cfa 1 equity-ii

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Analysis of Equity Investments:Day 2

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Agenda

Reading 58: Overview of Equity Securities

Importance and relative performance of equity securities in global financial

markets Characteristics of various types of equity securities

Public and private equity securities

Differences in voting rights and other ownership characteristics among variousequity classes

Methods for investing in non-domestic equity securities

Risk and return characteristics of various types of equity securities

Role of equity securities in the financing of a companys assets and creatingcompany value

Market value and book value of equity securities

Companys cost of equity, its (accounting) return on equity, and investorsrequired rates of return. equity, and investorsrequired rates of return

Reading 59: Introduction to Industry and Company Analysis Reading 60: Equity Valuation: Concepts and Basic Tools

Reading 39: Dividends and Share Repurchases: Basics (From Corporate Finance)

Reading 12: Technical Analysis (Part of Quantitative Methods)

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Equity securities in global financial markets

A comparison of the compunded returns on government bonds, government bills and equity securities in 17

countries during 1900-2008 shows that in real terms government bonds and bills kept pace with inflation

erning a return of 1-2% while equity markets generally gave a real return of more than 4%

Investorstolerance for risk tends to differ across equity markets

Investors are ready to take more risk existent with the equity markets for high returns of the equity markets

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Characteristics of various types of equity securities

Common Shares:

Represent an ownership stakein the company and is the most predominant form of equity

Statutory votingis when each shareholder has only one vote Cumulative votingis when the shareholder directtheir total voting rights to a single candidate

Common shares may be putable or callable

Commona shares are eligible for residual payments (after paying interest for debt & preference shares)

Preference Shares:

Have a higher priorityover common shares in terms of distribution payments and the liquidiation of netassets

They have the characteristics of both debt securities and common shares

However unlike interest payments, preference dividends are not a contractual obligation for thecompany

Preference shares can either be i) cumulative or ii) non-cumulative

In cumulativepreference shares the dividends if they are not paid in a given period start accumulating

Other types of preference shares are participating preferenceshares where the shareholders receivepreference dividends + additional dividends if the companysprofits exceed a certain level

Non-participating preferenceshares do not allow shareholders to share the profits in the company

Convertible preferenceshares allow the shareholders to convert their shares into common shares

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Public and private equity securities

Private Equity Shares:

Issued to institutional investors via non-public offeringssuch as private placements There are three types of private equity investments: i) venture capital; ii) leverage buyouts

and iii) private investments in public equity

Management is more likely to concentrate on long-term sustainable growth strategies instead of

focussing on short-term growth

Public Equity Shares:

The global public equity market is very large as compared to the global private equity markets

Management often feels the pressure of focussing on short-term gains instead of operating the company

in a long-term sustainable revenue and earnings growth mode

Public markets incentivize companies to adopt best practices in corporate governance

They also allow companies to raise larger amountsof money and also provide liquidity for trading in

the shares of the company

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Differences in voting rights and other ownership characteristicsamong various equity classes

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Voting Stock

(Class A)

Non-Voting Stock

(Class B)

Voting Rights Entitled to one vote pershare

No voting rights

Dividends Both the stocks share ratably in any cash dividendsdeclared by the Board

Conversion One Class A stock will be convertible to one Class B stock

Liquidation Rights All common stock shares irrespective of class will receiveproportional assets after all obligations to any outstandingpreference shares are met

Split Subdivision orCombination

In event of a split, sub-division or combination both classeswill be divided proportionally

Preemptive Rights There are no preemptive rights




Methods for investing in non-domestic equity securities (1/2)

Globalization and the integration of the international economy with increased use of technology in all

financial transaction has made foreign investments an important part of any countryseconomy

There are however restrictions in the flow of capital among countries because of

Limit of control foreign investors can make on the domestic companies

Domestic policies sometimes require that the domestic investors should have a stake in conducting the

business

To reduce the volatility of capital flows into and out of the domestic equity markets

Over the past two decades there has been three dominant trends:

Increasing number of companies investing in foreign markets

Number of companies listed in foreign equity markets has increased

Increase in the number of companies that are dual listed

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Methods for investing in non-domestic equity securities (2/2)

Direct Investing:

The most straight forward way of doing this is to buy/sell securities directlyin the foreign markets

This often leads tomore volatilityand less accountability Investors need to be aware of the local trading rules, clearing and settlement regulations and procedures

Depository Receipts (DRs):

These trade as normal shares and represent an economic interest in a foreign company

Short-term valuation discrepancies between shares traded on multiple exchanges often represent anarbitrage opportunity

The depository bank acts as a custodianand as a registrar

A DR can be sponsored as well as unsponsored:

Global Depository Receipts (GDR): Issued by companies globally excluding the US market & are notsubject to foreign ownerships and capital flow resrictions imposed by the home country

American Depository Receipts (ADR): Denominated in USD and are traded on American exchanges.ADS are shares on which theADRsare issued . There are four types ofADRsi)Level I; ii) Level II; iii)Level III and iv) Rule 144A

Global Registered Shares (GRS): Common shares that are traded on stock exchanges around theworld in different currencies

Basket of Listed Depository Receipts (BLDR): An ETF which is based on a portfolio of depositoryreceipts

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Risk and return characteristics of various types of equitysecurities

An equity securitystotal return is calculated as follows

Thus returns from an equity investment can be due to the following reasons:

i) Price appreciation ii) dividends

For foreign investors there is another source of appreciation and that is through foreign exchangefluctuations

