Financial MarketsMgmt 183

Fecon 173A

Equity 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 Perspectives

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

Technical Analysis• Search for time-series patterns in stock prices

• Extensive use of Charts

• Expectation that there is systematic information in price trends.

• Seems like theorizing with hindsight

Fundamental Analysis• Evaluate the financial condition and operating

results of a specific company– Competitive position– Composition and growth in sales– Profit margins and dynamics of earnings– Asset 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.

Empirical

• Financial Statements

• Creating and Using Financial Ratios

• Fundamental analysis is often the most demanding and most time-consuming phase of stock selection.

The Valuation Approach & Method

1. Cost = De Novo or M&A

2. Income = Revenues, Earnings, Cash flows

3. Market = Comparables

Concepts of Value

• Book Value

• Market value

• Liquidation Value

• Fair Market Value, Intrinsic Value

a) Market Value - given a thorough appreciation of the Company, its prospects, and the market

b) Look for mispricing

c) Alpha = E(HPR) less Market RRR

Valuation Models

• Dividend Discount Model

• D.C.F.

• C.A.P.M.

Discount Rates

• Build-up Method

a) Risk-free Rate +

b) Equity risk premium +

c) Company risk premium

• P/E implied

• C.A.P.M.

a) Risk-free Rate +

b) Non-systematic risk premium

Fundamental Valuation• Top down

– Macroeconomic Analysis– Sector Selection– Industry Analysis– Company Selection– Security Analysis– Technical Analysis

Looking for What, exactly?

Intrinsic value - the PV of its expected CFs discounted at the appropriate RADR

•Compared to

Market value – today’s price compared to similar companies.

Intrinsic Valuation

• Forecast Earnings and Cash Flowsa) Growth ratesb) Dividend payout rate• Model Selection• Discount Ratea) Exogenous or endogenous considerations• Conclusion & Recommendationa) Under or over Valued: Buy, Sell, Hold

Intrinsic Valuation Methods

– Shifting Growth Rate Model or Multistage DDM

• g1 = first growth rate

• g2 = second growth rate• T = number of periods of

growth at g1

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Intrinsic Valuation Methods

• Dividend Discount Models (DDM): General Dividend Discount Models (DDM): General Model Model

• V0 = Intrinsic value of Stock

• Dt = Dividend; use D1

• k = required rate of return (“RRR”) a risk-adjusted discount rate

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If a no growth company

Intrinsic Valuation Methods

• Simplified versions of the DDM:

– Assume a resale price criterion:

• PN = the expected sales price for the stock at time N• N = the specified number of years the stock is

expected to be held

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Intrinsic Valuation Models

• Intrinsic Value:Intrinsic 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 equities• Magnitude of the cash flows• Timing of those future cash flows• Proper discount rate

Intrinsic Valuation Methods

• Dividend Discount Models (DDM): General Dividend Discount Models (DDM): General Model Model

• V0 = Intrinsic value of Stock

• Dt = Dividend• k = required return

10 )1(t

t

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k

DV

10 )1(t

t

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DV

Intrinsic Valuation Methods• Gordon’s constant growth model

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

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Intrinsic Valuation Methods

– Example:

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:

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Intrinsic Valuation Methods

• The 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.

g

P

gDk

0

0 1

Intrinsic Valuation Methods

– Shifting Growth Rate Model or Multistage DDM

• g1 = first growth rate

• g2 = second growth rate• T = number of periods of

growth at g1

TT

T

tt

t

kgk

gD

k

gDV

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Intrinsic Valuation Methods• Advantages of DDM

– Simplicity• Disadvantages of DDM

– Apply 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 Methods

• Simplified versions of the DDM:

– Assume a resale price criterion:

• PN = the expected sales price for the stock at time N• N = the specified number of years the stock is

expected to be held

)1()1()1(...2

21

10

kPD

kD

kDV N

NN

Intrinsic Valuation Methods• Gordon’s constant growth model

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

stock theof riskiness the

toaccordingfactor discount theis

rategrowth dividend expected theis

yearnext paid be todividend theis

dividendcurrent theis where

1

1

0

100

k

g

D

D

gk

D

gk

gDV

Discount Rates

• Build-up Method

a) Risk-free Rate +

b) Equity risk premium +

c) Company risk premium

• P/E implied

• C.A.P.M.

