Fundamental Analysis

1
Fundamental Analysis

• Finance 7320
• Lecture 6

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Objective Value Shares

• Fundamental Analysis the process of using
  fundamental information about a company to arrive
  at an estimate of the share price
• Fundamental ? would influence opinion of value
• Value ? present value of future cash flows

3
Fundamental Analysis

• Issue Must forecast EPS, DPS and growth
• Must forecast economy better than others, then
  translate into investment advice
• Economic forecast gt Asset Allocation
• Recession Bonds ? Stocks ?
• Expansion Bonds ? Stocks ?
• Stocks gt Which Industry? gt Which Cos

4
Fundamental Analysis

• Top Down Analysis
• Global Economy
• Macroeconomy
• Industry Analysis
• Equity Valuation Models
• Economic forecast gt Industry gt Cos

5
Global Economy

• Historically -- highly variable growth
• Why important?
• Export Cos - growth opportunities
• Competition - imports
• Exchange rates

6
Effect of Exchange Rates

• Exchange rate - price of one currency in terms of
  another
• Rising gt takes more of foreign currency to
  buy a (price of s ?)
• Hurts exports - US goods more expensive
• Makes imports more competitive
• Helps foreign investment in US
• Hurts US investment in foreign

7
Effect of Exchange Rates

• Falling gt takes more to buy foreign
  currency (price of s ?)
• Helps exports - US goods cheaper
• Makes imports more expensive
• Hurts foreign investment in US
• Helps US investment in foreign countries

8
Macroeconomy

• GDP
• Auto
• Steel
• Manufacturing in general
• Inflation
• Regulated cos utilities
• Input prices more flexible than output
• Oil companies w/reserves

9
Macroeconomy

• Exchange Rates
• Export sensitive want weak dollar
• Import sensitive (inputs) want strong dollar
• Interest rates
• Housing
• Consumer durables
• Business investment
• Financial services companies
• Utilities

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Macroeconomy

• Consumer sentiment
• Autos
• Consumer durables
• Fiscal Policy
• Government Spending
• Taxes

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Monetary Policy

• Money supply prices
• Open market operations Fed buys/sells bonds gt
  two impacts
• Market Clearing (short-run)
• Buys gt reserves ? bond prices ? rates ?
• Sells gt reserves ? bond prices ? rates ?
• Inflation Expectations (long-run)

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Leading Economic Indicators

• Tend to lead rest of economy
• Money Supply
• Stock Market
• Weekly hours
• Changes in raw materials prices
• ?s in consumer expectations

13
Industry Analysis

• Issue How sensitive is industry to business
  cycle?
• First Define Industry
• SIC codes (recently revised)
• Moodys, SP, Value Line forecasts

14
Sensitivity to Business Cycle

• Sensitivity of Sales
• Sensitive Autos, Steel, Luxuries
• Non-Sensitive Necessities cons. Staples
• Operating Leverage - firms with high OL are more
  sensitive (more fixed costs gt cannot reduce
  costs with sales)
• Financial Leverage - use of debt financing

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Industry Analysis

• Industry Life Cycles or Phases
• Start up (product development rapid growth)
• Consolidation (software stable growth)
• Maturity (utilities slowing growth)
• Decline (domestic tobacco)
• High growers gt profit opport. gt competition
• Ease of entry gt competition

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Summary
Economy
Sales
Operating/Financial Leverage
Earnings (Cash Flow)
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Equity Valuation Models

• Balance Sheet ? Book Value per share
• Equity shares
• Book value reflects acctg entries only
• Does not include
• Brand name
• Customer loyalty
• Expertise reputation
• Future growth opportunities
• Liquidation Value
• Replacement Value

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Intrinsic Value

• Value today Present Value of Future CFs
• V0 D1 P1 / (1R)
• Also R P1 - P0/P0 D1/P0
• Returns
• Expected - given price expected CFs
• Required - based on risk
• Realized - actual return after the fact

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Example

• Suppose
• P1 52 (expected)
• D1 4.00 (expected)
• P0 48
• Beta 1.2
• Rf 6 Rm - Rf 5
• Recall R Rf B(Rm - Rf)

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Example

• Expected Return
• R 52 - 48/48 4/48 16.67
• Required R 6 1.2(5) 12
• Is Stock Over or Under valued?
• gt undervalued stock price has to rise
• Intrinsic Value
• P0 52 4 / (112) 50 gt 48

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Dividend Discount Model

• P0 D1/(1R) D2/(1R)2 D3/(1R)3 ...
• If Dividends are expected to grow at the constant
  rate g, then
• P0 D1/(R-g) or P0 Do(1g)/(R-g)
• Price will be higher
• The higher the expected dividend
• The lower the capitalization rate, R
• The higher the expected growth rate, g
• The model is extremely sensitive to inputs

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Dividend Discount Model

• Example
• D1 4.00
• g 5
• R 12
• P0 D1/(R-g) 4/(12-5) 57.14
• Note Since P1 D2/(R-g) D1(1g)/(R-g)
• P1 D1/(R-g) x (1g)
• P1 P0 x (1g)
• Price grows at constant rate

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Dividend Discount Model

• Suppose
• D1 4.00
• g increases from 5 to 6
• What happens to price?
• What happens to expected return?
• P0 4/(12-6) 66.67
• E(R) D1/P0 g 4/66.67 6 12
• (unchanged)

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Stock Prices Investment Opportunities

• Sustainable Growth Rate rate of growth such that
  D/E remains constant no new equity is needed
• SGR r x ROE
• R retention ratio (1-DPS)/EPS
• DPS Dividends per share

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Example

• Suppose EPS 5.00 and R 12.5
• Compute Value P/E ratio for following

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Example, cont.