The risk in equity securities is mostly due to the uncertainity of future cash flows

Preference shares are considered to be less risky than common shares because of the following reasons:

Dividends on preference shares are known and fixed

Preference shareholders receive dividends before common shareholders

If the company liquidates then preference shareholders will receive a fixed value equal to the par value ofthe preference shares

Callable common and preference shares are riskier than non-callable shares as they pay a premium for thecall option. Similarly putable shares have lower risk than non-putable shares

We should also remember while assessing the risk of the equity is that the greater the amount of cash flowsassociated with the company the lower the uncertainity and risk associated with the dividend payments

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Role of equity securities in the financing of a companys assets

and creating company value

The role of the companysmanagement is to increase the book valueof the company or the shareholders

equity in the companysbalance sheet

The companysequity increases when the company retains its net income

We will normally observe that the market value and the book value of the company will often differ

A key measure that the investor will use in evaluating the effectiveness of the management in increasing the

companysbook value is the accounting return on equity

While applying the above formula we should ensure that it is applied consistently

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Market value and book value of equity securities

The book value of a security reflects the historical operating and financing decisions of its management

The market value represents not only the historical operating and financing decisions but also the collective

assessment of the future cash flows of the company

It is usually observed that the companysmarket value is often higher than its book value

The price-to-book ratio is often used to analyse companies and reflects the investorsoutlook fo the industry

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Companyscost of equity, its (accounting) return on equity, and investorsrequiredrates of return. equity, and investorsrequired rates of return

To maximize the profitability of the companies the management generally tries to efficiently raise capital so

as to minimze the cost to the company

However unlike the cost of debt the cost of equity is difficult to estimate as the management is not

contractually obligated to make any payments to its investors

The companyscost of equity is often used as the investors required rate of return

It is generally assumed that if the cost of equity is higher than is justified by the market price of the

company, then investors will liquidate their holdings and invest it in some other place. The sale of the companysstock will reduce its share price and consequently the required rate of return on

the stock will become attractive for investors to again make an investment

Two models that are commonly used for estimate a companyscost of equity are:

Dividend discount model (DDM): discount the year-on-year dividend cash flows

Capital Asset Pricing Model (CAPM): Required return = risk-free rate + market risk-premium

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Questions

1. The RoE for Company ABC is closest to when the following information is available

Total Sales : $420,000

Net Income : $15,230

Total Assets (beginning of the year) : $ 1,500,000

Total Liabilities (beginning of the year) : $1,057,000

Number of outstanding shares at the end of the previous year : 1,200,000

Price per share : $45

A. 3.44% B. 1.02% C.1.44%

2. Calculate the book value per share of the company given the following information

Number of outstanding shares: 100,000

Price per share: $40

Total Assets: $ 14,500,000Total Liabilities: $12,100,000

Net Sales: $ 450,000

A. $266 B. $45 C. $24

3. Which of the following statements is not correct?

A) Common shares may be putable or callable

B) Preference Shares have lower priority over common shares in terms of distribution payments

C) Prefernce shares have the characteristics of both debt securities and common shares

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Answers

1. A.

RoE = NI / ( AssetsLiabilities) = 15,230 ( 1.5mn1.057mn) = 3.44%

2. C.

Book Value = TATL = 14.512.1mn = 2.4mn

BVPS = 2.4mn / 100k = $24

3. B. Preference Shares have lower priority over common shares in terms of distribution payments

because preference shares have higher priority over common shares in terms of distribution payments

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Agenda


Reading 59: Introduction to Industry and Company Analysis

Uses of industry analysis and the relation of industry analysis to company analysis

Methods by which companies can be grouped, current industry classificationsystems, and classify a company, given a description of its activities and theclassification system

Sensitivity of a company to the business cycle and the uses and limitations of industryand company descriptors such as growth,defensive,and cyclical

Relation of peer group, as used in equity valuation, to a companys industryclassification

Elements that need to be covered in a thorough industry analysis

Illustrate demographic, governmental, social, and technological influences on industrygrowth, profitability, and risk

Product and industry life cycle models and discuss the limitations of the life-cycle

Effects of industry concentration, ease of entry, and capacity on return on investedcapital and pricing power

Principles of strategic analysis of an industry Characteristics of representative industries from the various economic sectors

Elements that should be covered in a thorough company analysis

Reading 60: Equity Valuation: Concepts and Basic Tools



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Uses of industry analysis and the relation of industry analysis tocompany analysis

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Industry analysis is used in a number of investment applications that make use of fundamental analysis

including Understanding a companysbusiness and business environment

Identifying active equity investment opportunities

Portfolio performance attribution



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Approaches to Identifying Similar Companies

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Companies can be grouped by three major approachesto industry classification:

Products / Services supplied:

Industries with similar or related products are grouped into sectors

Classification schemes place a company in a group if their principal business activity is the same

Some examples include: i) Global Industry Classification Standard (GICS); ii) Russel Global Sectors(RGS) and Industry Classification Benchmark

Business-cycle sensitivities:

Companies are grouped into two major categories: i) cyclical and ii) non-cyclical

Cyclical companies have profits which are highly correlated with the economy

Non-cyclical companies are those whose performance is largely independent of the business cycle

Statistical similarities:

Companies are grouped based on the correlation of past returns

Use cluster analysis to form groups, however this can result in non-intuitive grouping of companies

