CHAPTER 14 SECURITY ANALYSIS

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CHAPTER 14SECURITY ANALYSIS
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DILEMNA FOR INVESTORS

• Should one search for undervalued stocks or
  follow a passive investment strategy by investing
  in index funds because markets are efficient?

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Two types of security analysis

• Fundamental Analysis
• Searching for info concerning the current and
  future profits of the company to determine its
  value
• Eg. dividends, net income, growth, etc..
• Technical Analysis
• Looking for trends in stock data to forecast
  future stock data

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• See textbook p. 505

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How do you invest in equities?

• Buy them (ie. go LONG)
• You make money through dividends and price
  increases
• Sell them (ie. go SHORT)
• Buying on margin

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Chapter Summary

• Objective Introduction to fundamental stock
  analysis. This chapter introduces different types
  of valuation models and shows how economic
  conditions affect the results.
• Dividend discount models
• Price-Earnings ratios
• - Macroeconomic analysis

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Fundamental Analysis Models of Equity Valuation

• Basic Types of Models
• Dividend Discount Models
• NPVGO model
• Price/Earning Ratios
• Estimating Growth Rates and Opportunities

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Ideas behind the models

• Intrinsic Value (IV) is calculated
• Variety of models are used for estimation
• Market Price (MP)
• Consensus value of all potential traders
• Trading Signal
• IV gt MP Buy
• IV lt MP Sell or Short Sell
• IV MP Hold or Fairly Priced

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Valuation fundamentals

• Expected holding period return (HPR)
• HPR D1 P1 P0
• P0
• Financial models like CAPM can predict stock
  returns
• If E(HPR) gt predicted return then INVEST

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Summary Reminder

• Objective Introduction to fundamental stock
  analysis. This chapter introduces different types
  of valuation models and shows how economic
  conditions affect the results.
• Dividend discount models
• Price-Earnings ratios
• Macroeconomic analysis

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Dividend Discount ModelsGeneral Model

• V0 Value of Stock
• Dt Dividend
• k required return

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No Growth Model

• Stocks that have earnings and dividends that are
  expected to remain constant
• Preferred Stock

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No Growth Model Example

• E1 D1 5.00
• k .15
• V0 5.00 / .15 33.33

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Constant Growth Model

• g constant perpetual growth rate

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Differential growth

• Example
• g 15 for years 1-5 g10 afterwards
• D0 1
• K 15
• What is the price of the stock?

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Estimating Dividend Growth Rates

• g growth rate in dividends
• ROE Return on Equity for the firm
• b plowback or retention ratio
• (1- dividend payout ratio)

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Growth rates

• Example
• Trent just reported earnings of 2MM and plans to
  retain 40 of tearnings. Historically, ROE is 16
  and is expected to continue indefinately into the
  future.
• What is the growth rate of the company?

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Specified Holding Period Model

• 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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NPVGO model

• PVGO Present Value of Growth
• Opportunities
• E1 Earnings per share for period 1

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Partitioning Value Example

• ROE 20 d 60 b 40
• E1 5.00 D1 3.00 k 15

g .20 x .40 .08 or 8
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Partitioning Value Example (contd)
Vo value with growth NGVo no growth
component value PVGO Present Value of Growth
Opportunities
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Summary Reminder

• Objective Introduction to fundamental stock
  analysis. This chapter introduces different types
  of valuation models and shows how economic
  conditions affect the results.
• Dividend discount models
• Price-Earnings ratios
• - Macroeconomic analysis

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Earnings, Growth and Price-Earnings Ratios

• P/E Ratios are a function of two factors
• Required Rates of Return (k)
• Expected growth in Dividends
• Uses
• Relative valuation
• Extensive Use in industry

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P/E Ratio No Expected Growth
(Divide both sides by E1)

• E1 - expected earnings for next year
• E1 is equal to D1 under no growth
• k - required rate of return

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P/E Ratio with Constant Growth

• b retention ratio
• ROE Return on Equity

What does P/E mean?
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P/E Ratio with Growth Opp
(Divide both sides by E1)
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P/E ratios

• What does P/E mean?
• As PV of growth opp increases, P/E increases

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Numerical Example No Growth

• E0 2.50 g 0 k 12.5
• P0 D/k 2.50/.125 20.00
• PE 1/k 1/.125 8

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Numerical Example with Growth
b 60 ROE 15 (1-b) 40 k 12.5
g 9

• E1 2.50 (1 (.6)(.15)) 2.73
• D1 2.73 (1-.6) 1.09
• P0 1.09/(.125-.09) 31.14
• PE (1 - .60) / (.125 - .09) 11.4

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Pitfalls in P/E Analysis

• Use of accounting earnings
• Historical costs
• May not reflect economic earnings
• Reported earnings fluctuate around the business
  cycle
• ie. model assumes earnings rise at a constant
  rate on a smooth line

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Growth or Value Investing

• Growth Investing picking companies that are
  considered to have superior growth prospects
• More risk therefore more reward
• Value Investing choosing companies for which
  fundamental analysis reveals unrecognized value
• More conservative

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Summary Reminder

• Objective Introduction to fundamental stock
  analysis. This chapter introduces different types
  of valuation models and shows how economic
  conditions affect the results.
• Dividend discount models
• Price-Earnings ratios
• Macroeconomic analysis

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Macroeconomic Analysis

• Look top-down

Economic analysis
Industry analysis
Firm analysis
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Global Economic Considerations

• Performance in countries and regions is highly
  variable
• Political risk
• Exchange rate risk
• Sales
• Profits
• Stock returns

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Key Economic Variables

• Gross domestic product (GDP)
• Unemployment rates
• Interest rates inflation
• International measures
• Consumer sentiment

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Government Policy

• Fiscal Policy - Government spending and taxing
  actions
• Monetary Policy - manipulation of the money
  supply to influence economic activity
• Tools of monetary policy
• Open market operations
• Bank Discount rate
• Reserve requirements

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Demand and Supply Shocks

• Demand shock - an event that affects demand for
  goods and services in the economy
• Tax rate cut
• Increases in government spending
• Supply shock - an event that influences
  production capacity or production costs
• Commodity price changes
• Educational level of economic participants

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Business Cycles
Peak (Expansion)

• Business Cycle
• Peak
• Trough
• Industry relationship to business cycles
• Cyclical
• Defensive
• (Some industries are more sensitive than others
  to the business cycle)

Trough (recession)
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Cyclical Indicators

• Leading Indicators - tend to rise and fall in
  advance of the economy. Examples
• Average work week
• New orders - durables
• Residential construction
• Stock Prices
• Lagging Indicators - indicators that tend to
  follow the lag economic performance

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INDUSTRY ANALYSIS

• Factors influencing sensitivity of earnings to
  business cycle
• Sensitivity of sales to the economy
• Operating leverage (ie. VC vs FC)
• Financial leverage
• Industry life cycle
• Porters model
• Government regulations and subsidies