The Rationale for Stock Selection
Volkswagen (VW) has been considered a good choice for long-term investment for several reasons. The company’s business model follows a holistic approach as VW not only produces high-quality vehicles but also sells them and provides after-sale services to make sure customers are satisfied with the products (Volkswagen AG, 1). VW is one of the strongest automakers, and its revenues have been growing over the past several years (Statista, 2; Volkswagen AG, 3).
It is also worth mentioning that the organization has a large market capitalization, which is why its stock is less risky than the stock of small-cap or middle-cap companies (Volkswagen AG, 4). For conservative investors, the business entity offers another source of income, such as dividends (Volkswagen AG, 5). This may indicate that the senior management of VW is confident in the future earning power of the company’s stock.
VW stock has been selected for the client, who is a 38-year old family man with the middle level of income. He has a rather low risk tolerance and needs an additional source of income to pay for college for his children. An important factor in choosing stock was the client’s personal interest in cars and his strong concern with the environment. VW produces a new generation of full electronic vehicles, which make a considerable portion of the corporation’s global sales (Matousek, 6; Bullard, 7). Taking into account all the above-said, the purchase of VW stock seems to be a rational choice that is based upon the client’s personal financial goals and preferences and that is within his risk-tolerance level.
Calculation of the Financial Ratios
Even though the rationale for the selection of VW stock seems well-reasoned, a thorough assessment of the company’s financial health should include the estimation of its financial ratios. This will allow for analyzing the firm’s performance in terms of profitability, liquidity, and solvency over the past several years. Financial ratios that will be computed include the current ratio and quick ratio (both are characteristics of liquidity), the total debt ratio (the long-term solvency ratio), the earnings per share, and the price-to-earnings ratio. All the information needed to calculate the financial ratios was taken from the annual reports of VW for 2016-2018.
Current Ratio
The current ratio is calculated by dividing current assets by current liabilities. The current ratio of VW for 2016 was equal to:
The current ratio of VW for 2017 was equal to:
The current ratio of VW for 2018 was equal to:
Quick Ratio
The quick ratio is calculated by subtracting inventories from current assets and dividing the result by current liabilities. The quick ratio of VW for 2016 was equal to:
The quick ratio of VW for 2017 was equal to:
The quick ratio of VW for 2018 was equal to:
Earnings per Share and Price per Share
The earnings per share (EPS) was presented in the annual report of VW. In 2016, the EPS of VW was equal to 10.24, and the price per share was 136.75 (Volkswagen AG, 8). In 2017, the EPS of VW was equal to 22.63, and the price per share was 168.7 (Volkswagen AG, 9). In 2018, the EPS of VW was equal to 23.57, and the price per share was 138.92 (Volkswagen AG, 10). Over 2016-2017, the stock was rather volatile as its market price changed from 136.75 to 168.7.
Price-to-Earnings Ratio
The price-to-earnings ratio is calculated by dividing the price per share by earnings per share. The price-to-earnings ratio of VW for 2016 was equal to:
The price-to-earnings ratio of VW for 2017 was equal to:
The price-to-earnings ratio of VW for 2018 was equal to:
Total Debt Ratio
The total debt ratio was calculated by subtracting total equity from total assets and dividing the result by total assets. The total debt ratio of VW for 2016 was equal to:
The total debt ratio of VW for 2017 was equal to:
The total debt ratio of VW for 2018 was equal to:
Table 1 shows all the financial ratios computed in this section.
Table 1. Key Financial Ratios.
Analysis of Financial Ratios
The current and quick ratios were computed in order to analyze the firm’s liquidity. The company’s current ratio increased by 11% in 2017 and by 10% in 2018. This stable annual growth indicates an increase in VW’s current assets and a decrease in current liabilities. Since the current ratio was lower than 1.0 in both 2016 and 2017, the organization was unable to cover its short-term debt with liquid assets.
In 2018, however, the company’s current assets exceeded its current liabilities, which means that it was well-placed to cover its short-term debt obligations. VW’s quick ratio increased by 9% in 2017 and by 7% in 2018 due to an increase in the current assets. Overall, the company’s liquidity is satisfactory, yet it is lower than 1.0, which is why VW may experience problems meeting its short-term debt with the most liquid assets, such as cash and cash equivalents, accounts receivable, and marketable securities.
The earnings per share indicates how much profit is generated by the basic share of the business. Over the past three years, there was a stable growth in the portion of VW’s net income earned by the basic shares. Therefore, one may note that investors were positive about the future growth of the company. It is possible to deduce that VW’s profits increased over the past three years, so it had more money available to distribute to shareholders. Overall, an increase in the EPS and its positive value speak of the good profitability of VW.