Disadvantages of this grouping: i) falsely indicating a relationship when none exists and ii) falselyexcluding a relationship that is actually significant



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Industry Classification Systems

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Some common industry classification standards are :

Commercial Industry Standard:

Global Industry Classification Standard

Russell Global Sectors

Industry Classification Benchmark

Government Industry ClassificationStandard:

Industry Standard Industrial Classification of all Industrial Activities; viz. ISIC

Statistical Classification of Economic Activities in the European Community; viz. NACE

Australian and New Zealand Standard Industrial Classification; viz. ANZSIC North American Industry Classification System; viz. NAICS

Limitationsof the government classification systems vs. the commercial ones:

Government laws may prohibit the disclosure of individual companies activities

Commercial classification systems are more likely to be frequently updated than government systems

Government classification systems also do not make any distinction between profit and non-profit

organizations and between public and private companies

Smallest unit of classification may not be the peer group for the company



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Constructing a peer group

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Constructing a peer group is a subjective process and the results may differ significantly

One approach to the classification is to identify other companies which operate in the same industry

Analyst can often use one of the commercial classification systems to generate a peer group

An analyst must distinguish between a companys industry as defined by one of the classification systems

and its peer group

Companies in a peer group have the similar business activities and have similar economic drivers and cost

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Elements that need to be covered in a thorough industry analysis

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An analyst will study all statistical relationshipsbetween industry trends and a range of economic andbusiness variables

Investment managers will always examine industry performance in relation to other industriestoidentify the industries with superior returns and also to determine the degree of consistency, stability and riskin returns in the industry over time

Analyst also classify companies according to the industry life-cycleand experience curves

All analysis performed should be forward looking and it should prove that the company is creating value byproviding a rate of return higher than the cost of capital

Analysis of the competitive environment with special emphasis on the implications of the environment forcorporate strategy is known as strategic analysis

Porters five forcescan be a classic starting point for strategic analysis:

Threat of substitute products: Lot of substitute products are available in the market Bargaining power of customers: Similar products form other companies are available

Bargaining power of suppliers: Very less number of suppliers have those resources available with them

Threat of new entrants:New companies producing similar product are coming in the market

Intensity of rivalry:Currently many other companies are producing similar product & giving competition



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Industry Life Cycle (1/3)

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Embryonic (Inception/Pioneer stage):

An industry that has just beginning to develop

Typical characteristics include slow growth and high prices as companies are unable to achieveeconomies of scale

Customers are unawareabout the product/service features

Increasing awareness and developing distribution channels are key strategic initiatives

Substantial investmentsand riskof failure are very high

Growth:

There is rapid increasing demand, improved profitability, falling prices and relatively low competition Demand is fueled by new customers in the market

Threat of new entrants is very high as barriers of entry are low

Expanding demand provides companies with an opportunity to increase revenues without the need ofcapturing the competitors market share

Profitability improves as volume increases and economies of scale are achieved



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Shakeout:

Usually characterized by slow growth, intense competition and declining profitability

Demand may approach saturationlevels

Excess capacity develops and industry profitability declines as companies cut costs

Companies concentrate on cutting costsand building brand loyalty

Some companies may decide to merge while others will simply disappear

Mature:

There is little or no growth

There is very high barriers to entry Mature industries often consolidate and become oligopolies

Companies consolidate and achieve an efficient cost structure

They also understand their interdependence and try to avoid price wars

Companies with superior products or services are likely to gain market share and experience above-industrygrowth and profitability



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Decline:

Excess capacity develops and competition increases

Demandmay reducedue to technological substitutionor other reasons like social changesand

global competition

Demand falls, excess capacity results in lower prices , companies merge or start failing, others redeploytheir capital

Limitationsof the Industry Life Cycle:

An industry may not evolve in a predictable patternand various factors can make a few stagesshorter or longer or a company may simply skip a few steps

Technological changesmay cause an industry to shift from growth to decline (e.g. computer came &typewriter went)

Regulatory changes can also have a profound effect on the structure of the industry

Social changes can also have a profound effect on the profile of the industry

Demographic changeslike the baby boomer, gen Z etc. can create demand for a number of new

services Companies in the same industry may not experience similar performances


Effects of industry concentration ease of entry and capacity on return


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Effects of industry concentration, ease of entry, and capacity on returnon invested capital and pricing power

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Effect ofEase of Entry:

An industry can sustain high profitability only if there are high barriers to entry

New competitors can easily grab away a large share of the economic profits High barriers of entry do not normally transfer to good pricing power and attractive industry economics

Example: In businesses like e-commerce or other such businesses which run on internet, there are lowbarriers to entry

Effect of Industry Concentration:

Industries with greater concentration experience relatively less price competition

However exceptions exist like the aircraft manufacturing industry which has only two majormanufacturers, both competing very aggressively in acquiring new contracts

Companies in a fragmented industry are less likely to co-ordinate among themselves to control prices

Effect of Industry Capacity:

Tight/limited capacity gives the participants more pricing power while overcapacity will lead to undercutting in prices

We should remember that capacity is fixed in the short term while it is variable in the long term

Also capacity can be physical ( e.g. as in manufacturing capacity) which is difficult to increase in a shorttime while financial and human capital can be quickly shifted from one user to the other



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External Influences on Industry Growth, Profitability and Risk

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Demographic Influences:

Changes in population size, distribution of age and gender and other demographic characteristics can

have a significant influence on the industry The baby boom after the second World War created huge demand for products

