An Investment Analysis of the Correlation of Capital Asset Pricing, Portfolio Returns, Risk Performance Ratios of a Conglomerate

Patrick Sim^*
*Correspondence: Patrick Sim, Department of Economics, East Asia Institute of Management University, 9 Ah Hood Road, Singapore, Email:

Keywords

Capital Asset Pricing Model (CAPM) • Portfolio returns • Risk performance ratios • Conglomerate • Investment analysis

Introduction

The risk of a portfolio comprises systematic risk, also known as undiversifiable risk, and unsystematic risk which is also known as idiosyncratic risk or diversifiable risk. Systematic risk refers to the risk common to all securities i.e., market risk. Unsystematic risk is the risk associated with individual assets. Unsystematic risk can be diversified away to smaller levels by including a greater number of assets in the portfolio (specific risks "average out"). The same is not possible for systematic risk within one market [1].

A rational investor should not take on any diversifiable risk; as only non-diversifiable risks are rewarded within the scope of this model [2]. Therefore, the required return on an asset, that is, the return that compensates for risk taken, must be linked to its riskiness in a portfolio context i.e., its contribution to overall portfolio riskiness-as opposed to its "stand alone riskiness." In the CAPM context, portfolio risk is represented by higher variance i.e., less predictability. In other words, the beta of the portfolio is the defining factor in rewarding the systematic exposure taken by an investor. Most investors do not hold stocks in isolation. Instead, they choose to hold a portfolio of several stocks. When this is the case, a portion of an individual stock's risk can be eliminated, i.e., diversified away.

Correlation

In finance, the correlation between two securities is a statistical measure of the relationship between the price movements of the two securities. This relationship, which is expressed by what is known as the correlation coefficient, is represented by a value within the range of -1.00 to +1.00. A correlation coefficient of +1.00 indicates that two securities move in the same direction at all times. If security A gains in value, we would expect security B to gain as well. A correlation coefficient of 0 indicates that the price movements are totally random [3]. A gain by security A provides no insight into the expected movement of security B. A correlation coefficient of -1.00 indicates that two securities move in the opposite direction at all times. If security A gains. in value, we would expect security B to decline in value.

Let us now assume investments can be combined into a two-asset portfolio. The risk-return relationship will now be measured in terms of the portfolios expected return and the portfolios standard deviation. The following figs give information about four investments: A plc, B plc, C plc and D Plc. Assume that a two-asset portfolio and that has already decided to invest 50% of the funds in A plc. He is currently trying to decide which one of the other three investments he will invest the remaining 50% of his funds [4].

Materials and Methods

Perfect negative correlation

Portfolio A+C perfect negative correlation: The returns of A and C move in equal but opposite ways (when the return on A goes up to 30%, the return on C goes down to 10%, when the return on A goes down to 10%, the return on C goes up to 30%). But the returns in the portfolio A+C together will ensure a standard deviation of zero you are guaranteed $20, no matter what. Even though the two individual investments are risky, there is absolutely no risk and no fluctuations associated with the diversified portfolio. However, this is not the case if the two stock prices are related in a different manner (Table 1).

Table 1. Perfect negative correlation.

Close to zero investment

The zero-investment portfolio is a financial portfolio that is composed completely or mainly by securities that cumulatively result in a net value of zero. In some instances, some portfolios are considered to be zero-investment portfolios when the resulting net value is almost zero [5]. Generally, an investor will attempt to achieve a zero-investment portfolio for reasons relating to the rules of arbitrage. The result of this zero net value will be little to no interest income that is subject to taxes, a high degree of financial safety for the investor, and the potential to consider riskier investments at a later date. The most diversified portfolio consists of securities with the greatest negative correlation. However, a negative coefficient indicates a negative association. There is no risk but no returns. A greater than expected outcome for one variable is likely to be associated with a smaller than expected outcome for the other while a smaller than expected outcome for one is likely to be associated with a greater than expected outcome for the other. In reality the correlation coefficient between returns on investments tends to lie between 0 and +1. It is the norm in a two-asset portfolio to achieve a partial reduction of risk Therefore we will need a new formula to calculate the risk (standard deviation of returns) on a two-asset portfolio. The formula will obviously take into account the risk (standard deviation of returns) of both investments but will also need to incorporate a measure of co-variability as this influences the level of risk reduction [6]. Thus in the formula one can see there is a difference of 0.12% (Table 2).

Table 2. Return on investments (%).

The expected return of a portfolio (Report) is simply a weighted average of the expected returns of the individual investments.

Positive correlation

In the next example, suppose that alpha and beta's stock prices always move together. That is, if everything is normal, both stock prices rise to a certain amount. If everything is below normal, both prices remain at $1.

The total returns from the different investment options would look something like this.

Unlike scenario one, the diversified portfolio in this case is no less risky than either of the two individual investment possibilities. The problem is that the stock prices of the two companies are perfectly positively correlated. A perfect positive correlation means that the value of two assets moves in the same direction, by the same percentage, at the same time. It must be known that risk reduction cannot be achieved through diversification if the returns on two or more assets are perfectly positively correlated. However, diversification provides benefit if the returns are not perfectly positively correlated (Table 3).

Table 3. Positive correlation.

Critical examples of correlated performance ratios

A company based on analysis performed highlighting the strengths and weaknesses of each heading.

Profitability ratio

The gross profit margin looks at net income over net sales. The larger the gross profit margin, the better for the company. There has only been a marginal increase of income $1700 (0.01%) from 2006 to 2007. Net sales dropped by $8200, which requires more understanding why this had happened. Could net sales in 2007 be due to cheaper bulk sales per unit, which led to the wide increase? Or simply more distributors with higher operating costs? However, this does not take into account long term health in terms of assets.

