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FINANCE PROJECT WORK

ujwal

11BSPHH010754 Sec H Seat 62


COMPANY OVERVIEW Indian Oil Corporation Ltd (Indian Oil), a MAHARATNA downstream oil company was founded in the year 1964. IOCL is Indias largest company by sales, with a turnover of Rs. 271074 crore and profit of Rs. 10221 crore for the year 2009-10. 2010-2011 was marked by registering the highest ever turnover of Rs. 328744 crore. IOCL is the highest ranked Indian company in the latest Fortune 1

Global 500 listings, ranked at the 125th position. The companys operations include research and development, refineries, pipelines and marketing. Its portfolio of brands includes Indane LPGas, SERVO lubricants, XTRAPREMIUM petrol and XTRAMile diesel. In exploration and production, Indian oils domestic portfolio includes eleven oil and gas blocks and two coal bed methane blocks while the overseas portfolio consists of ten blocks spread across Libya, Iran, Gabon, Nigeria, TimorLeste and Yemen. Indian oils refineries processed 50.696 million tonnes of crude during fiscal 2010. During fiscal 2010, the companys marketing division sold 63.030 million tonnes of petroleum products. FINANCIAL PERFORMANCE Indian Oils gross turnover (inclusive of excise duty) for the year 2010-11 touched Rs. 3,28,744.27 crore which is the highest ever. The profit after tax was Rs.7445.48 crore. While the profit for the third quarter was Rs. 1634.76 crore, the same for the fourth quarter was Rs. 3905.16 crore. For the year 2010-11, the companys Earnings per Share (EPS) stands at Rs. 30.67 as compared to Rs. 42.10 for 2009-10. For the year 2010-11, Indian Oil has accounted for cash compensation of Rs. 22,604.84 crore, out of which Rs. 11,662.40 crore has been received during the year. In addition, the company has been granted discount of Rs. 16,703.73 crore received from upstream companies and CPCL, as per the under-recovery sharing mechanism. The face value of equity shares is Rs. 10. Over the years the company has paid good dividends to its shareholders. The Board of Directors has recommended a dividend of Rs 9.50 per share for the year 2010-2011. The bonus announcements have been consistent too. RISK AND RETURNS SINGLE SECURITY OPTION: - In this case we consider the share prices of the company (IOCL), the market and another peer group company (BPCL). For a detailed analysis I have considered a data set of 499 points which gives a holistic viewpoint over the last two years. The market is also considered a single entity and an investable option. The annual rates of return for all the entities have been good with BPCL having the most favourable returns (exhibit I). The risks or the standard deviation associated with these returns are directly proportional as well. The more the returns, the more the amount of risk associated with the stock. This explains why a single stock option of BPCL has more risk associated to it. Whereas IOCL has shown an optimum risk and return over the past two years (exhibit II). TWO ASSET PORTFOLIOS: - A portfolio is a combination of individual assets or securities. In this case we assume that the investors are risk averse. This means that an investor would invest in a well-diversified portfolio to reduce the risk factor instead of investing the whole amount in a single 2

stock option. The portfolio options considered here are individual companies with the market and a combination of both the peer companies. Considering equal weights to both the securities, the expected return comes out to be normalised and the risk involved gets reduced (exhibit III). The portfolio variance and standard deviation depends on the co-movement of returns on two assets. This is determined by the covariance of the portfolio. In this case we have a positive covariance between all the securities. This means that the securities move together with the change in the market conditions. A minimum variance portfolio can also be created by assigning optimum weights to all the securities. This reduces the standard deviation or the risk associated with the portfolio (exhibit IV). For a detailed analysis we also take the correlation factor between the securities in a portfolio. A correlation factor gives a linear relationship between two variables. The correlation factor between the market, IOCL and BPCL considering each of them in a different portfolio scenario gives a positive result. Thus, we can conclude that all the security options are positively related to each other. VALUATION OF STOCK CAPITAL ASSET PRICING MODEL (CAPM) FOR VALUATION OF STOCKS This model gives a framework to determine the required rate of return on an asset. This rate of return specified by CAPM helps in valuing an asset and helps us to know whether the asset is fairly valued. There are certain assumptions for the CAPM model:a) The capital market efficiency implies that share prices reflect all available information. No individual investor can affect the price of the securities. b) The second assumption is that the investors are risk averse i.e an investor would expect highest possible return for a given risk. c) Thirdly, all investors have same expectations about the expected returns and risks of a security. d) All investors can lend and borrow at a risk free rate of interest. These include publicly traded securities like shares and bonds. In our case I have assumed a government issued RBI bond for 10 years with an 8.0907% rate of return. e) The last assumption is that the market behaves the same in the last 20 days. This is because my data recorded is till 31st July. So I expect my beta value to remain the same over these 20 days. The company considered here is considered to be an all equity company. Considering all these assumptions to be true we find out the beta value (exhibit V) associated with each security. Beta is the slope associated with the graph with market return as one axis and security 3