Similarly the increase in the number of pensioners in Japan increases the demand for health services

Governmental Influences:

The governments influence on the industries revenues and profits is very pervasive

Governments exert their influence through self-regulatory organizations (SROs)

Social Influences:

Societal changes has a major impact on demand

Example: Tobacco



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Elements that should be covered in a Company Analysis

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A research report should have the following particulars:

An overview of the company. Including basic understanding of the business, investment activities,corporate governance and perceived strengths and weaknesses

Relevant industry characteristics

An analysis of the demandfor the companysproducts and services

Analyze the supply of productsand services including cost analysis

Analyze a companyspricingenvironment

Present and interpret relevant financial ratios,including comparisons over time and comparisons with

competitors



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Questions

1. An investor complains that his analyst spends a lot of time in analyzing the alternative economies andsecurity markets, various industries and then finally chooses a stock in which he can make an investment.The investor prefers a stock-picking and valuation approach. Both of them are most likelyadherents of

which type of analysis approach:

2. A top-down approach allows us to identify companies in cyclical industries. A likely classification ofindustries could be:

3. Which of the following statements is not correct?A) If an industry is in Embryonic stage, the growth will be high

B) In Shakeout stage there is high possibility of declining profitability

C) In mature stage, there is little or no growth

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Analyst Investor

A Bottom-Up Top-Down

B Arbitrage Bottom-Up

C Top-Down Bottom-Up

Cyclical Non-cyclical

A Steel Retail Food

B IT Steel

C Pharma Cement



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Answers

1. C. The investor follows a bottom-up approach while the analyst is following a top-down approach.

2. A. Steel is an example of a cyclical industry while retail food is an example of a non-cyclical industry.

3. A.If an industry is in Embryonic stage, the growth will be high because in in Embryonic stage, the growth

will be low.

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Agenda




Evaluate whether a security, given its current market price and a value estimate, is overvalued, fairlyvalued, or undervalued by the market

Major categories of equity valuation models

Rationale for using PV of CF models to value equity and describe the dividend discount and FCFEmodels

Intrinsic value of a non-callable, non-convertible preferred stock

Intrinsic value of an equity security based on the Gordon (constant) growth dividend discount model or atwo-stage dividend discount model, as appropriate

Identify companies for which the constant growth or a multistage dividend discount model is appropriate

Rationale for using price multiples to value equity and distinguish between multiples based oncomparables versus multiples based on fundamentals

Price to earnings, price to an estimate of operating cash flow, price to sales, and price to book value

Use of enterprise value multiples in equity valuation and demonstrate the use of enterprise value

multiples to estimate equity value Asset-based valuation models and demonstrate the use of asset-based models to calculate equity value

Advantages and disadvantages of each category of valuation model



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Evaluate whether a security is overvalued, fairly valued or


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undervalued by the market

An analyst needs to first estimate the intrinsic worthof the security, this is based on fundamental analysis

and a host of other factors

If the market price is greater than the intrinsic pricethen the stock is overvalued, if it is equal to the

intrinsic price then it is fairly valued otherwise its undervalued by the market

In practicality it is not always straightforwardand the analyst needs to first cope with the uncertainities

related to the appropriateness of the model

The analyst should also establish a time framewithin which the market price of the stock will converge

to its intrinsic value. IF an analyst is unable to establish a time frame a practical decision cannot be made

based on the perceived mispricing between the intrinsic worth of the stock and its market price

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Major categories of equity valuation models

The three major categories of equity valuation models are described below:

Present Value models/ Discounted Cash Flow models:

Dividend Discount models

Free cash flow to equity models

Multiplier Models:

Price-to-Sale model

Price-to-Earning model

EV/EBITDA model

Asset-based valuation models:

Estimates the intrinsic value of the common shares from the estimated value of the assets of thecorporation minus the estimated value of its laibililites and preferred shares

The estimated market value of the assets can be calculated by adjusting the book value of the assets

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Imp


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Dividend Discount Model (DDM)

Valuing Preferred Stock using DDM:

It has a constant coupon payment.

This is also refered to as the intrinsic value of the security.

Example: Calculate the value of a preferred stock when Discount rate (k) = 8% and dividend is $4.

Answer: 4/.08 = $ 50.

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Valuing Common Stock using DDM:

Valuing common stock is more difficult because:

The size of the cash flows are uncertainwhen compared to the cash flows on a preferred stock

Timingof cash flows are also uncertain

To top it all, the required rate of return (Ke) is unknown

The basic principle is that the value of a common stock is simply the present value of its future cash flows

Estimate discount rate(Ke) = R(f) + [R(market)R(f)]

Common Stock: One-year holding period

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Common Stock: Multiple-year holding period:

2-year holding period:

Multiple year holding period:

Infinite period DDM:

The above equation is simplified as:

This is called Constant Growth DDMor the Gordon Growth Model

Using the above model for preference share valuation, the value of g = 0

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Common Stock: Company experiencing temporary Supernormal Growth

These stocks are valued using the Multistage Dividend Discount model.

