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Exxon Rate of Return, Essay Example

Pages: 4

Words: 1028

Essay

The capital asset pricing model is used to determine the rate return of an asset. It states that the expected return on the capital asset is equal to the risk-free rate of interest plus the beta times the risk premium. The standard DCF (discounted cash flow) model states that the discounted present value is equal to the nominal value of a cash flow amount in a future period divided by 1 plus the interest rate raised to the number of years before the cash flow occurs is also equal to the nominal value of the future cash flow times 1 minus the discounted rate raised to the number of years before the cash flow occurs (Pratt et al., 2000). For these models, we will assume that the beta of the stock for the Exxon Mobil Corporation is 0.46, the rate of return is 2.80%, and the expected rate of return is 13.12% (Stock Analysis on Net, 2013). According to the capital asset pricing model, the rate return for Exxon is 7.51%:

rXOM = RF + βXOM [E(RM) – RF]

= 2.80% + 0.46 [13.12% – 2.80%]

= 7.51%

The average earnings per share for Exxon over the last 12 months is $85.40, earnings are expected to grow at a rate of 6.30% for the next five years before leveling off to a growth rate of 5% after. Using a market benchmark of 0.06%, this model indicates that the stock value will increase to $1,261 per share.

These calculations don’t seem to indicate the current company trends. Exxon Mobil stock value has mainly been increasing over this past year at a fast rate. Based on this information, I would expect a higher rate of return. In addition, the stock value of the company in 5 years will be higher than what it is not, but it is unlikely that is will reach $1,261 per share. Since the increase and decrease of the stock value for the company has been anything but consistent over the past year, data smoothing techniques should be employed. One useful technique would be seasonal adjustment to separate the data fluctuations that appear in the same month every year; these fluctuations indicate trends that are independent of how the company is actually performing, such as weather influencing consumers and the holiday season. For example, it is less likely that people will buy gasoline when it is snowing and more likely to purchase it on holidays that bring people together. To do so, the X12 procedure could be used which “estimates effects that occur in the same month every year with similar magnitude and direction”, then “separates out the seasonal component, leaving the trend-cycle and irregular components” (Federal Reserve Bank of Dallas, n.d.).

Estimates could be made more accurate by using a proxy group of several similar companies. It is difficult to indicate the trends of the oil industry by using only one company; this would not lead to statistically significant data that would allow us to draw conclusions about the industry as a whole. It is therefore important to compare the rate return of the asset, the discounted cash flow, and the average stock over a defined period of time across several related companies after accounting for seasonal fluctuations. Using this information, financial trends should be compared which will give us a much greater understanding of this market.

There are many market factors that impact trends and therefore also influence returns for risk. It is better to pursue aspects of the market that reduce this risk. The oil business is risky at the moment due to governmental investments in clean and renewable sources of energy. Ultimately, the four factors that shape the market include the government, international transactions, speculation and expectation, and supply and demand. Exxon Mobil is impacted in part by all of these factors. While the government is actively pursuing alternative energy sources, officials do recognize that if oil companies were to completely shut down it would have a negative impact on many aspects of our economy. Therefore, the government subsidized many fuel companies and provides them with funds to create oil rigs. International transactions are a major issue in this business because a majority of oil and other fossil fuels are drilled in international waters or are exported from the Middle East. Therefore, the government aims to reduce tariffs to make these exchanges affordable and keep the price low, which benefits both Exxon Mobil and its consumers. Speculation and expectation contributes to the decrease in risk to a significant extent; when studies are done to predict consumer wants and needs, corporations are able to produce and sell a proper amount of product. This concept ties into the idea of supply and demand; it is essential that Exxon Mobil doesn’t overproduce or underproduce to ensure that they make maximal profit.

Over time, these required returns will be affected by changes in interest rates, inflation, performance of the economy, and returns on alternative investments. If required return rises, the stock prices of the company will decrease. In addition if the stock prices of the company decrease, it may be doing so because of a poor performance of the economy. Although inflation doesn’t impact the actual stock price, it reflects a poor performance of the economy, which indicates a higher required return; this is what actually impacts the change in stock price. When the economy falters, interest rates will increased and so will the price of alternative investments. All of these concepts are highly connected and if one factor is altered, the rest will definitely follow suit.

To remain competitive, Exxon Mobil first needs to ensure that oil still has a place in the modern world or find ways to become involved in alternative energy sources. Next, it must find ways to take advantage of the market so that its value will increase; this includes keeping up with supply and demand, lobbying the government to enact policies that benefit them, and to speculate and predict what their future needs will be.

References

Federal Reserve Bank of Dallas. (n.d.). Seasonally Adjusting Data. Retrieved from http://www.dallasfed.org/research/basics/seasonally.cfm

Pratt, Shannon, Robert F. Reilly, Robert P. Schweihs. (2000). Valuing a Business. McGraw-Hill Professional. McGraw Hill.

(2013). Stock Analysis on Net. Retrieved from http://www.stock-analysis-on.net/NYSE/Company/Exxon-Mobil-Corp/DCF/Present-Value-of-FCFE

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