return as the other. IOCL has a beta value of 0.4388. This means that a unit change in the market would yield a 0.4388 times return in the securities. Beta can be calculated through covariance, correlation and regression. Finally, CAPM implies that the investors would be compensated for the risk that cannot be diversified. This market related risk is known as systematic risk and is shown in exhibit VI. So finally calculating all the parameters we get the expected cost of borrowing for IOCL to be 10.86% compared to the returns the company is giving which is 20.19%. So Indian Oil Corporation seems to be a good stock to be invested upon. DIVIDEND DISCOUNT MODEL FOR VALUATION OF STOCKS In this method is based on a theory that a stock is worth the discounted sum of all of its future dividend payouts. It is used to evaluate a stock based on the net present value of all the future dividends. For this model I have taken certain points under assumption. They are as follows:a) A company is supposed to pay out dividends all its life. It means that there would be a perpetual payout of dividends. b) The company is also expected to pay an increasing dividend every year i.e the growth rate should be positive. This is based on the assumption that the company earns increasing profits every year. c) When extrapolated from the previous dividend payouts the growth rate comes out to be 16.21% which is more than the cost of equity (10.86%). So this gives a negative value to the share price. To solve this issue I have taken a mature growth rate of 7.50% because a company is supposed to stabilize in the near future and expected to payout dividends on a constant growth pattern. After calculating by this model a share price of Rs. 304.30 is what we get. The present market price of the shares of IOCL is around Rs. 314.60. Hence, we can conclude that the market prices are fairly over valued and it is a good option to invest in this company.

RELATIVE VALUATION OF STOCKS Relative valuation is a simple method to determine the price of a stock of a company from the fundamental ratios of peer group companies in the same industry. The first step is to value stocks on a relative basis. The prices have to be standardized by converting them into multiples of certain common variable such as P/E ratio, EV/EBIT ratio etc. In this scenario I have considered four peer companies all in the same sector and industry. The companies considered are BPCL, HPCL, 4

RELIANCE PETROLEUM and ESSAR OIL LIMITED. From the analysis I came to a conclusion that IOCLs share prices are in the range of Rs. 365.31 to Rs. 458.34. The current market price of the share is Rs. 314.6. As a result, the price calculated is more than the present market price. This can also be due to the fact that certain parameters of the earnings multiple like P/BV and P/CF gave abnormally small values. So, for the clear understanding I have neglected these values in the calculation of the share prices. However, the prices calculated are in the range of the industry growth pattern. CONCLUSION So we can conclude by saying that a companys growth pattern, risk and return can be calculated by the traditional methods of averaging and standard deviation. The portfolio returns and risks gives us an estimate on how our diversified portfolio works and how much should be invested in each stock options to get maximum returns in a given risk condition. Then there are certain models which help us to value our stock options with the present market prices and contemplate on how and where they are priced. This is again a good parameter on an investors point of view. The CAPM and the DDM model have too much of assumptions and are quite tedious to calculate. But the relative valuation model is quite a widespread model and is easy to come to a conclusion. Thus, by looking at all these parameters I can conclude that Indian oil corporation limited is faring quite well for its shareholders and investors. Not only IOCL but its peer companies in the same oil and gas sector have been on a constant rise. Considering the recent developments in these sectors I find no reason as to why an investor should not invest in these money minting companies.

TABLES 1) Annual Rate of Return (exhibit I) NIFTY 14.39% IOCL 20.19% BPCL 39.71%

2) Standard Deviation or Risk (exhibit II) NIFTY 0.0113453 IOCL 0.018847864 BPCL 0.021026603

3) Portfolio Return of two assets considering 0.5 weight to each (exhibit III) NIFTY+IOCL NIFTY+BPCL IOCL+BPCL

0.170768959

0.289831164

0.2970394

NIFTY+IOCL VARIANCE 0.000149173

NIFTY+BPCL 0.000174641

IOCL+BPCL 0.00033886

SD

0.012213653

0.013215185

0.01840815

SD REDUCTION

0.002882942

0.00297078

0.001529083

4) Minimum variance portfolio option (exhibit IV) NIFTY+IOCL Wx 0.80510669 NIFTY+BPCL 0.853642999 IOCL+BPCL 0.681536345

Wy

0.19489331

0.146357001

0.318463655

Expected return NIFTY+IOCL 0.166370398 NIFT+BPCL 0.200521851 IOCL+BPCL 0.2538112

5) BETA ESTIMATION (EXHIBIT V) B (IOCL) From Covariance From correlation From Regression 0.43791 0.4388 0.4388 B (BPCL) 0.4961 0.4971 0.4971

6) Systematic Risk (exhibit VI) NIFTY Variance 0.00012 IOCL 2.47838E-05 BPCL 3.1815E-05

Systematic Risk Unsys Risk

0.01134 0

0.00497 0.01386

0.00564 0.01538

7) Cost of equity IOCL Re 10.86% BPCL 11.22%