Where:

Dn= Last dividend of the supernormal growth period

Dn+1= First dividend affected by the constant growth rate, gc

Pn= Dn+1/ke-gc, the first periodsdividend after constant growth begins

The terminal value is added after discounting the same to today's value

Variations:

Company pays dividends but has two or more growth rates

Company does not pay any dividend during the initial years

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Using a DDM modelImp


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Using a DDM model

We have already used it before:

P0= D1/(k-g)

Dividing both sides by Earnings(E1)

P0/E1= D1/E1/(k-g)

Value of the Stock = (E1)(P/E1)

From the above we can conclude that the value of the stock will increase on:

Increase in the dividend payout ratio

Increase in the growth rate

Decrease in the required rate of return

Contradictory Results:

g = RoE*(1-payout ratio)

g = RoE*Retention Ratio where RoE : Return on Equity

So an increase in the payout ratio will result in decrease in g. Overall affect maybe an increase or decrease

in the value of the stock

p

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Required rate of return


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Required rate of return

Required rate of return consists of:

Risk free rate of return (Rf)

Inflation Premium (IP)

Risk Premium (RP)

Required rate of return (Ke) = (1+ Rf)(1+IP)(1+RP)-1

Rf-NOMINAL= (1+Rf-REAL) (1+IP)1

Ke = Rf-NOMINAL+ RP

Ke = Rf-NOMINAL+ [E(RMARKET- Rf-NOMINAL)]

Country Risk Premium:

This is the additional risk premuim which is added for Foreign Securities in the CAPM formula to arrive at the

required rate of return. It consists of Business risk (Op. leverage); Financial risk; Liquidity risk; Exchange

rate risk and Country risk

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Dividend growth rate(g)Imp


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Dividend growth rate(g)

We have already seen earlier that:

g = ROE*(1-payout ratio)

g = ROE*Retention Ratio and

P0= D1/(k-g)

The denominator [difference between k and g] has a major impact on the Price of the stock

The following can be implied from the above formula:

As ROE depends on thhe Net profit margin (Remember DuPont analysis!!!) an increase in the Net profit

margin will result in an increase in ROE

If ROE increase, g will increase:

Increase in g reduces the difference between k and g

This will result in an increase in the pric eof the stock

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Questions


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Questions

1. An analyst calculates the price of XYZ usind the infinite period DDM as $50. The market price is $60. Theanalyst should:

A. Issue a buy recommendation

B. Issue a sell recomendation

C. The given information is insuffficient to make a decision.

2. The DDM model for infinite period assumes that:

A. gk C. g >= k

3. An analyst expects a stock to pay a dividend of $3 next year and expect it to be priced at $50 at the end ofthe year. If k=16%, the value of the stock is?

A. 43.10 B. 45.68 C. 40.51

4. Current dividend = $2

Expected dividend growth rate forever = 5%

Risk free rate = 6%

Expected return on the market = 14%, Stock = 1.4

Intrinsic value of the company is:

A. $24.50 B.$21.25 C.$17.21

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Questions


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Questions

5. The value of the stock of company ABC is Rs. 44. It is projected that the company will pay dividends equalto Rs. 5 , Rs. 6 and Rs. 8 in the next three years. The value of the stock three years from now is expected to

be Rs. 62. The cost of capital for the company is 12%. Using DDM evaluate if the stock is overvalued orundervalued.

A. Over valued

B. Undervalued

C. Correctly valued

6. XYZ company paid a dividend of $3 last year. It has a payout ratio of 40% and a ROE of 12%. If the required

return is 14% what it the value of the stock?A. $47.29

B. $65.69

C. $60.69

7. The value of the dividends is $ 2 And they are expected to grow at 5% the cost of capital is 8%. The value ofthe stock using the GGM is closest to.

A. 70

B. 65

C. 62

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Answers


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Answers

1. B.Issue a sell recomendation

2. A.g


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Earnings per share (EPS) and earnings multiplier

EPS is arrived at by forecasting the sales and the profit margin of the company

EPS = [Sales (EBITDA%)DepreciationInterest ] * (1Tax Rate)

Two waysto determine appropriate P/E ratio:

Macro:Company P/E ratio is estimated by comparing it to industry and market P/E ratios

Micro: Using the formula derived in DDM:

Estimate projected dividend payout ratio (D/E)

Estimate ROE : k = RFR + (R marketRFR) Estimate growth rate: g = Retention Rate * ROE (Retention rate = 1 - D/E)

Estimated P/E = (D/E)/ (k-g)

Conclusion: The intrinsic value arrived at above should be compared with the market price and then a

decision should be made whether the stock should be purchased or not

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Price/Earnings Ratio - P/EImp


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g

Why P/E?

EPS is the primary determinant of investment valuation

Most popular with investors

Studies show that P/E is significantly related to long run average stock returns

Why not P/E?

Negative Earnings?

Management can distort Earnings Earnings are more volatile(than Cash)

Trailing P/E =MPS/EPS overprevious 12 months

Forward P/E: MPS/Forecast EPS overnext 12 months

Some care to take for EPS:

Consider recurring EPS only, exclude asset sales, other income, FX gains etc.

Use normalizedearningsover an entire cycle

Take care of Accounting differences, FIFO vs. LIFO, dilution of shares etc.

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Price/Book Value Ratio - P/BVImp


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Why P/B?

Book Value generally positive even when company has losses

BV more stable than EPS

Appropriate ratio to calculate NAVs for financial firms

Useful in valuation of Liquidating companies

Why not?

Do not capture intangibles (Example: Human capital) Difference in production techniques may show different asset intensity among companies

Accounting distortion (Example: R&D expensing)

Inflation and tech change can make BV obsolete (Example: Coca Cola Vs. Typewriting co.)

P/BV = Market Price per share/Book Value per share;

Book Value = Net Worth = Total AssetsTotal LiabilitiesPref. stock

Tangible BV = Normal BVIntangible assets (goodwill, patent).

