CIC3007 ADVANCED PORTFOLIO CONSTRUCTION

SEMESTER 1, 2018/19

INDIVIDUAL ASSIGNMENT

LECTURER : DR. JACINTA CHAN

PREPARED BY : WONG YE WA CIC160097

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Question

It is your first day as an intern in fund management company.

You are given a computer with basic Microsoft word which includes Excel.
You are told to analyse A stock for the senior fund managers to consider.
Your A stock must be an investment opportunity that will outperform the market benchmark.
Use the finance theories that you have learnt in your advanced portfolio construction course to
explain :
1. Calculate i) the expected return and ii) the possible standard deviations from your expected
return.
2. Analyse the financial ratios to project next year’s ratios.
3. Calculate the intrinsic value of the company.
4. Run a regression and write out the relationship between your stock and the market.

Answer
The stock of my choice is Intuit Inc.. It is an US-based company listed in NASDAQ Global Select
Consolidated in year 1993. The company is operating in the technology sector as a business and
financial management solutions software provider to small business, consumers and professional
accountants. It introduces several business software such as QuickBooks, TurboTax , payroll services
and ProConnect which are designed specifically to meet the different demands and needs for different
clientele.
Below is some basic information regarding Intuit Inc. market portfolio:
Ticker INTU
Stock Exchange NASDAQ Stock Exchange Global Select Market
Sector Technology
Industry Software
52-week price range (USD) 143.46 – 231.84
50 days average daily volume (million) 1.62
Shares outstanding (million) 258.67
Market capitalisation (USD billion) 54.79
Beta 1.21
ROE (%) 67.64
Dividend yield (%) 0.89
EV/EBITDA 30.58
P/E 44.27
Source: Thomson Reuters

1. i) Expected return of INTU

Method 1 :
Capital Asset Pricing Model (CAPM) is used to derive INTU expected return.
E(R) = Rf + β(Rm – Rf)

Information:
Risk free rate 3.17%
Beta 1.21
Market return 9.59%
E(R) = 3.17% + 1.21( 9.59% - 3.17% )
= 10.94%

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 The U.S. 10-year Treasury yield is taken as a benchmark for risk free rate and S&P 500 5-year
monthly annualized return is chosen as the proxy for market return. A 10.94% expected return
of INTU which is higher than the market portfolio return of 9.59% is derived by using the CAPM
model.

Method 2 :
Holding period return is calculated simply by using INTU 5-year monthly closing prices and
dividends. The calculation details can be found on the Excel spreadsheet attached.
(𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑐𝑙𝑜𝑠𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒−𝑝𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑐𝑙𝑜𝑠𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒)+𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
HPR = 𝑝𝑟𝑒𝑣𝑖𝑜𝑢𝑠 𝑐𝑙𝑜𝑠𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒

By using the formula above, INTU’s annualised expected return is equalled to 24.66%.

ii) Standard deviation of INTU

By using INTU 5-year monthly returns, an annualised standard deviation of 31.24% is arrived.
This indicates the total risks of the stock which includes both systematic and idiosyncratic risks.
The calculation details can also be found on the Excel spreadsheet.

2. Financial ratio analysis

i)Leverage
Interest burden 𝐸𝐵𝐼𝑇−𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒
𝐸𝐵𝐼𝑇
1,497,000−19,000
= 1,497,000
= 0.98

Explanation:
(100%-98%)2% of the EBIT is used to cover the interest expense.
In other words, 98% of the EBIT is the company’s profit retained
after paying for the interest. Therefore, we can say that Intuit
Inc. has a similar low interest burden as the previous year.

Interest coverage 𝐸𝐵𝐼𝑇

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒
1,497,000
= 19,000
= 78.79

Explanation:
Intuit Inc. is getting better in handling its outstanding debt
repayments because it has the ability to pay its interest expense
78.79 times by using its EBIT compare to 45 times in year 2017.

Leverage (equity 𝐴𝑠𝑠𝑒𝑡𝑠

multiplier) 𝐸𝑞𝑢𝑖𝑡𝑦
5,178,000
=2,354,000
= 2.20

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 Explanation:
This ratio indicates 2.20 of the assets is funded by equity and
provides an implication of the amount of debt used to finance
the firm as well. The leverage being employed by company has
dropped from 3.00 to 2.20 this year. The smaller the equity
multiplier, the lesser the financial leverage employed by the
company and the is less exposed to default risk as well.

Compound leverage 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑏𝑢𝑟𝑑𝑒𝑛 × 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒

factor = 0.98 × 2.20
=2.16

Explanation:
Since Intuit Inc. compound leverage factor is greater than 1,
the company’s debt has a positive contribution to its ROA.

ii)Asset utilization
Total asset turnover 𝑆𝑎𝑙𝑒𝑠
𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
5,964,000
=5,178,000
= 1.15

Explanation:
Each dollar of asset, Intuit Inc. is able to generate 1.15 dollar
sales. This shows that, the company is utilising its assets very
well to increase the efficiency in order to generate sales.
However, this ratio has slightly declined from 1.27 last year.