a) Risk-free Rate +

b) Non-systematic risk premium

Economy, Sector, Industry, Market, Company

• Inherent sector and industry profitability

• Industry structure

• Company’s relative competitive position

a) Market share

b) Cost leadership

c) Pricing power

d) Product differentiation versus product focus

Forecasting• Top-down forecast

a) Economy-Sector-Industry-Company

b) Financial forecast

c) Financial Statement Analysis: revenues & expenses

d) From profits to cash flows, esp. Free Cash Flows

e) Costs, 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 Value– High Price-to-Earnings for Growth

The Economy

• Economic Analysis

– Structural economic changes.• Demographic trends.• Lifestyle changes• Technological changes.• Politics and Regulation.

The Economy• Economic Analysis

– Cyclical Changes - business cycle• Financial 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

1) Consumer Discretionary – 17 industries2) Consumer Staples – 9 industries3) Energy – 3 industries4) Financials – 12 industries5) Health Care – 8 industries6) Industrials – 17 industries7) Information Technology – 10 industries8) Materials – 6 industries9) Telecommunications Services – 3 industries10) Utilities – 6 industries

Industry

• Industry Analysis – Life Cycle Analysis

– Pioneering development– Rapid accelerating growth– Mature growth– Stabilization and market maturity– Deceleration of growth

Industry

• Industry Analysis – Porter Five– threats of new entrants– Rivalry among existing competitors– Threat of substitutes– Buyer’s bargaining power– Supplier’s 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.

Company

• Company Analysis– Choosing particular companies:

• Growth rates

• Price to Earning Ratio

• Price to Book Ratio

• Intrinsic Valuation Models

Value Vs. Growth Investing• Two factions within Fundamental analysis

– Value investors believes that securities should be purchased only when the underlying fundamentals (macroeconomic information, industry news, and a firm’s 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 stock’s future prospects; they are buying future earnings that may or may not develop.

Price to Book Ratio

• The price-to-book ratio is computed by dividing the current stock price by the firm’s 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 obsolescence• intangible assets

Price to Book Ratio

• The price-to-book ratio is computed by dividing the current stock price by the firm’s 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 obsolescence• intangible assets

Price to Earning Ratio

• The price-earnings ratio (PE) is computed by dividing the current stock price by the firm’s earnings per share.– Trailing PE– Forward PE

– Growth stocks tend to have higher PE ratios than average

Price to Earning’s Growth– The P/E ratio divided by the company’s growth rate of

its earnings for a specified time period.P/E ratio ÷ Annual EPS Growth

– The 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 Earning’s Growth– A 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 Earning’s Growth

Example - Calculating the PEGLet\'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 = 1.66XYZ 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 Rates• Choosing 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/S– Whisper Number -- thewhispernumber.com

Other Valuation Perspectives

• Price Earnings Ratio:Price Earnings Ratio: The ratio of a firm’s stock price to its earnings per share.

• Price-to-book value ratiosPrice-to-book value ratios

• Price-to-Cash flow RatiosPrice-to-Cash flow Ratios

• Price-to-SalesPrice-to-Sales

Finding a Reasonable Discount Rate, aka RRR

Maybe the most important metric in terms of Maybe the most important metric in terms of sensitivity to intrinsic value.sensitivity to intrinsic value.

Requires an appreciation of many obvious, and Requires an appreciation of many obvious, and also some subtle, factors affecting investor also some subtle, factors affecting investor sentiment and confidence.sentiment and confidence.

Changes daily w/ the news.Changes daily w/ the news.

But there are some tools.But there are some tools.

Beta

• 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 stock’s expected rate of return.

• Beta is one of the fundamentals that stock analysts consider when choosing stocks for their portfolios.

Beta

• Look 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.

Beta

• Another 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.

Beta

• Beta looks backward and history is not always an accurate predictor of the future.

• Beta also doesn’t account for changes that are in the works, such as new lines of business or industry shifts.

• Beta suggests a stock’s 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 Methods

• Price Earnings Ratio:Price Earnings Ratio: The ratio of a firm’s stock price to its earnings per share.

• Price-to-book value ratiosPrice-to-book value ratios

• Price-to-Cash Flow RatiosPrice-to-Cash Flow Ratios

• Price-to-SalesPrice-to-Sales

Adjusted Closing Price

• 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