Financial MarketsMgmt 183Fecon 173AEquity Valuation

Security Analysis

How to determine the correct value of a security in the market place.Choosing stocks over alternatives.Buy, Sell, or Hold if you are already in.

Analytical PerspectivesFundamental Analysis: Research to find the appropriate time, place, company, and stock. Focuses on determinants of sales and earnings, risks and expectations for future company performance.Attempt to find mis-priced securities.

Technical Analysis: Research to find recurrent and predictable stock price patterns, proxies for buy or sell pressure in the market.

Technical AnalysisSearch for time-series patterns in stock pricesExtensive use of ChartsExpectation that there is systematic information in price trends.Seems like theorizing with hindsight

Fundamental AnalysisEvaluate the financial condition and operating results of a specific companyCompetitive positionComposition and growth in salesProfit margins and dynamics of earningsAsset mix (i.e. cash balance, inventory, accounts receivable, fixed assets)Financing mix ( i.e. debt, stock)The value of a stock is influenced by the financial performance of the company that issued the stock.

EmpiricalFinancial StatementsCreating and Using Financial RatiosFundamental analysis is often the most demanding and most time-consuming phase of stock selection.

The Valuation Approach & MethodCost = De Novo or M&AIncome = Revenues, Earnings, Cash flowsMarket = Comparables

Concepts of ValueBook ValueMarket valueLiquidation Value Fair Market Value, Intrinsic ValueMarket Value - given a thorough appreciation of the Company, its prospects, and the marketLook for mispricingAlpha = E(HPR) less Market RRR

Valuation ModelsDividend Discount ModelD.C.F.C.A.P.M.

Discount RatesBuild-up MethodRisk-free Rate +Equity risk premium +Company risk premiumP/E impliedC.A.P.M.Risk-free Rate +Non-systematic risk premium

Fundamental ValuationTop downMacroeconomic AnalysisSector SelectionIndustry AnalysisCompany SelectionSecurity AnalysisTechnical Analysis

Looking for What, exactly?

Intrinsic value - the PV of its expected CFs discounted at the appropriate RADRCompared toMarket value todays price compared to similar companies.

Intrinsic ValuationForecast Earnings and Cash FlowsGrowth ratesDividend payout rateModel SelectionDiscount RateExogenous or endogenous considerationsConclusion & RecommendationUnder or over Valued: Buy, Sell, Hold

Intrinsic Valuation MethodsShifting Growth Rate Model or Multistage DDM

g1 = first growth rateg2 = second growth rateT = number of periods of growth at g1

Intrinsic Valuation MethodsDividend Discount Models (DDM): General Model

V0 = Intrinsic value of StockDt = Dividend; use D1k = required rate of return (RRR) a risk-adjusted discount rateIf a no growth company

Intrinsic Valuation MethodsSimplified versions of the DDM:

Assume a resale price criterion:

PN = the expected sales price for the stock at time NN = the specified number of years the stock is expected to be held

Intrinsic Valuation ModelsIntrinsic Value: the present value of a the future cash flows that will accrue to the owner of the asset.

Return on a stock investment is comprised of cash dividends and capital gains or losses.

Factors in valuing equitiesMagnitude of the cash flowsTiming of those future cash flowsProper discount rate

Intrinsic Valuation MethodsDividend Discount Models (DDM): General Model

V0 = Intrinsic value of StockDt = Dividendk = required return

Intrinsic Valuation MethodsGordons constant growth model

The model assumes that the dividend stream is perpetual and that the long-term growth rate is constant.

Intrinsic Valuation MethodsExample: If a common stock is expected to pay a dividend of $3.00 next year, has a long term growth rate of 5%, and should be priced to provide a return of 15%, it is worth:

Intrinsic Valuation MethodsThe Gordon growth model can also be used to get an idea of how risky the market thinks a particular stock is at that moment or shareholders required rate of return.

Use the current price as the P0 and solve for k.

