Ameritrade – Harvard Case Study Background: Ameritrade Holding Corporation is securities brokerage services and technology-based financial services firm from the United States. The company was founded in 1971 and is headquartered in Omaha, Nebraska. Ameritrade MERITRADE for self-directed retail investors; TD AMERITRADE Institutional that provides brokerage and custody services; trading platforms that enables research and analysis; a suite of education products and services for stock, option, foreign exchange, futures, mutual fund, and fixed-income investors; Amerivest, an online advisory service that develops portfolios of exchange-traded funds to help long-term investors pursue their financial goals; and TD AMERITRADE Corporate Services, which offers self-directed brokerage services to employees and executives of corporations (Yahoo Profile). Ameritrade also serves as a provider of services such as; trade execution, clearing, trustee, and trust-related services; and cash sweep products through third-party banking relationships. Ameritrade offers its clients “innovative trading technology, easy-to-use and understand investment tools and services, investor education and superior client service to create a market-leading financial services experience (Ameritrade). The firm’s common stock trades under the ticker symbol AMTD on the NasdaqGS and trades at approximately $19. 30.
Even in difficult times Ameritrade has held pretty strong, during the latest market fluctuation Ameritrade has held its value relatively well from a high 9/15/2008 ($23. 58) it’s value is only down 18% compared to it’s competitors such as Charles Schwab Corp who over the same period is off over 28% ($25. 25 to $18. 18). Ameritrade planned to grow their revenues by targeting self directed investors. Joe Rickett the CEO decided Ameritrade’s mission was to be the largest brokerage firm worldwide based on the number of trades. This plan called for price cutting, technology enhancements, and increased advertising.
This requires project risk. Obviously, the plan would only create value if this investment returned more than it cost. Estimating the cost of capital for Ameritrade is important. Ameritrade is doing to the right thing by evaluating their risks. Knowing the cost of capital is important to determine the company’s value of operations and evaluate the effects of alternative strategies. We will use the Capital Asset Pricing Model to estimate the required rate of return for investments. Some of the firms that are direct competitors of Ameritrade include, Charles Schwab Corp, E*TRADE Financial Corporation and Pvt1 a privately held firm.
Below is a direct comparison of these firms in certain segments. |DIRECT COMPETITOR COMPARISON | | |AMTD |SCHW |ETFC |Pvt1 |Industry | |Market Cap: |11. 37B |22. 20B |3. 18B |N/A |505. 85M | |Employees: |5,240 |12,400 |3,084 |400,001 |801 | |Qtrly Rev Growth (yoy): |3. 0% |-23. 20% |N/A |N/A |17. 90% | |Revenue (ttm): |2. 39B |4. 16B |436. 22M |12. 94B1 |233. 42M | |Gross Margin (ttm): |96. 77% |100. 00% |60. 87% |N/A |89. 88% | |EBITDA (ttm): |N/A |N/A |N/A |N/A |8. 36M | |Oper Margins (ttm): |44. 96% |36. 69% |-180. 29% |N/A |16. 2% | |Net Income (ttm): |595. 54M |787. 00M |-1. 30B |N/A |N/A | |EPS (ttm): |1. 016 |0. 678 |-1. 185 |N/A |0. 24 | |P/E (ttm): |18. 98 |27. 46 |N/A |N/A |18. 98 | |PEG (5 yr expected): |2. 38 |2. 86 |N/A |N/A |1. 5 | |P/S (ttm): |4. 71 |5. 35 |7. 27 N/A |2. 16 | | | |SCHW = Charles Schwab Corp. | |ETFC = E*TRADE Financial Corporation | |Pvt1 = FMR LLC (privately held) | |Industry = Investment Brokerage – National | |1 = As of 2008 |
Because Ameritrade gets most of its revenue from transactions and interest will mean that we will need to find companies in the industry that have similar revenue streams. This also means that Ameritrade’s revenue should be very sensitive to the movement of the market. It is also important to note that since Ameritrade’s revenue is sensitive to market fluctuations we will have to forecast how it will react in situations where the market is stable or quiet? We anticipate that revenues will be good in a volatile market.
Another important factor is the reduction in commission prices from $29. 95 to $8. 00. How will this huge shift in commission prices affect the bottom line if Ameritrade is not able to increase its volume the required amount to break even? These factors should be considered when risk is being assessed. When looking at the annual income statement for Ameritrade it is clear that 90% of its revenues come from commission and interest income. Looking at exhibit number four, we find that the following firms are a close match to Ameritrade in their brokerage revenue percentages.