Fixed asset turnover 𝑆𝑎𝑙𝑒𝑠

𝐹𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠
5,964,000
=2,774,000
= 2.15

Explanation:
This year Intuit Inc. generates a 2.15 sales per dollar which is
tied up in fixed assets compare to 1.95 sales per dollar.

Days receivables 𝐴𝑐𝑐𝑜𝑢𝑛𝑡 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒

× 365
( Average collection 𝐴𝑛𝑛𝑢𝑎𝑙 𝑠𝑎𝑙𝑒𝑠
137,000
period ) =5,964,000 × 365
=8.38

Explanation:
Intuit Inc. takes 8 days to collect its account receivables from
its customers. This has shown an improvement from 11.70 days
last year.

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iii) Liquidity
Current ratio 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦
2,404,000
=2,116,000
= 1.14

Explanation:
Intuit Inc. has sharpened its ability to repay short-term
obligations from 0.73 to 1.14 this year.

Quick ratio 𝐶𝑎𝑠ℎ + 𝑚𝑎𝑟𝑘𝑒𝑡𝑎𝑏𝑙𝑒 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠 + 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦
1,853,000
=2,116,000
= 0.88

Explanation:
After take out the inventory, Intuit Inc. ability to service its
current immediate liabilities by the most liquid assets has
improved from 0.49 to 0.88 this year. However, this figure is
still not satisfactory.

Cash ratio 𝐶𝑎𝑠ℎ + 𝑚𝑎𝑟𝑘𝑒𝑡𝑎𝑏𝑙𝑒 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠

𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦
1,716,000
=
2,116,000
= 0.81

Explanation:
Taking out inventory and receivables, the company’s ability to
pay its short-term liabilities by cash and cash equivalent is not
satisfactory as well even though there was an increment from
0.40 to 0.81 this year.

iv) Profitability
Return on assets 𝐸𝐵𝐼𝑇
𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
1,497,000
=5,178,000
=28.91%

Explanation:
Intuit Inc. asset is able to generate 28.91% of profit which had
decreased from 34.29% last year.

Return on equity 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒

𝑇𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦
1,211,000
=2,345,000
= 51.64%

Explanation:

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 The ROE has weakened from 71.71% last year to 51.64%. By
using the capital invest by shareholders, Intuit Inc. is able to
generate a relative small earnings this year.

Profit margin 𝐸𝐵𝐼𝑇

𝑆𝑎𝑙𝑒𝑠
1,497,000
=
5,964,000
= 25.10%

Explanation:
Profit margin has fallen slightly from 26.95% to 25.1%. This
ratio manifests the sales that is able to retain after all expenses
are deducted.

v) Market price
Market-to-book 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
211.82
=
9.07
= 23.35

Explanation:
Investors are willing to pay 23.35 times more than each dollar
of the book value in the balance sheet compared to 30.14
times last year.

Price-earnings ratio 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
211.82
=
4.90
= 43.23

Explanation:
The P/E ratio this year is getting higher from 41.74 to 43.23. It
means that the INTU is traded very expensive than its actual
earning per share in the market.

Earnings yield 𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
4.90
=211.82
= 2.31%

Explanation:
2.31% of each dollar invested in the stock was earned by the
company which is slightly lower than last year, 2.40%.

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 vi) Ratios projection
The ratio projections for year 2019 is forecasted based on the basis of past 5 years average.
2014 2015 2016 2017 2018 2019 F
Leverage ratios
Interest burden 0.98 0.96 0.97 0.98 0.98 0.97
Interest coverage 41.94 27.33 35.49 45.00 78.79 45.71
Leverage 1.69 2.13 3.66 3.00 2.20 2.54
Compound 1.66 2.04 3.55 2.94 2.16 2.46
leverage factor
Asset utilization
ratios
Total asset 0.82 0.84 1.10 1.27 1.15 1.03
turnover
Fixed asset 1.64 1.74 1.78 1.95 2.15 1.85
turnover
Days receivable 12.90 15.24 9.95 11.70 8.38 11.63
Liquidity ratios
Current ratio 1.84 1.47 0.72 0.73 1.14 1.18
Quick ratio 1.45 1.06 0.54 0.49 0.88 0.88
Cash ratio 1.35 0.97 0.48 0.40 0.81 0.79
Profitability ratios
ROA 25.00% 14.86% 29.22% 34.29% 28.91% 26.46%
ROE 27.71% 17.71% 69.42% 71.71% 51.64% 47.64%
Profit margin 30.64% 17.60% 26.46% 26.95% 25.10% 25.35%
Market ratios
Market-to-book 7.75 10.70 25.60 30.14 23.35 19.51
P/E ratio 30.83 65.65 37.31 41.74 43.23 43.75
Earnings yield 3.24% 1.52% 2.68% 2.40% 2.31% 2.43%

Given the financial data above, the financial health of the company is sound and attractive
especially in term of profitability ratio. Despite the insignificant drop in the profitability ratios,
the company is still able to record a strong earning power and profit status compared to its
peers. Besides, the company’s leverage obligation is being handled carefully, it does not incur
a lot of debt which will potentially expose the firm to financial distress and default risk.
However, the company is exposed to potential liquidity risk because of quick ratio and cash
ratio are both under 1. This can be fatal if it couldn’t service its short-term debt obligations
with sufficient liquidity which can eventually lead to insolvency issue

3. Intrinsic value of the company

INTU is undoubtedly a high growth stock. In order to determine whether Gordon Constant
Growth Model can be used to derive its intrinsic value, dividend growth rate is computed and
compare to the cost of equity.