Intrinsic Valuation MethodsShifting Growth Rate Model or Multistage DDM

g1 = first growth rateg2 = second growth rateT = number of periods of growth at g1

Intrinsic Valuation MethodsAdvantages of DDMSimplicityDisadvantages of DDMApply only to dividend paying stocks.Risk is not an explicit variable; it is implied.Estimates of the discount rate and the growth rate may be in error.Small changes in the discount rate and the growth rate produce large differences in valuation.Models do not reflect the value of underutilized assets.

Intrinsic Valuation MethodsSimplified versions of the DDM:

Assume a resale price criterion:

PN = the expected sales price for the stock at time NN = the specified number of years the stock is expected to be held

Intrinsic Valuation MethodsGordons constant growth model

The model assumes that the dividend stream is perpetual and that the long-term growth rate is constant.

Discount RatesBuild-up MethodRisk-free Rate +Equity risk premium +Company risk premiumP/E impliedC.A.P.M.Risk-free Rate +Non-systematic risk premium

Economy, Sector, Industry, Market, CompanyInherent sector and industry profitabilityIndustry structureCompanys relative competitive positionMarket shareCost leadershipPricing powerProduct differentiation versus product focus

ForecastingTop-down forecastEconomy-Sector-Industry-Company Financial forecastFinancial Statement Analysis: revenues & expensesFrom profits to cash flows, esp. Free Cash FlowsCosts, prices, and the Product life cycle

Value Stocks and Growth Stocks: How to Tell by Looking.

No precise definition exists.Low Price-to-Book for ValueHigh Price-to-Earnings for Growth

The EconomyEconomic Analysis

Structural economic changes.Demographic trends.Lifestyle changesTechnological changes.Politics and Regulation.

The EconomyEconomic AnalysisCyclical Changes - business cycleFinancial companies tend to bottom just prior to the business cycle troughs and peak before the peak of a business cycle.At troughs, stock of consumer durable goods companies tend to bottom and peak at the peak.Capital goods companies tend to bottom shortly following a trough and peak when there is evidence the economy is weakening.As the economy enters into a recession investors tend to gravitate towards consumer staple companies.

Sector Analysis4.33%

4.71%

The Ten Industrial Sectors

Consumer Discretionary 17 industries Consumer Staples 9 industries Energy 3 industries Financials 12 industries Health Care 8 industries Industrials 17 industries Information Technology 10 industries Materials 6 industries Telecommunications Services 3 industries Utilities 6 industries

IndustryIndustry Analysis Life Cycle Analysis

Pioneering developmentRapid accelerating growthMature growthStabilization and market maturityDeceleration of growth

IndustryIndustry Analysis Porter Fivethreats of new entrantsRivalry among existing competitorsThreat of substitutesBuyers bargaining powerSuppliers bargaining power

By considering each of these five elements of industry structure an analyst will develop a better estimate of how the industry is likely to fare in the future.

CompanyCompany AnalysisChoosing particular companies:

Growth rates

Price to Earning Ratio

Price to Book Ratio

Intrinsic Valuation Models

Value Vs. Growth InvestingTwo factions within Fundamental analysis

Value investors believes that securities should be purchased only when the underlying fundamentals (macroeconomic information, industry news, and a firms financial statements) justify the purchase.

Growth investors seek steadily growing companies. Growth traders are willing to pay more than might seem reasonable because they like the stocks future prospects; they are buying future earnings that may or may not develop.

Price to Book RatioThe price-to-book ratio is computed by dividing the current stock price by the firms book value per share.Book value per share is an accounting concept synonymous with equity per share or net asset value.

Share price is rarely equal to book value, but closest for banks - because of depreciation, uncollectible debts, goodwill, etc.economic obsolescenceintangible assets

Price to Book RatioThe price-to-book ratio is computed by dividing the current stock price by the firms book value per share.

Book value per share is an accounting concept synonymous with equity per share or net asset value.