These are the firms we should look to when comparing risk assessments. | | | | | | | | | | | | | | | | | | | |Debt/Value | |Debt/Capital | | | | |(Market Values) | (Book Values) | | | |Firm Name (Industry) |Current |Average | |Current |Average | |Brokerage | | | |1992-1996 | | |1992-1996 | |Revenues (%) | |Charles Schwab Corp (Discount Brokerage) |0. 05 |0. 08 | |0. 5 |0. 3 | |82 | |E*Trade (Discount Brokerage) |0 |NA | |0 |NA | |95 | |Quick & Reilly Group (Discount Brokerage) |0 |0 | |0 |0 | |81 | |Waterhouse Investor Srvcs (Discount |NA |0. 38 | |NA |0. 0c | |99 | |Brokerage) | | | | | | | | | | | | | | | | | Source: Compustat; Standard & Poor’s; company public filings. Risk Free rate= 6. 61% (Taken from prevailing yield of 30- year bonds) (Due to the long range nature of the investment) Industry Risk premium (1950-1996) =14. 0% – 6. 0%=8% Industry Risk Premium (1929-1996) =12. % – 5. 5%=7. 2% (The risk premium is calculated using the difference between the historical large company stocks and long term bonds. Exhibit 3) The first thing that needs be done is to calculate returns from stock prices of our comparable firms. We used the following formulas against the spreadsheet worksheet Exhibit 5 to calculate returns. *Please see the attached spreadsheet for calculations. Return = (Pt+1 – Pt + Divt+1)/Pt If stocks are split, we use this for the rate of return: [pic] We then need to estimate the CAPM equity and asset betas from capital market data:
This cost of capital is the weighted average of all debt and equity investment in business. Assets = debt + equity securities. In these discount brokerages, there is no traditional asset management. The main revenue is derived from sales commission and security purchases. The Cost of capital = cost of debt x debt ratio + cost of equity x equity ratio. There is no debt listed on the annual balance sheet for Ameritrade for 1997. (Exhibit 2)(Notes Payable to Bank) No debt means that the cost of capital is going to be the cost of equity. The cost of equity will be the expected return on equity. Expected ROE = Risk free return + risk premium. Risk premium in this case is the RP for Ameritrade (Its Beta) and RP here is the average return in the market – risk free return. ) All-cash flow streams from companies that have the same risk will have the same asset beta. The firms that we have selected have similar cash flows and similar risks and therefore have similar asset betas. So the beta for Ameritrade is going to be equal to the beta of our comparable companies. So the estimation of the beta for our comparable companies will be the beta times the debt ratio plus the beta times the equity ratio. We can estimate the equity beta by regressing the stock returns on the market returns.
Since in practice debt is supposed to be risk-free then a very low beta can be used, in the range of . 2 to . 3. If we take the price per share multiplied by the total number of shares outstanding we get the market value of the equity. If we then add in the market value of the debt (which is usually the book value of the debt), with the market value of the equity, we find the market value of the firm. Equity Betas: Charles Schwab = 2. 236 E*Trade = 3. 024 Quick and Reilly = 1. 785 Waterhouse = 3. 403 Another way to calculate the beta is by using the expected (required) rate of return, the risk free rate and the market premium.
We used 30% from the range that the CEO laid out. 30% – 50%. Req RoR = Rf + beta(Market premium) .30 = . 0661 + beta(. 08) .30 – . 0661 = beta(. 08) .2339/. 08=beta 2. 92=beta Using a smaller return ror = . 20 would give a beta of: 1. 67=beta Book Value taken from Ameritrade balance sheet. 1997 (Exhibit 2) Stockholders equity of $66,989,094 / 13,768,889 shares outstanding = $55 book value per share. Using the beta from Schwab we can now use finish the CAPM estimate for the cost of common equity. E(R ) = Rf + ? ?[E(Rm) ? Rf ] Risk Free rate= 6. 61% Industry Risk premium = 8% Waterhouse beta = 3. 03% Schwab beta = 2. 236% CAPM estimate of Rs: E(R) = 6. 61 + 2. 236 (8%) = 24. 498% Conclusion: This high cost of common equity is based mostly upon the high risk of the project. Most of the firms suffer from the same fate, that they are very sensitive to market fluctuations. Their betas are all above average which means that the revenue that they count on through commissions will fluctuate wildly as the market moves (90% of Ameritrade’s revenue comes from market commissions). When the market is stable or in a recession commission revenue will slow down. When there is a volatile market, revenues should surge.
When we factor in this high cost of equity (see appendix calculations), we find that the return on investment must be very high indeed in order for this project to make a profit. In fact it must be over 30% in order for the NPV to even be positive. A positive Net Present Value must be achieved in order for the project to be accepted under this method. With the variety of differing opinions amongst the CEO’s financial advisors, this project would be very risky. Ricketts would be making a very bold move. One of the biggest issues with the high cost of this capital has to do with the large risk premium added to this expected return.