The price-to-earnings ratio links the market price of a share with the earnings per share. This financial measure indicates how many times the market price of a share is higher than its current level of earnings. In 2016, the market value of one share of VW was more than thirteen times higher than EPS. In 2017, the market value of one share of VW was 7.45 times higher than EPS. In 2018, the market value of one share of VW was only 5.89 times higher than EPS. Such a decrease in the price-to-earnings ratio is mainly attributable to an increase in EPS and a rather unstable market price per share.
Over the past three years, the stock price became lower relative to earnings. One may say that in 2016, the stock was more overvalued than in 2017 and 2018. On the other hand, it is also possible to state that investors expected higher earnings in 2016 than in the following years. This means that they were ready to pay more for the company’s stock in 2016 than in 2017 and 2018. However, it is important to consider that one of the main disadvantages of the price-to-earnings ratio is that it does not take into account the capital structure of the business.
Total Debt Ratio
The total debt ratio was calculated in order to measure the company’s level of indebtedness. As can be seen from table 1, VW’s total debt ratio decreased by 3% in 2017 and remained the same in 2018. The firm financed 77% of its current and non-current assets with current and non-current liabilities. In other words, it had to sell 77% of its assets to finance its debt. Since a lower total debt ratio speaks of a stronger financial structure of a business, it would be desirable for VW to repay some of its short-term and long-term obligations.
The Risk Level of the Stock
Despite the fact that there is no real agreement on how unsystematic risk should be measured, several conclusions about the risk level of the VW stock can be made based on the analysis of the financial ratios of the company. The organization shows stable performance, and the trends in its liquidity, solvency, and profitability may be viewed as positive. Considering the EPS and P/E ratios over the past three years, it is highly unlikely that the organization will experience a permanent loss of value or perform worse than expected (Atrill, 11). Even though investors are not prepared to pay more for the stock, they still expect high returns on the investment in the company’s shares. The only drawback associated with this investment decision is the rather high level of indebtedness of VW, which may result in the liquidity problems (Atrill, 12; MarketLine, 13). Overall, the risk level of VW stock may be considered as low or middle.
Recommendations and Key Strategies
This stock may be recommended for investment, but the fund strategy should be blend fund. This means that apart from VW stock, several other stocks need to be chosen, some of them should be growth stocks, and other ones should be value stocks (Kjetsaa, 14). Such a portfolio will be diversified, so the stability of the value stocks will be balanced with the high potential returns of the growth stocks (Baker, 15; Hancock, 16).
As a result, the client will be immune to losses because his assets will be distributed over diverse funds. In such a case, it will be difficult to predict the unsystematic risk of this portfolio due to diversification, yet blend funds usually have low levels of risk. Even though the blend fund is a perspective strategy, value and growth stocks have to be carefully chosen with consideration of their historical performance over the past five years. Among other strategies that can help reduce the risk of the investment portfolio are dollar-cost averaging, which means investing small amounts at regular intervals instead of a large sum at once, and diversification across sectors and regions.
Sources
- Volkswagen AG. 2019. Brands and Business Fields. Web.
- Statista. 2019. Global Car Market Share of the World’s Largest Automobile OEMs in 2018. Web.
- Volkswagen AG. 2019. Income Statement. Web.
- Volkswagen AG. 2019. Sales and Marketing. Web.
- Volkswagen AG. 2019. Dividend. Web.
- Mark Matousek. 2019. Electric Vehicles Are a Tiny Piece of the Global Car Market, but Volkswagen Is Making a Huge Bet on Them. It Doesn’t Have a Choice. Web.
- Nathaniel Bullard. 2019. China Is Winning the Race to Dominate Electric Cars. Web.
- Volkswagen AG. 2016. Volkswagen Annual Report. Web.
- Volkswagen AG. 2017. Volkswagen Annual Report. Web.
- Volkswagen AG. 2018. Volkswagen Annual Report. Web.
- Peter Atrill. 2018. Issues in Accounting and Finance. p. 78-80. Web.
- Peter Atrill. 2017. Accounting and Finance for Non-Specialists. p. 279-282. Web.
- MarketLine. 2019. Volkswagen AG: Company Profile. Web.
- Richard Kjetsaa. 2016. Impact of Expenses, Turnover and Manager Tenure on Blend Fund Performance. Web.
- Harold Baker. 2015. Investment Risk Management. p. 112. Web.
- Phil Hancock. 2015. Contemporary Accounting: A Strategic Approach for Users. p. 56. Web.