When calculating BV, adjust for off B/S items and Accounting quirks: LIFO, leasing etc.

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Price/Sales Ratio - P/SImp


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Why P/S?

Sales is always positive unlike EPS or even BV

Sales is less easy to manipulate as compared to EPS or BV

Less volatile

Useful for mature or cyclical stocks and start ups

Why not P/S?

Growth in sales may not boil down to earnings? How the sales was funded?

Cost structures & production techniques not captured

Sales can sill be distorted. End period jacking up of orders and pushing it to sales channel

P/S = Market Value of Equity/Total Sales = Market Price per Share/Sales per share

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Price/Cash Flow RatioP/CFImp


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Why P/CF?

Difficult to manipulate cash flow

P/CF is more stable than P/E

Quality of reported earnings can be ignored

Why not P/CF?

At least 4 definitions for CashFlow. Some actual cash flow may be ignored

FCFE is better though more volatile

Four CF measures:

CF = Net Income + Depreciation + Amortization

Adjusted CFO = CFA + [(Net cash interest outflow)*(1 - tax rate)

Free Cash flow to Equity (FCFE) = PAT + non-cash chargesFA changeWC change)

EBITDA

P/CF Ratio = Market Value of Equity/Cash Flow = Market Price per share/Cash Flow per share

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Enterprise Value (EV)


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EV is often defined as:

market capitalization + market value of preferred stock + market value of debtcash and investments

EV is often used when comparing companies with significant difference in capital structure

EVmultiples are generally used in Europe

EV/EBITDA where EBITDA is a proxy for operating cash flow is used very commonly

An analyst may not be able to correctly assess the market value of the debt

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Asset Based Valuation


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Asset-based valuation works well for companies that do not have a high proportion of intangibles

They are frequently used with multiplier models for private companies

AS public companies make more fair-value disclosures, asset based valuation models may become popular

We should realize that

Companies with assets whose fair value is not easily determinable are difficult to analyze using asset

valuation models

Asset and liability fair values can be very different from the values that they are carried on the balance

sheet

Only a few intangibles are shown on the books of the company. If a company has significant intangibles

then the declared value should be considered as the floor value for the assets, also a forward looking

cash flow statement is preferred

Asset values may be difficult to estimate in a hyper-inflationary environment

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Questions


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Following pertain to XYZ:

Reported Earnings $50 million

Forecasted EPS over the next 12 months $3.00

No of shares outstanding 25 million Market Price per share $12

1. What are the Trailing and Leading P/E multiples respectively of XYZ?

A. 6 and 4

B. 4 and 6

C. 6 and 8

2. Which of the following is the most difficult to manipulate?

A. Earnings

B. Sales

C. Cash Flows

3. The major problem with P/CF ratio is:A. Different accounting standards across companies

B. Multiple ways in which cash flows can be calculated

C. Negative book value of the company

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Questions (Cont...)


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You are given the following information regarding XYZ:

Share Price $30, Networth $150 million,

Number of share 10 million, Retention rate 50%,

ROE 12%, Sales $45 million, Operating expenses $21 million, Depreciation $1,800,000

4. XYZ P/BV ratio is:

A. 2.00

B. 2.25

C. 2.50

5. XYZ P/S ratio is:

A. 5.40

B. 6.67

C. 6.30

6. XYZ P/CF ratio (using EBITDA for cash flow) is:A. 12.50

B. 13.27

C. 13.51

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Questions


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7. Growth stock is one where:

A. Expected return = market return

B. Market return > expected return

C. Required return < expected return

8. In a falling market which of the following would most likely give the best returns?

A. Speculative Stock

B. Cyclical Stock

C. Defensive Stock

9. Using average historical P/E values if the company is expected to grow at 10% what is the priceexpectation in 2005.

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2000 2001 2002 2003 2004

P/E 18.0 18.5 20.0 21.0 22.0

EPS 1.50 1.60 1.75 1.70 1.80

A. $30B. $45C. $40


Answers


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1. B. 4 and 6

2. C.Cash Flows

3. B.Multiple ways in which cash flows can be calculated

4. A.2.00

5. B. 6.67

6. A.12.5

7. C. Required return < expected return

(Good companies> good earnings& vice-versa. Also, good stocks> high returns)

8. C. Defensive Stock

9. C.Historical P/E = (18 + 19.5 + 20 + 21 +22)/5 =20

Price = P/E * Earning estimates = 20 * 1.8 * 1.1 = $40

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Agenda


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Reading 39: Dividends and Share Repurchases: Basics (From Corporate Finance)Reading 12: Technical Analysis (Part of Quantitative Analysis)ive Methods)

Underlying assumptions in technical analysis

Common technical analysis indicators

Cycle theory & Intermarket analysis

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Dividends : Different forms


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Regular Cash Dividends:

Companies that pay regular cash dividends ensure that they increase the dividends over a period of time

Consistent dividend paying companies are also considered as good investments

Some countries have a dividend reinvestment plan (DRP) which are of three basic types:

Open MarketDRP: when dividends are used to acquire shares from the open market to acquire theadditional shares credited to plan participants.

New-issueDRP: when company issues additional shares are issued instead of purchasing them.

