Analysis of Gearing
Gearing will tell long term stability by showing the firm’s exposure to long term debts in relation to its stockholders’ investments. Thus gearing is measured by debt to equity ratios for which in the case of Marks and Spencer as computed were reflected at 2. 26, 3. 37, 4. 35, 2. 01 and 2. 18 for the years 2007, 2006, 2005, 2004 and 2003 respectively. See Table I above. Based on these data, one could only infer an above the normal rate of 1. 0 which means that debts must be ideally matched with equivalent investments. Exceeding by 2.
0 is therefore very high but in relation to stock price behaviour for the last three years despite high gearing could indicate still a sign of stability for the company. But given the marked improvement from 2005 towards 2007, one could only believe that management must really also be concerned in maintaining stability of the company and the reduction of the risks. If the ratios are analyzed together at this point, the company profitability seems to have benefited the company’s gearing but not the company’s liquidity.
Although both liquidity and gearing ratios are indications or measures of risks, the company has chosen to have prioritized gearing which speaks for long term stability and more in consonance with the Hermes principles. It may be recalled that Hermes principles appeared to have indicated a focus on both profitability and gearing since the two are the more important ones. As explained earlier, the decline in current ratios despite the increase in profitability, was caused by a choice to finance increased demand for company’s products.
The observed phenomenon in terms of improved debt to equity for the last two recent years is an additional explanation, that is the company used its working capital to pay it long terms obligations hence the reduced debt to equity ratio. 2. 5 Cost of Capital and Valuation 2. 5. 1 Using the CAPM and P/E reciprocal to get cost of capital Marks and Spencer’s stock intrinsic value makes use of company’s cost of capital, Ks using the CAPM model (Brigham and Houston) under the following formula: Ks = Risk-Free Rate + (Market Return – RF Rate) x Beta.
At Bank of England’s (Housepricecrash, 2008) base rate of 5. 25% and a beta of 1. 5 (Telegraph. co. uk, 2008) and market rate of 6. 0% are used, the computed cost of capital is 6. 75% calculated as follows: 5. 25% + 1. 5 (6. 0%- 5. 25%) = 6. 75% The market rate of 6. 0% is the market rate of based on the reciprocal of the average P/E ratios of TESCO with 15. 91 , Sainsbury plc with 16. 96 (Google. com, 2008) and Marks and Spencer with 17. 33 (Telegraph, 2008) Getting the average of the three and then getting their reciprocal would produce 6%.
Compared with the reciprocal of the P/E ratio for Marks and Spencer, the latter also has 6% which is almost the same with the market rate except for some decimal points. It is notable that the cost of capital of 6. 75% computed under CAPM is very close to the computed cost of capital for Marks and Spencer using the reciprocal of its latest P/E ratio as 6%. There are other firms that could be included but this paper limits the computation to companies which have readily available information from the retail industry. The beta of 1.
5 is taken from Telegraph. co. uk (2008). It must be noted that market rates of the selected industries show small variability and therefore it could be an indication that rates computed really represents the average. 2. 5. 2 Intrinsic value under constant growth model v quoted stock price outside Valuation applies the constant growth model using an assumed growth rate of the dividend per share of 5% per year after failure to use 15% actual average growth rate together with discount rate of Ks of 6. 75% (computed) using the formula: P0= D1/(KS-g).
The actual rate is not working because it will generate a divisor of negative value that would give a negative value of stock price. The same should be considered invalid for the purpose of the model. This is notable to indicate now a limitation of the model. P0= D1/(KS-g) has P0 as the price per share, and D1 or the estimated dividend next year taken from dividend last year, D0 was multiplied by (1 + 5% assumed). It must be noted that the constant growth rate of dividend must be lower than cost of capital to allow the application of the model.