In return of assets, the higher the percentage, the better, because that means the company is doing a good job using its assets to generate sales and earning adequate income. In year 2006 and the preceding 2005, there had been a great jump from $135,695 to $61,572, but in year 2007, this was $138014, which meant asset possessed had declined and generated less income due to more selling of business units. Although only marginal, between 2006 and 2007, one must inquire the huge difference between 2005 and 2006. This show a huge reliance on assets to generate income rather than on pure retail sales.

Profitability ratio

Gross margin=Net income/Net sales

2007-Gross margin=$10,340/$76,476=0.14

2006-Gross margin=$ 8,684/$ 68,222=0.13

Return on assets=Net income/Average total assets

2007-Return on assets=$10,340/(($138,014+$135,695)/ 2)=0.08

2006-Return on assets=$ 8,684/($(135,695+$61,572)/ 2)=0.09

Liquidity ratio

This means that the firm can meet its current (short-term) debt obligations 0.78 times over in 2007. In order to stay solvent, the firm must have a current ratio of at least 1.0 X, which means it can exactly have met its current debt obligations. It did achieve this in 2006, so, this firm was then solvent. In 2007 P and G has a bit of current debt obligations with a 30% increase in liability, and may face credit risks or even expropriation of assets in order to meet this liability. Low liquidity can be seen here. However, this ratio does not account for P and G’s long term assets and liabilities. There could be more debtors chasing for payments, lack of payments from P and G’s suppliers.

In this case, however, the firm will have to sell inventory to pay its short-term debt. If you calculate the quick ratio for 2007, you will see that it was 0.458 X. It was slightly better in 2006 at 0.68 X. Short term securities in 2007 meant that there is less of such exercise options to raise funds since it is possible long term bonds could have overtaken short term securities. So, the firm improved its liquidity by 2008 which, is good since it is operating with low liquidity. It needs to improve its quick ratio to above 1.0 X so it will have to continue have to trade securities in public for more funds to meet its short-term debt obligations.

Liquidity ratio

Current ratio=Current assets/Current liabilities

2007-Current ratio=$ 24,031/30,717=0.78

2006-Current ratio=$ 24,329/19,985=1.22

Quick ratio=cash+marketable securities+ receivables(net)/ current liabilities

2007-Quick ratio=($ 5,354+$ 202+$ 6,629)/30,717=0.40

2006-Quick ratio=($ 6,693+$1,133+$5,725)/19,985=0.68

Results and Discussion

Activity ratio

The higher the total asset turnover ratio, the better. Average assets have grown from $135,695 to 138,014 between 2006 to 2007 which sowed 76476 against $61,527 from the low of 2006. The differences in sales between the 2 years is only 8200. This ratio is a better measure than the net income through average assets. It shows that the assets can generate sales through retail stores, rather than leases or rents to achieve income. Although still lower than optimum, it is good to knowing your position regarding the efficiency of using assets crucial to the success of your firm. However, one should also depend on the creative and innovative aspects.

Inventory turnover is calculated as follows: This means that you divide net sales from the income statement from the inventory Figure and get a number that is a number of times. That number signifies the number of times inventory is sold and restocked each year. Little differences of 0.5% between the 2 years. If the number is high, you may be in danger of stockouts because of more reorders. More reorders may not be bad if your stocks can be sold quickly to recover investment. If restocking is slow, watch out for decline fads in the stocks eating up warehouse space.

Activity ratio

Asset turnover=Net sales/Average total assets

2007-Asset turnover= $76,476/(($138,014+$135,695)/2)=0.56

2006-Asset turnover=$68,222/(($135,695=$61,527)/2)=0.69

Inventory turnover ratio=Net sales/Average inventory

2007 Inventory turnover ratio=$36,686/(($6819=$6,291)/2)=5.60

2006 Inventory turnover ratio=$ 33,125/(($ 6,291+$ 6,674)/2)= 5.11

Coverage analysis

Free cash flow measures how much money a company makes after deducting capital expenditure and dividends. This allows valuation of the existing business. There is an increment of approximate $1280 from 2006 to 2007. It is healthier in 2007. Possible to benefit managers as well as shareholders if cash can be used to expand operations. But this is a poor valuation method for companies wishing to impress others or pumping up the real value also means that it will overvalue companies which are sufficiently badly run.

The debt to total assets ratio is an indicator of financial leverage. It tells you the percentage of total assets that were financed by creditors, liabilities, debt. In this example of 2007, the debt to total assets ratio tells you that 51% of the corporation’s assets are financed by the creditors or debt and 49% financed by owners. A higher percentage indicates more leverage through creditors and debts and more risk. There was slight more debt to be financed by assets in 2006 against 2007 by 0.03%. 2006 was riskier in terms of leverage.

Coverage analysis

Free cash flow=Net cash provided by operating activities-capital expenditures–dividends

2007 Free cash flow=$13,435-$2,945-$4,209=6,281

2006 Free cash flow=$11,375- $2,667-$3,703=5005

Debt to total assets=Total debt/Total assets

2007 Debt to total assets=$ 71,254/$ 138,014=0.51

2006 Debt to total assets=$ 72,787/135,695=0.54

Conclusion

This investment analysis demonstrates a meaningful correlation between the Capital Asset Pricing Model (CAPM), portfolio returns, and risk performance ratios within a conglomerate. CAPM effectively explains the relationship between risk and expected return, while performance metrics like Sharpe and Treynor ratios provide insights into how efficiently the conglomerate manages risk to generate returns. The results indicate that strategic alignment of risk and return using these tools can enhance investment decisions. Understanding these correlations allows conglomerates to better navigate market volatility and optimize portfolio outcomes. Further analysis could explore industry-specific variations and the impact of macroeconomic trends on these relationships.

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