Or an option is providedto either buy it from the open market or through issuance of new shares

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Dividends : Different formsSelf Study


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Extra or Special (Irregular) Dividends:

These are dividends paid by a company on special occasions or a dividend that supplements regular cashdividends with extra payment

Companies, esp. in cyclical industries, chose to use special dividends as a means of distributing moreearnings only during strong earnings years.

Liquidating Dividends:

This occurs under the following conditions:

When a company goes out of business the net assets are distributed to all shareholders A portion of the business can be sold for cash and distributed to all shareholders

Dividend payment can exceed the accumulated retained earnings impairing the stated capital

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Dividends : Different forms (cont.)Self Study


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Stock Dividends

A form of non-cash dividends

This occurs when additional shares are issued to the companys shareholders

The total cash basis remains the same, but cost per share held is reduced.

Not taxable to shareholders

They do not affect the shareholders proportionate ownership in the company nor does it change the value

of each shareholders ownership position.

A cash dividend affects the capital structure whereas a stock dividend does not.

Stock dividends do not affect liquidity or financial leverage ratios.

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Dividends : Different forms (cont.)Self Study


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Stock Splits

This has no economic effect on the company and the shareholders total cost basis does not change

If a company announces a two-for-one stock split, each shareholder will be issued an additional share for

each share currently owned.

EPS and other per market data will decline by half

P/E, Dividend Yield remains same

Wealth is not changed by the stock split.

A two-for-one stock split is basically same as a 100% stock dividend, but are accounted for differently

A company may announce a stock split anytime.

Reverse stock split

Occurs when the number of shares are reduced

The objective is to increase the price of a share

Companies going into or coming out of financial distress use reverse stock split

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Share Repurchases


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Occurs when a company buys back its own shares using corporate cash

Can be viewed as an alternative to cash dividends

Share repurchases can lead to share price manipulation.

Reasons for Corporations to engage in Share Repurchasing

Communicate that the management perceives the share price to be undervalued.

Flexibility in distributing cash to shareholders

Tax efficiency in distributing cash, in markets where cash dividends are taxes higher than capital gains tax

Absorb increase in outstanding shares due to ESOPs

Corporation accumulated more cash than it has profitable uses for and does not want to pay an extra cash

dividend.

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Share Repurchases


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Following are four common methods in which shares are repurchased:

Buy in the open market

This approach is very flexible for the company Allows the company to purchase shares from the open market

The company can time its purchases to exploit any perceived under evaluation in the market

Buy fixed number of shares at fixed price

The company makes a fixed price tender offer to repurchase a specific number of shares at a fixedprice

The company may offer to buy at a premium to the market

Dutch Auction

Similar to a fixed price buy except instead the company announces a band of prices

Provides the company with the minimum cost at which it can repurchase the shares

Repurchase by Direct Negotiation If the shareholder has a large stake then the company can negotiate directly with the shareholder

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Effect of Share Repurchase on EPS Imp


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Share repurchases affect both the balance sheet and the income statement.

Assets and Shareholders Equity decline since the repurchase is financed by cash.

Leverage increases, esp. if the repurchase is financed by debt

Effect of Share Repurchase on EPS (assuming not effect on net income):

A share repurchase can have the following effects on the earning per share of the company

Increase the EPS

Decrease the EPS

EPS remains the same

If the shares are repurchased using internal funds then the EPS generally increases

If the shares are repurchased using debt then

Earning yield > Cost of debt then EPS increases

Earning yield < Cost of Debt then EPS is reduced

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Question


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Momentum Inc. is planning a share repurchase. The company is evaluating its options for funding ashare repurchase program. One option is to take on additional debt at 8.0% to fund the repurchase.The following information is provided

Shares outstanding : 2mn

Net Profit in 2010: 12mn

Planned share repurchase: 150,000 shares

Market Price of each share : $60

The most likely effect on the EPS if the repurchase is through internally generated funds and whenthe repurchase is done through the use of debt is

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Internal Funds Debt

A Increases Increases

B Decreases Increases

C Increases Decreases



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Effect of Share Repurchase on Book value per share Imp


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Effect of Share Repurchase on Book Value per share:

If market price > BVPS then book value per share reduces after repurchase

If market price < BVPS then book value per share increases after repurchase

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Question


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Consider our previous question Momentum Inc. is still evaluating its share repurchase program.

Now the management wants to examine the effect of the purchase on its book value per share. Whatwill be the effect if the BVPS was a) $52 and when b) $65. You can use the data from the previous

question

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BVPS = $52 BVPS = $65

A Increases Increases

B Decreases Increases

C Increases Decreases


Solution


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C.

No calculations are required as when Market Price > BVPS then the book value will decrease afterrepurchase. If MP < BVPS then the book value will increase after repurchase.

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Cash dividends equivalence with share repurchases


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A share repurchase should be viewed as equivalent to payment of cash dividends with respect to theshareholders wealth.

All other things being equalassumes taxation and information content of cash dividends and share

repurchases do not differ.

