaustion of non-renewable sources such as coal. The increase of energy consumption in Australia in the recent year clearly represents a positive sign for the investors. The investors are recommend to invest in the energy sector under the present economic conditions of Australia that are in favor of strong financial performance of the energy sector in the coming period of time. The AGL Energy Limited is the major energy company within the Australia having largest market capitalization in terms of revenues as compared to other energy companies of the country. On the other hand, Origin Energy is also reporting strong financial growth in the energy sector in the recent years. As such, the top-down analysis of the Australia has suggested that investors should invest in the energy sector of the country with evaluating the stock performance of AGL and Origin Energy within the sector. This will help the top-down investors to identify the correct stock for investment purpose. The analysis of the financial performance of the selected companies can be done through bottom-up analysis.

Bottom Up of analysis of the selected industry through evaluating the financial performance of two companies in same industry

In this part micro analysis of the energy sector in Australia will be analyzed in terms of their financial performance. Bottom up analysis aims to review the individuals stocks in the industry and makes comments upon the company financial performance in order to evaluate the industrial performance as a whole. In this part, companies that are selected are AGL Energy and Origin Energy. In order to make comments on the financial performance of the selected companies, ratio analysis has been performed for the years 2016 and 2017. Financial data has been taken from the annual reports published at their websites. Below tables will the details of financial data and calculation of ratios.

Ratios analysis of the AGL Energy and Origin Energy 

In order to perform the ratio analysis, the ratios have been divided into four main categories, they are:

• Profitability analysis
• Capital Structure analysis
• Solvency/Liquidity Analysis
• Market Performance Analysis

Profitability Analysis: 

In this analysis profit earning capabilities of the company is evaluated on many grounds such as profit earned on assets, profit earned on net revenue and profit earned on shareholder’s equity. This part of ratio analysis is very important from the investor’s point of view as it help them to check the return they have earned on their investment. Following ratio are calculated to explain this ratio analysis in detail:

Net profit ratio: This ratio provides income generated on total earnings and it is calculated as net profit divided by the total earnings. Net profit ratio was -3.65% in year 2016 and 4.36% in year 2017 in case of AGL Energy. It shows that company has showed some rise in profits in year 2017 while in year 2016 company has suffered with losses. On the other hand, Origin Energy has faced negative net profit ratio in both the years. The net profit was further declined in year 2017 as compared to year 2016.

Return on Assets: This ratio calculates the profit earned using the assets of the company. This ratio is important from the management point of view as managers seek knowledge that how much returns are generated through the assets. AGL Energy has generated -2.79 % of ROA year 2016 and 3.73% in year 2017. It indicates that despite of poor performance in year 2016, company has earned good profit in year 2017. In case of Origin Energy, -2.09% and -8.13% returns on assets was generated in year 2016 and 2017 respectively. Overall profitability performance of Origin Energy was very poor as compare to AGL Energy.

Capital Structure Analysis

Under this analysis proportion of capital sources are reviewed to check the level of leveraged capital the company has used to finance the resources. Leverage capital means debt sources of capital that bears the fixed charge on the income of the company. The two main sources of capital are equity and debt capital. Following two ratios are being calculated to evaluate the capital structure of company.

Equity Ratio: This ratio provides the proportion of equity capital that company has in proportion of equity capital. It is calculated as equity capital divided by the total assets. Every management wants that major proportion of the capital should be financed through use of equity capital as it refers to owner’s capital and does not bear any fixed charge on the income of the company. The equity ratio of the AGL Energy in year 2016 was 54.27% and it got reduced to 52.39% in year 2017. So it can be said that about 50% of total assets was financed through use of equity capital. In case of Origin capital 50.21% of total assets was financed using the equity as the sources in year 2016 and it was reduced by 5% in year 2017.

Debt to Equity Ratio: This ratio tells exact proportion of the debt and equity capital, company has used to finance its working capital and fixed assets of the company. Debt refers to long term current liabilities. Debt to Equity ratio was 0.52 in year 2016 and 0.55 in year 2017 in case of AGL Energy and it was not at all satisfactory to poses such a high debt equity ratio. The position of Origin Energy was even more worst as compared to AGL Energy as 0.79 in year 2016 and 0.87 times debt to equity ratio was kept by the company.

Liquidity/Solvency Analysis

Solvency analysis means checking the level of working capital maintain by the company to carry out the operation activities in the easy manner. Following ratios are calculated to evaluate the liquidity of the company:

Current ratio: This ratio is calculated as current assets divided by the current liabilities. Current assets means the assets that can be converted into cash into shorter period of time and current liabilities are referred to liabilities that are due in one year time period. So it can be said that this ratio provides level of assets, company keeps to pay the liabilities in day to day period. Current ratio of the AGL Energy in year 2016 was 1.41 times which was reduced to 1.33 times in year 2017. While in case of Origin Energy the current ratio was 1.24 times in year 2016 and 1.30 in year 2017. Together it can be said that both companies maintain satisfactory amount of assets as compare to liabilities.

Quick Ratio: This ratio was equal to current ratio but these is some difference in this ratio as it ignore the some part of current assets such as inventory and prepaid expenses as it is not easy to convert these assets in shorter period. So it can be said that this ratio is better measure of liquidity ratio. The calculation of quick ratio shows that both companies has good amount of assets to pay their current liabilities.

Market Performance Analysis

Two ratios are calculated to analysis the market performance:

EPS (Earning per Share): This ratio provides the net income per share of the company. Earnings per share of the company was not all satisfactory in both the years and there need to review the strategies so that company can earn some good profits in order to have faith of shareholder’s in the company.

Conclusion

The overall analysis under the top down approach shows that there are huge opportunities waiting for the companies in future years but for that purpose companies has to make changes in their strategies so that they can take maximum out of the opportunities. Bottom up analysis shows that financial performance of the selected companies was not up to the mark as it was expected in the energy sector. It is highly recommended for the investors to wait for the companies to earn some better profits in future years and that time will the best time to sale the shares.