Investments

1
Chapter 14
Security Analysis
2
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
• Other methods and issues
• Macroeconomic analysis

3
Fundamental Analysis Models of Equity Valuation

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

4
Intrinsic Value and Market Price

• Intrinsic Value
• Self assigned Value
• Variety of models are used for estimation
• Market Price
• 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

5
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
• Other methods and issues
• Macroeconomic analysis

6
Dividend Discount ModelsGeneral Model

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

7
No Growth Model

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

8
No Growth Model Example

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

9
Constant Growth Model

• g constant perpetual growth rate

10
Constant Growth Model Example

• E1 5.00 b 40 k 15
• (1-b) 60 D1 3.00 g 8
• V0 3.00 / (.15 - .08) 42.86

11
Estimating Dividend Growth Rates

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

12
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

13
Partitioning Value Growth and No Growth
Components

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

14
Partitioning Value Example

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

g .20 x .40 .08 or 8
15
Partitioning Value Example (contd)
Vo value with growth NGVo no growth
component value PVGO Present Value of Growth
Opportunities
16
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
• Other methods and issues
• Macroeconomic analysis

17
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

18
P/E Ratio No Expected Growth

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

19
P/E Ratio with Constant Growth

• b retention ratio
• ROE Return on Equity

20
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

21
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 31.14/2.73 11.4
• PE (1 - .60) / (.125 - .09) 11.4

22
Pitfalls in P/E Analysis

• Use of accounting earnings
• Historical costs
• May not reflect economic earnings
• Reported earnings fluctuate around the business
  cycle

23
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
• Other methods and issues
• Macroeconomic analysis

24
Other Valuation Ratios

• Price-to-Book
• Price-to-Cash-Flow
• Price-to-Sales

25
The Free Cash-Flow Approach

• Fundamental idea the intrinsic value of a firm
  is the present value of all its net cash-flows to
  shareholders
• Estimate the value of the firm as a whole
• It equals the present value of cash-flows,
  assuming all-equity financing plus the net
  present value of tax shields created by using
  debt
• Derive the value of equity by subtracting the
  market value of all non-equity claims

26
Inflation and Equity Valuation

• Inflation has an impact on equity valuations
• Historical costs underestimate economic costs
• Empirical research shows that inflation has an
  adverse effect on equity values
• Research shows that real rates of return are
  lower with high rates of inflation

27
Potential Causes of Lower Equity Values with
Inflation

• Shocks cause expectation of lower earnings by
  market participants
• Returns are viewed as being riskier with higher
  rates of inflation
• Real dividends are lower because of taxes

28
Growth or Value Investing

• Growth Investing picking companies that are
  considered to have superior growth prospects
• Value Investing choosing companies for which
  fundamental analysis reveals unrecognized value
• The Graham technique

29
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
• Other methods and issues
• Macroeconomic analysis

30
Global Economic Considerations

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

31
Key Economic Variables

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

32
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
• Discount rate
• Reserve requirements

33
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

34
Business Cycles

• Business Cycle
• Peak
• Trough
• Industry relationship to business cycles
• Cyclical
• Defensive

35
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