One of Rickets main strategies has to do with cutting the price of commissions. He sees this as a way of gaining market share in becoming the largest brokerage firm worldwide. In the short run he may do well. But if greater than economic profits are being realized by Ameritrade, then competitors will quickly follow suit. There is no copyright or patent protection on what he is attempting to do and the barriers to entry are not all that severe. His return on investment (or his payback period); will have to be quick for Ameritrade to be successful in with this type of strategy.
The good news is that history has shown that companies that are the biggest risk takers, when successful, also endear themselves to the public giving them the upper hand for a while versus their competition, this time frame should give Ameritrade (if successful) the time it needs to recoup their investment and build on their new market strategy. Appendix: Calculations V0 = E(CF0)+ E(CF1 ) + E(CF2 ) + E(CF3 ) + E(CF3 ) + E(CF3 ) + E(CF3 ) + E(CF3 ) (1+r)1 (1+r)2 + (1+ r )3 + (1+ r )4 + (1+ r )5 + (1+ r )6 + (1+ r )7 NPV = -$255,000 + ($76,500/(1+. 11)) + ($76,500/(1+. 11)^2)+(76,500/(1+. 1)^3)+($76,500/(1+. 11)^4)+($76500/(1+. 11)^5)+($76500/(1+. 11)^6)+($76500/(1+. 11)^7) NPV = -255000 + 68918. 91+62089. 11+55936. 14+50392. 92+45399. 03+40900. 02+36846. 87 NPV = $110,483. 00 after 7 years with 11% cost of capital and 30% ROI NPV = -$255,000 + ($76,500/(1+. 245)) + ($76,500/(1+. 245)^2)+(76,500/(1+. 245)^3)+($76,500/(1+. 245)^4)+($76500/(1+. 245)^5)+($76500/(1+. 245)^6)+($76500/(1+. 245)^7) NPV = -255000 + 61445. 78+49354+39641. 80+31840. 80+25574. 94+20542. 12+16499. 70 NPV = -$10,100. 86 after 7 years with 24. 50% cost of capital and 30% ROI NPV = -$255,000 + ($102,000/(1+. 245)) + ($102,000/(1+. 245)^2)+( $102,000/(1+. 45)^3)+($102,000/(1+. 245)^4)+( $102,000/(1+. 245)^5)+( $102,000/(1+. 245)^6)+( $102,000/(1+. 245)^7) NPV = -255000 + 81927. 71+65805. 39+52855. 74+42454. 41+34099. 92+27389. 50+21999. 60 NPV = $71,532. 27 after 7 years with 24. 50% cost of capital and 40% ROI Return on Equity Average return on equity during 1975 to 1996 was 40% as all years except two, posted a positive return. Recent returns on equity were much higher, with each of the most recent five years having larger returns than the 40% average. Earnings per share in 1997 was $1. 00ROE 1% Earnings per share in 1997 was $. 87 ROE 1% Earnings per share in 1995 was $. 55ROE 1%
The higher the return on equity for a company the better it is as an indicator of the company’s financial strength. If the percentage increases so is future for the future market value of its share. Dividend payout ratio Common dividends paid per share/ earning available for common shares 5% / $1 = . 50 Took 5% from Charles Schwab. Ameritrade did not give common dividends. IPO- In March 1997 Ameritrade raised $22. 5 million in an initial public offering allowing the company to continue its long tradition of adopting the latest advances in technology, to do so substantially increase advertising to build its brand and improve market share.
Preferred Stock – Preferred stock normally carries a par of $100. Then, as noted preferred stocks pay a fixed dividend rate based on a stated percentage of the stocks par value. This fixed percentage is normally higher than that of bonds. This is because preferred stock dividends are only paid after the company satisfies its bond interest obligations. The typical purchaser of the preferred stock is not the individual investor but rather the Company treasurer with excess funds to invest. 30% of the dividends received by the corporate purchaser are subject to federal income tax.
This tax advantage stimulates the demand for preferred stocks by corporations as purchasers. Preferred stock has no maturity date like bonds. They will be sensitive to changes in interest rates. The normal range for this ratio is usually 25% to 50% of a company’s earning per share. The higher the dividend payout ratio, the more mature the company is with respect to number of years in operation. Perpetuity Valuation V= Dividend / Kp We have taken the dividend rate from Quick and Riley. We are assuming preferred stock has a par value of $100 and has a dividend rate of 6% or, $6 per year.
Because of the expected rate of inflation and the uncertainties of the dividend payout, Joe Ricketts stated he wanted a required rate of return on stock at 30%. Therefore the proper value of the stock to the investor is $20. 00 Investment Risk. Historic Prevailing Yields on US Government Securities has seen an increase in annualized yield to maturity as well as the Historic Total Annual Returns on US Government Securities and Common stock and Historic Average Total Annual Returns on US Government Securities and Common Stocks. All of their returns on securities have actually had a positive return.
