Investment Analysis and Portfolio Management Frank K' Reilly

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Investment Analysis and Portfolio
ManagementFrank K. Reilly Keith C. Brown
CHAPTER 13
BADM 744 Portfolio Management and Security
AnalysisAli Nejadmalayeri
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Applying the DDM Valuation Model to the Market

• The stream of expected returns
• The time pattern of expected returns
• The required rate of return on the investment

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Applying the DDM Valuation Model to the Market

• Determinants of the Earnings Multiplier
• 1. The expected dividend payout ratio
• 2. The required rate of return on the stock
• 3. The expected growth rate of dividends for the
  stock

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Market Valuation Using the Reduced Form DDM

• Estimating k and g for the U.S. equity market
• The nominal risk-free rate
• The equity risk premium
• The current estimate of Risk Premium and k
• Estimating the growth rate of dividends (g)
• g f(b, ROE)
• ROE Net Income / Equity

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Related Topics

• Equity risk premium
• Stocks or Bonds? Check AIMR forum
• Equity Valuation
• Systematic approach AIMR readings
• Quantitative Methods AIMR readings
• Technical Analysis
• Price charts CFA magazine

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Estimating Growth Rate

• Growth rate of dividends is equal to
• Retention rate - the proportion of earnings
  retained and reinvested
• Return on equity (ROE) rate of return earned on
  investment
• An increase in either or both of these variables
  causes an increase in the expected growth rate
  (g) and an increase in the earnings multiplier

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Return on Equity (ROE)
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Market Valuation Using the Free Cash Flow to
Equity (FCFE) Model

• FCFE is
• Net Income
• Depreciation Expense
• - Capital Expenditures
• - D in Working Capital
• - Principal Debt Repayments
• New Debt issues

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Market Valuation Using the Free Cash Flow to
Equity (FCFE) Model

• The Constant Growth FCFE Model
• The Two Stage Growth FCFE Model

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Market Valuation Using Relative Valuation
Approach

• The price-earnings ratio (P/E)
• The price-book value ratio (P/BV)
• The price-cash flow ratio (P/CF)
• The price-sales ratio (P/S)

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Market Valuation Using Relative Valuation Approach

• Two-part valuation procedure

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Market Valuation Using Relative Valuation Approach

• Two major components of value
• 1. Estimating the future earnings per share for
  the stock-market series
• 2. Estimating a future earnings multiplier for
  the stock-market series

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Estimating Expected EPS

• Estimating expected earnings per share
• Estimate sales per share for a stock-market
  series
• Estimate the operating profit margin for the
  series
• Estimate depreciation per share for the next year
• Estimate interest expense per share for the next
  year
• Estimate the corporate tax rate for the next year
• Estimating Gross Domestic Product

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Estimating Expected EPS Corporate Profits

• Alternative estimates of corporate net profits
• Direct estimate of the net profit margin based on
  recent trends
• Estimate the net before tax (NBT) profit margin
• Estimate an operating profit margin to obtain
  EBITDA estimate depreciation and interest to
  arrive at EBT estimate the tax rate (T) and
  multiply by (1-T) to estimate net income

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Estimating Expected EPS Aggregate Profit Margins

• Estimating aggregate operating profit margins
• Capacity utilization rate
• Unit labor costs
• Rate of inflation
• Foreign competition

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Estimating Expected EPS Depreciation Expense

• Estimating depreciation expense
• time series trends
• estimate based on property, plant, and equipment
• sales and turnover
• depreciation

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Estimating Expected EPS Interest Expense

• Estimating interest expense
• debt levels
• total assets
• expected capital structure
• interest rates
• subtract result from EBIT to estimate EBT

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Estimating Expected EPS Taxes

• Estimating the tax rate
• depends on future political action
• multiply (1 t) times the EBT per-share to
  estimate the net income per share

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Estimating Expected EPS Multiplier for a Stock
Market Series

• Determinants of the earnings multiplier
• Dividend payout ratio
• required rate of return on common stock
• the expected growth rate of dividends for the
  stocks

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Determinants of Earnings Multiplier for a Stock
Market Series

• Estimating the required rate of return (k)
• inversely related to the earnings multiplier
• determined by risk-free rate, expected inflation,
  and the risk premium for the investment
• Estimating the dividend payout ratio (D/E)
• active decision or residual outcome?
• time series plots
• long-run perspective

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Determinants of Earnings Multiplier for a Stock
Market Series (condt.)

• Estimating an Earnings Mutiplier
• An Example
• The Direction of Change Approach
• Specific Estimate Approach
• Calculating an Estimate of the Value for the
  Market series

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Other Relative Valuation Ratios

• Price to book value ratio (P/BV)
• Price to cash flow ratio (P/CF)
• Price to sales ratio (P/S)

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Analysis of World Markets

• Individual country analysis
• analyze economy and security markets before
  analyzing alternative industries or companies
• macro techniques
• micro techniques
• technical analysis
• top down approach