Share price is not normally equal to book value because of depreciation, uncollectible debts, goodwill, etc.economic obsolescenceintangible assets

Price to Earning RatioThe price-earnings ratio (PE) is computed by dividing the current stock price by the firms earnings per share.Trailing PEForward PE

Growth stocks tend to have higher PE ratios than average

Price to Earnings GrowthThe P/E ratio divided by the companys growth rate of its earnings for a specified time period.P/E ratio Annual EPS GrowthThe PEG ratio brings the earnings growth rate into the valuation process. A more complete picture than the P/E ratio because, while a high P/E ratio may make indicate the attractiveness of a stock, by factoring in the company's growth rate can tell a different story. The lower the PEG ratio, the more the stock may be undervalued given its earnings performance.

Price to Earnings GrowthA broad rule of thumb is that a PEG ratio below one is desirable. Why?Interpretive value is sensitive to inputs used. Using historical growth rates, for example, may provide an inaccurate PEG ratio if future growth rates are expected to deviate from historical growth rates. Distinguish between future growth and historical growth by using "forward PEG" and "trailing PEG" are sometimes used.

Price to Earnings Growth

Example - Calculating the PEG Let\'s look at two hypothetical stocks to see how the PEG ratio is calculated: ABC Industries has a P/E of 20 times earnings. The consensus of all the analysts covering the stock is that ABC has an anticipated earnings growth of 12% over the next five years. 20 (x times earnings) / 12 (n % anticipated earnings growth) = 20/12 = 1.66 XYZ Micro is a young company with a P/E of 30 times earnings. Analysts conclude that the company has an anticipated earnings growth of 40% over the next five years. 30 (x times earnings) / 40 (n % anticipated earnings growth) = 30/40 = 0.75

Analytical Factors: Growth RatesChoosing a Growth Rate

Financial analysts typically calculate a number of growth rates using different ways to determine a likely range for the statistic.Recent data may be more reliable than data from the more distant past.Company statements regarding company targets may be considered too.

Other analysts Zacks, First Call and I/B/E/SWhisper Number -- thewhispernumber.com

Other Valuation PerspectivesPrice Earnings Ratio: The ratio of a firms stock price to its earnings per share.

Price-to-book value ratios

Price-to-Cash flow Ratios

Price-to-Sales

Finding a Reasonable Discount Rate, aka RRRMaybe the most important metric in terms of sensitivity to intrinsic value.

Requires an appreciation of many obvious, and also some subtle, factors affecting investor sentiment and confidence. Changes daily w/ the news.

But there are some tools.

BetaBeta is the volatility, or risk, of a particular stock relative to the volatility of the entire stock market. Beta is used to evaluate a stocks expected rate of return. Beta is one of the fundamentals that stock analysts consider when choosing stocks for their portfolios.

BetaLook at the time frame chosen for calculating beta. Provided betas are calculated with time frames unknown to their consumers. Long-term investors will certainly want to gauge the risk over a longer time period than a position trader who turns over his or her portfolio every few months.

BetaAnother problem may be the index used to calculate beta. Most provided betas use the American standard of the S&P 500. By calculating your own beta you can adjust for these differences and create a more encompassing view of risk. You can also gauge the beta's reliability by calculating the coefficient of determination, its R2.

BetaBeta looks backward and history is not always an accurate predictor of the future. Beta also doesnt account for changes that are in the works, such as new lines of business or industry shifts. Beta suggests a stocks price volatility relative to the whole market, but that volatility can be upward as well as downward movement. In a sustained advancing market, a stock that is outperforming the whole market would have a beta greater than 1.

Other Valuation MethodsPrice Earnings Ratio: The ratio of a firms stock price to its earnings per share.

Price-to-book value ratios

Price-to-Cash Flow Ratios

Price-to-Sales

Adjusted Closing PriceAdjusted Closing Price The adjusted closing price is a useful tool when examining historical returns because it gives analysts an accurate representation of the firm's equity value beyond the simple market price. It accounts for all corporate actions such as stock splits, dividends/distributions and rights