• Company 1
• r 0 gt D1 5.00
• g ROE x r 15 x 0 0
• P0 5/(12.5 - 0) 40.00
• P/E 40/5 8 ( 1/R) capitalization rate

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Example, cont.

• Company 2
• r 60 gt D1 .4 x 5.00 2.00
• g ROE x r 15 x .6 9
• P0 2/(12.5 - 9) 57.14
• P/E 57.14/5 11.43 gt 1/R

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Example, cont.

• Company 3
• r 60 gt D1 .4 x 5.00 2.00
• g ROE x r 12.5 x .6 7.5
• P0 2/(12.5 - 7.5) 40.00
• P/E 40.00/5 8 1/R

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Summary

• Expected EPS same for all three firms
• Only positive NPV growth leads to increase in
  share value (ROE gt R)
• P/E 1/R for no growth
• P/E gt 1/R for positive NPV growth firms
• P0 E/R PVGO
• P0 40 17.14

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Relation Between P/E Growth

• P D/(R-g)
• D E x (1 - r)
• g ROE x r (sustainable growth rate)
• SO
• P E x (1 - r) / (R - ROE x r)
• P/E (1 - r) / (R - ROE x r)

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Relation Between P/E Growth

• Now, take derivative of P/E w/r/t r
• (R - ROE x r) x (-1) - (1 - r) (-ROE) / (xx)2
• Denominator is always positive
• Numerator ROE - R
• ROE gt R gt P/E increases when r increases
• If ROE lt R, growth reduces P/E P
• Growth must be value enhancing!

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Example

• Consider a takeover target w/ entrenched mgmt
• r 60 ROE 10 R 15 EPS 5.00
• D (1 - 60) x 5 2.00
• g 10 x 60 6
• P 2 / (15 - 6) 22.22
• PVGO P0 - E/R 22.22 - 5/.15 -11.11
• Buy firm increase value by setting r 0
• P0 5/.15 33.33

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P/E ratios Risk

• From Before we know that
• P/E (1 - r) / (R - ROE x r)
• P/E (1 - r) / (R - g)
• Risk is reflected in R R is investors required
  return
• Higher risk gt Higher R
• Higher R gt Lower P/E (ceteris paribus)

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Pitfalls with P/E Approach

• Earnings can fluctuate dramatically
• What are normal earnings?
• P/E in DDM uses expected Earnings
• Reported P/E based on historical earnings
• Example
• P/E 1997 actual earnings 21.9
• P/E 1998 forecast earnings 18.3

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Multi-stage Growth Model

• Company grows at different rate early
• Eventually becomes constant growth
• Example Semiconductors Utilities
• ROA 18 7.6
• Payout 4.3 70.8
• Growth 8.3 3.8

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Problem 13

• Assume Rf 8 Rm 15 Beta 1.2
• r 60 E0 10 ROE 20
• What is intrinsic value per share?
• g 20 x 60 12
• R 8 1.2(15-8) 16.4
• P0 D1/(R-g) 4 x(112)/(16.4 - 12)
• 101.82

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Problem 13

• What is HPR if P is currently 100 and is
  expected to equal intrinsic value in 1 year?
• P1 101.82 x 1.12 114.04
• D1 4.00 x 1.12 4.48
• R (4.48 114.04 - 100) / 100
• 18.52

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Problem 15 a

• EPS 4.24 DPS 1.91
• 20 growth next 5 years 7 thereafter
• R 10
• D1 1.91 x 1.20 2.29
• D2 2.29 x 1.20 2.75
• D3 2.75 x 1.20 3.30
• D4 3.30 x 1.20 3.96
• D5 3.96 x 1.20 4.75
• D6 4.75 x 1.07 5.09

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Problem 15 a

• Recall Pt Dt1/(R - g)
• P5 D6/(R-g) 5.09/(.10 - .07) 169.67
• Present Value
• D1 1.91 x 1.20 2.29 (1.1) 2.08
• D2 2.29 x 1.20 2.75 (1.1)2 2.27
• D3 2.75 x 1.20 3.30 (1.1)3 2.48
• D4 3.30 x 1.20 3.96 (1.1)4 2.70
• D5 3.96 x 1.20 4.75 (1.1)5 2.95
• P5 169.67 (1.1)5 105.35
• P0 (2.082.272.482.702.95105.35) 117.83

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Problem 15, bc

• Phillip Morris P/E 80.25/4.24 18.9
• SP 500 P/E 417.09/16.29 25.60
• Relative 18.9 / 25.60 .74
• PM Price/Book 80.25/(12512/920) 5.9
• SP 500 P/Bk 417.09/161.08 2.59
• Relative 5.9/2.59 2.28

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Financial Statement Analysis

• Historical gt Analyst gt Future
• Accounting v. Economic Earnings
• Economic earnings maintains productive capacity
• ROE Leverage
• ROE (1 - t)ROA (ROA - i) D/E
• ROE increases with D if ROA gt i

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Decomposition of ROE

• Net Profit / Pretax profit (tax burden)
• x
• Pretax Profit / EBIT (interest burden)
• x
• EBIT / Sales (profit margin)
• x
• Sales / Assets (asset turnover)
• x
• Assets / Equity (equity multiplier)

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ROE analysis

• ROE tax burden x ROA x Leverage factor
• Leverage factor Interest burden x leverage
• ROA EBIT/Assets ( ROS x ATO)
• Meaningful for same industry only
• Ex Utility supermarket chain
• Can differ within industry
• Ex Wal-Mart and Neiman Marcus
• (Low ROS, High ATO High ROS, low ATO)

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Ratio Analysis

• Turnover ratios Use average B/S amount
• Comparability
• Accounting v. Economic Earnings
• FIFO v. LIFO
• Economic v. Acctg. Depreciation
• International Practices
• Reserving Intangibles
• Depreciation