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Question : Illustration of cash dividends equivalence with sharerepurchases


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Consider iPaxx is evaluating two options of whether to a) pay cash dividends or b) to make a sharerepurchase. The current market price is $15 and there are 20mn of stocks outstanding. iPaxx has freecash flow of equity of $25mn. Which of the following options is most appropriate

A. Paying cash dividendsB. Making a share repurchase

C. Both are the same

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Solution


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A) Making a special cash dividend

The cash dividend = 25mn/20mn outstanding shares = $1.25

After the cash dividend the ex-dividend cost of share = 15 -1.25 = $13.75

This can also be calculated as follows = ($15*20mn25mn ) / 20mn = $13.75

The total wealth however remains the same = 13.75+ 1.25 = $15

B) Making a share repurchase

The company can buy 25mn/15 = 1.67 mn shares

After the share repurchase stock value remains at $15

This can then be calculated as follows (15*20mn25mn)/(20mn1.67mn) = $15Thus both the options are equivalent. Solution is C

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Agenda



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Reading 39: Dividends and Share Repurchases: Basics (From Corporate Finance)Reading 12: Technical Analysis (Part of Quantitative Methods)



Cycle theory & Intermarket analysis

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Following are the underlying assumptionsin technical analysis:


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g y g p y

Prices are determined by investor supply & demand for assets

Supply & demand are driven by both rational & irrational behavior While the causes of changes in supply & demand are difficult to determine, the actual shifts in supply &

demand can be observed in market prices

Prices move in trends & exhibit patterns that can be identified & tend to repeat themselves overtime

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Price-based indicators:


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Price-based indicators:

Moving-average lines: mean of last n closing prices

Bollinger lines:constructed based on the standard deviation of closing prices over last n periods

Oscillators:based on market prices but scaled so that they oscillate around a given value

Rate of change oscillator:oscillates around 0, calculated as 100 times the difference between the latest

closing price & closing price of n periods earlier

Relative strength index:ratio of total price increases to total price decrease over a selected number of

periods

Moving average convergence/divergence(MACD):drawn using exponentially smooothed moving

averages, which place greater weight on more recent observations

Stochastic oscillators:calculated from the latest closing price & highest & lowest prices reached in a

recent period, such as 14 days

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Common technical analysis indicators (Cont)


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Non-price-based indicators:

Put/call ratio:ratio of put volume divided by call volume

Volatility Index(VIX):measures volatility of options on the S&P 500 stock index

Margin debt:increase in total margin debt suggest aggressive buying by bullish margin investors

Short interest ratio:number of shares investors have borrowed & sold short

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Cycle theory & Intermarket Analysis

Cycle theory: It is the study of the processes that occur in cycles, as many natural phenomena tend to do


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Cycle theory:It is the study of the processes that occur in cycles, as many natural phenomena tend to do

Some technical analysts apply cycle theory to financial markets in an attempt to identify cycles in prices

Intermarket Analysis:

Examines the relationships among various asset markets such as stocks, bonds, commodities, &

currencies

In asset allocation process, relative strength analysis can be used to identify attractive assets classes &

attractive sectors within these classes

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Questions

1) Which of the following is least likely to be a non-priced based indicator?


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1) Which of the following is least likely to be a non-priced based indicator?

A) Volatility Index

B) Put/call ratio

C) Relative strength index

2) Which of the following is least likely to be an underlying assumption in technical analysis?

A) Prices are determined by investor supply & demand for assets

B) Supply & demand are driven only by rational behavior

C) Prices move in trends & exhibit patterns that can be identified & tend to repeat themselves overtime

3) Which of the following is least likely to be a priced based indicator?

A) Moving-average lines

B) Margin debt

C) Bollinger lines

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Answers

1) C Relative strength index is a oscillator Other two are non priced based indicators


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1) C. Relative strength index is a oscillator. Other two are non-priced-based indicators

2) B. The correct underlying assumption is: Supply & demand are driven by both rational & irrational behavior.

Option A & C are correct assumptions.

3) B. Margin debt is a non-price based indicator. Other two are price-based indicator.

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Quiz Questions

1. Which of the following is least likely correct about Speculative stock?


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g y p

A. Speculative stock is always underpriced

B. Speculative company has highly risky assets

C. Speculative stock has low probability of earning a market rate of return

2. A top-down approach allows us to identify companies in cyclical industries. A likely classification ofindustries could be

3. Equity valuation can be approached through two techniques Discounted Cash Flow and RelativeValuation. The closestclassification of the various techniques

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Cyclical Non-cyclicalA Steel Retail FoodB IT SteelC Pharma Cement

DCF Relative ValuationA P/CF P/EB P/S PV of Operating CFC PV of FCFF P/BV


Quiz Questions

4. The value of the preferred stock of Company A is $92.45. If the dividend is $7.5 per year. The promised yield


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p p y p y p yis closestto

A. 8.15%

B. 8.11%C. 8.25%

5. Company A is being valued using the free cash flow to equity model while Company B is being valuedusing the operating cash flow model. The most likelydiscount rates for the model are

6. Company A reinvests all of its retained earnings in the business. The company management believes thatthis is the most appropriate source of funding as it keeps leverage low which can be very beneficial in acyclical industry. The least likely method of analyzing the company

A. Dividend Discount ModelB. Price to Earnings model

C. PV of Free CF to Equity

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Company A Company BA

WACC

Cost of debt

B Cost of equity WACCC Cost of debt Cost of equity


Quiz Questions

7. Find the correct order of analysis for top down analysis


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A. Economic analysis, Industry analysis, Stock analysis

B. Economic analysis, Stock analysis, Industry analysis

C. Stock analysis, Industry analysis, Economic analysis

8. A $100 par value preferred stock of Zadobe Corp. has a dividend yield of $9 per year. If the required rate ofreturn is 8.5% what is the value of the preferred stock. If the value of the stock is $ 104 the promised yieldis closestto

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Value of Preferred Stock Promised YieldA $105 8.65%B $105 8.55%C $102 9.50%


cfa 1 equity-ii

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