Dividend growth rate = 𝑅𝑂𝐸 × 𝑏

= 0.5164 × (1 − 0.3246)
= 34.88%

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Since the cost of equity, 10.94% is smaller than the dividend growth rate, 34.88%, the Gordon
Constant Growth Model can no longer be used to find the true value of the underlying stock.

Dividend Discount Model (DDM) is then selected to derive the intrinsic value. There are few
steps involved to reach the price :

Step 1: Estimate the expected EPS growth rate

Expected EPS growth rate = 𝑅𝑒𝑛𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑖𝑜 × 𝑅𝑂𝐸
= (1 − 0.3246) × 51.64%
= 34.88%
Assumptions:
Since the growth rate is relatively high, it is projected to reduce gradually all the way until the
stable growth period.
i) The EPS growth rate from FY2018 to 2022 is expected to be 34.88%.
ii) The EPS growth rate from FY2023 to 2027 is estimated to be 24.88%.
iii) The EPS growth rate from FY2028 to 2032 is estimated to be 14.88%.
iv) The EPS growth rate for post FY2032 is estimated to be 4.88%.

Step 2: Define the high growth and stable growth period

Assumptions: i) High growth period – FY2018 to 2032
ii) Stable growth period – Post 2032

Step 3: Estimate the dividend payout ratio

Assumptions: Intuit.Inc dividend payout ratio is assumed to remain constant for future years
which is the company’s 5 years average dividend payout ratio 37%.
This dividend payout ratio is then used to get the expected dividend per share for the following
years.

Step 4: Compute the cost of equity

Cost of equity is computed based on CAPM.
High growth period Stable growth period
Risk free rate 3.17% 3.17%
Beta 1.21 1
Market risk premium 9.59% 9.59%
Cost of equity 10.94% 9.59%
From the table above, the cost of equity for high growth period and stable growth period is
10.94% and 9.59% respectively, after adjusting the beta.

Step 5: Discount the expected dividend to arrive at the present value today.

Step 6: Sum up all the present value to get the price per share.
The price per share is USD 251.21. By comparing with its current market price USD 212.98,
INTU is traded below its intrinsic value. Thus, it is a call for buy recommendation because it is
substantially underpriced.

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 Sensitivity analysis
The sensitivity analysis provides the intrinsic value when the growth rate for earning per share
and the cost of equity for stable growth period vary by one percent.

4. Regression
The table below provides the regression result for a multifactor model with 160 samples
involved.
Variable Coefficient Standard t-statistic Prob.
Error
Inflation -0.679831374 1.434504048 -0.473913876 0.637471931
S&P 500 0.548446171 0.32149042 1.705948722 0.09376375
Unemployment rate -0.116369573 3.873833767 -0.030039899 0.976145985
Dow Jones US 0.559412203 0.223999797 2.497378166 0.015591589
Technology Index
GDP 0.105652606 0.423539207 0.249451771 0.8039578
C 0.008335304 0.005626764 1.481367215 0.144320722

R-squared 0.497626307 Mean dependent var 0.020547926

Adjusted R-squared 0.451110225 S.D. dependent var 0.052068105
S.E. of regression 0.038575747 Akaike info criterion -3.577746473
Sum of squared residual 0.080356767 Schwarz criterion -3.368312017
Log likelihood 113.3323942 Hannan-Quinn -3.4958825144
criterion

Based on the regression result above, an equation between the stock and the market factors
is as follow:
E(R)= 0.0083 + 0.1057 GDP + 0.5594 Dow Jones - 0.1164 Unemployment + 0.5484 S&P - 0.6798
Inflation

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The equation derived demonstrates the linear relationship among the common market factors.
When GDP in the United States increases by 1%, the expected return from INTU will raise by
0.1057% in tandem. Besides, when Dow Jones US Technology index move up 1%, INTU stock
price will move up 0.5594%. The stock price will decrease by 0.1164% and increase by 0.5484%
when unemployment rate and S&P 500 index rise up by 1% respectively. Last but not least,
each percent change in inflation rate will drive the stock return to drop by 0.6798% as well.
All the common market factors identified above are deemed to impact the selected stock with
a 49.76% significance. When the changes in each variable are positive, the expected return of
the stock price will be positively affected as well, vice versa. It shows how the market changes
will influence the expected return of INTU as the systematic risks exposed are not diversifiable.

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