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Chapter 14

Chapter 14. Security Analysis. 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

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Chapter 14

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  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 > MP Buy • IV < 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 Models:General 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 (cont’d) 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 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 b = 60% ROE = 15% (1-b) = 40% k = 12.5% g = 9%

  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

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