Which means the company likes to take risks. Standard Deviation: Prevailing Yields on US Government Securities (August 31, 1977) from H10B Calc. 5. 24 ? + 5. 59 ? + 6. 22 ? + 6. 34 ? + 6. 69 ? + 6. 61 ? + Shift x,y = 6. 12 Shift Sx, Sy = . 58 This reflects an average or mean return of 6. 12 and a standard deviation of . 58. Historic Average Total Annual Return on US Gov. and Common Stocks(1950-1996) 5. 2 ? + 6. 4 ? + 6. 0 ? + 14. 0 ? + 17. 8 ? + Shift x,y = 9. 88 Shift Sx, Sy= 5. 67. This reflects an average or mean of 9. 88 and a standard deviation of 5. 76 Historic Average Total Annual Returns on US Gove Sec. nd Common Stock (1929-1996) 3. 8 ? + 5. 4 ? + 5. 5 ? + 12. 7 ? + 17. 7 ? + Shift x,y= 9. 2 Shift Sx,Sy= 5. 95 This reflects an average or mean of 9. 2 and a standard deviation of 5. 95 These expected returns are based on historical results. There is no guarantee that the future is linked to the past. But we have no other way to base our expectations. Coefficient of Variation for 1997 The coefficient of variation is a measure of the relative measure of total risk per unit expected return Their returns for 1997 reflect an average or mean return of 6. 12 and a standard deviation of . 58. 6. 12%/. 8 = 10. 55 this reflects approximately 10. 55 units of risk per unit of expected return. Beta: For Large company stocks and Small Company Stocks (1950-1996) Standard Deviation for large stock C 16. 8% and the standard deviations of the market were 10. Lets also assume that the correlation coefficient between stock C and the market is 40% 16. 8 x . 40 / 10 = . 64 Beta Small Company Stock D Standard Deviation for small stock D 25. 6% and the standard deviations of the market were 10. Lets also assume that the correlation coefficient between stock D and the market is 40% 25. 6 x . 40 / 10 = 1. 02 Beta
Weight x Beta = Weighted Beta Large Stock C . 50 x . 64 =. 32 Small Stock D . 50 x 1. 02 =. 51 Total Weighted Beta =. 83 Market and Stock Risk Premium The return to market is 10%and that the 90 day Treasury bill return rate is 5. 24%. The bet coefficient for Stock D is 1. 02. The stock risk premium associated with Stock D is . 10 – . 05 x 1. 02 = 50%. This means the required annual return of 50% in excess of what he or she could achieve.
We learned through the efficient market hypothesis that investors can not outperform the overall market consistently. Compound Rate of Return for the 3 month T-Bill 1 +n Annualized yield 5. 24% (1. 05)(1. 05)(1. 05)(1. 05 = 1. 22 1. 22-1= 22% 22% is compound rate. Risk Adjusted Return Large company stock Average Annual return for 1996 was 14% with beta . 64 . 14/. 64 = . 22 Risk adjusted return for stocks is . 22 Constant Growth Dividend Model Dividend is . 5 and expected to grow 15% and expected investors required return is 10% . 5 x (1+. 10) / (. 15-. 0) = . 55 /. 05 = 11. 00 Price to Earning EPS x P/E Ratio 1. 0 x . 50 =. 5 Book value taken from Ameritrade balance sheet. 1997 Stockholders equity of $66,989,094 / 13,768,889 shares outstanding = $55 book value per share. Capital Asset Pricing Model 3 month T Bill rate 5. 24% expected rate of return is 15% beta coefficient of 1. 02 5. 24% + 15%-5. 24 %( 1. 02) = 15. 20% Beta comparable = beta * Debt ratio + beta * Equity ratio Charles Schwab = . 3 * . 05 + 2. 236 * . 25 = . 574 E*Trade = . 3 * 0 + 3. 024 * 0 = 0 Quick and Reilly = . 3 * 0 + 1. 785 * 0 = 0
Waterhouse = . 3 * . 38 + 4. 39 * . 7 = 3. 187 References: “AMTD: Summary for TD Ameritrade Holding Corporati- Yahoo! Finance. ” Yahoo! Finance – Business Finance, Stock Market, Quotes, News. N. p. , n. d. Web. 4 Apr. 2010. . “AMTD: Profile for TD Ameritrade Holding Corporati – Yahoo! Finance. ” Yahoo! Finance – Business Finance, Stock Market, Quotes, News. N. p. , n. d. Web. 1 Apr. 2010. . TD AMERITRADE – Company Fact Sheet. ” TD AMERITRADE – . N. p. , n. d. Web. 1 Apr. 2010. . “Standard ; Poor’s. ” Standard & Poor’s. N. p. , n. d. Web. 1 Apr. 2010. .