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##### Economics 173A Financial Markets

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**Economics 173AFinancial Markets**Investments 2 (stocks – equity analysis)**Fundamental Stock Analysis**• Introduction to Securities Analysis • Value Vs. Growth Investing • Balance Sheet Valuation Methods • Analytical Factors: Growth Rates • Intrinsic Valuation Methods**Introduction**• Security Analysis: determining correct value of a security in the market place.How do analysts choose the stock and other securities to hold in their portfolio? • Macroeconomic Analysis • Sector Selection • Industry Analysis • Company Selection • Security Analysis • Technical Analysis**Analytical Perspectives**• Fundamental Analysis: Research to find the appropriate time, place, company, and stock. Focuses on determinants of sales and earnings, risks and expectations for future company performance. Attempt to find mis-priced securities. • Technical Analysis: Research to find recurrent and predictable stock price patterns, proxies for buy or sell pressure in the market.**Long-run v. Short-run**• The Changing Paradigm. • In long run, earnings are the most important factor in determining stock value. • In the short run, however, changes in market sentiment and consumer confidence are equally if not more important.**The Role of Information**• Security prices reflect information ? • Global news – economic and political • Domestic news • Industry news - trends • Firm news – marketing, products, management.**The Economy**• Economic Analysis • Structural economic changes. • Demographic trends. • Lifestyle changes • Technological changes. • Politics and Regulation.**The Economy**• Economic Analysis • Cyclical Changes - business cycle • Financial companies tend to bottom just prior to the business cycle troughs and peak before the peak of a business cycle. • At troughs, stock of consumer durable goods companies tend to bottom and peak at the peak. • Capital goods companies tend to bottom shortly following a trough and peak when there is evidence the economy is weakening. • As the economy enters into a recession investors tend to gravitate towards consumer staple companies.**Sector Analysis**4.33% The Ten Industrial Sectors Consumer Discretionary – 17 industries Consumer Staples – 9 industries Energy – 3 industries Financials – 12 industries Health Care – 8 industries Industrials – 17 industries Information Technology – 10 industries Materials – 6 industries Telecommunications Services – 3 industries Utilities – 6 industries 4.71%**Industry**• Industry Analysis – Life Cycle Analysis • Pioneering development • Rapid accelerating growth • Mature growth • Stabilization and market maturity • Deceleration of growth**Industry**• Industry Analysis – Porter Five • threats of new entrants • Rivalry among existing competitors • Threat of substitutes • Buyer’s bargaining power • Supplier’s bargaining power • By considering each of these five elements of industry structure an analyst will develop a better estimate of how the industry is likely to fare in the future.**Company**• Company Analysis • Choosing particular companies: • Growth rates • Price to Earning Ratio • Price to Book Ratio • Intrinsic Valuation Models**Value Vs. Growth Investing**• Two factions within Fundamental analysis • Value investors believes that securities should be purchased only when the underlying fundamentals (macroeconomic information, industry news, and a firm’s financial statements) justify the purchase. • Growth investors seek steadily growing companies. Growth traders are willing to pay more than might seem reasonable because they like the stock’s future prospects; they are buying future earnings that may or may not develop.**Value Stocks and Growth Stocks: How to Tell by Looking.**No precise definition exists. Apple Lulu Wrigley • Low Price-to-Book for Value • High Price-to-Earnings for Growth**Price to Book Ratio**• The price-to-book ratio is computed by dividing the current stock price by the firm’s book value per share. • Book value per share is an accounting concept synonymous with equity per share or net asset value. • Share price is rarely equal to book value, but closest for banks - because of • depreciation, uncollectible debts, goodwill, etc. • economic obsolescence • intangible assets**Price to Earning Ratio**• The price-earnings ratio (PE) is computed by dividing the current stock price by the firm’s earnings per share. Two types: • Trailing PE • Forward PE • Growth stocks tend to have higher PE ratios than average**Price to Earning’s Growth**• The P/E ratio divided by the company’s growth rate of its earnings for a specified time period. P/E ratio ÷ Annual EPS Growth • The PEG ratio brings the earnings growth rate into the valuation process. • A more complete picture than the P/E ratio. • Although a high P/E ratio may indicate the attractiveness of a stock … • factoring in the company's growth rate can tell a different story. The lower the PEG ratio, the more the stock may be undervalued given its earnings performance.**Price to Earning’s Growth**• A broad rule of thumb is that a PEG ratio below one is desirable. Why? • Interpretive value is sensitive to inputs used. Using historical growth rates, for example, may provide an inaccurate PEG ratio if future growth rates are expected to deviate from historical growth rates. Calculate both: future growth and historical growth: • “forward PEG" • “trailing PEG“.**Analytical Factors: Growth Rates**• Choosing a Growth Rate • Financial analysts typically calculate a number of growth rates using different ways to determine a likely range for the metric. • Recent data may be more reliable than datafrom the more distant past. • Company statements regarding company targets may be considered too. • Other analysts – Zacks, First Call, I/B/E/S • Whisper Number -- thewhispernumber.com**Intrinsic Valuation Models**• Intrinsic Value: the present value of a the future cash flows that are likely to accrue to the owner of the asset. • Return on a stock investment is comprised of cash dividends and capital gains or losses. • Three Factors required for intrinsic value: • Magnitude of the expected cash flows • Timing of those future cash flows • Proper (“risk-adjusted”) discount rate**Intrinsic Valuation Methods**• Dividend Discount Models (DDM): General Model • V0= Intrinsic value of Stock • Dt = Dividend; use D1 • k = required rate of return (“RRR”) a risk-adjusted discount rate If a no growth company**Intrinsic Valuation Methods**• Simplified versions of the DDM: • Assume a resale price criterion: • PN = the expected sales price for the stock at time N • N = the specified number of years the stock is expected to be held**Intrinsic Valuation Methods**• Gordon’s constant growth model • The model assumes that the dividend stream is perpetual and that the long-term growth rate is constant.**Intrinsic Valuation Methods**• Example:If a common stock is expected to pay a dividend of $3.00 next year, has a long term growth rate of 5%, and should be priced to provide a return of 15%, it is worth:**Intrinsic Valuation Methods**• The Gordon growth model can also be used to get an idea of how risky the market thinks a particular stock is at that moment or shareholders’ required rate of return. • Use the current price as the P0 and solve for k.**Intrinsic Valuation Methods**• Shifting Growth Rate Model or Multistage DDM • g1 = first growth rate • g2 = second growth rate • T = number of periods of growth at g1**Intrinsic Valuation Methods**• Advantages of DDM • Simplicity • Disadvantages of DDM • Apply only to dividend paying stocks. • Risk is not an explicit variable; it is implied. • Estimates of the discount rate and the growth rate may be in error. • Small changes in the discount rate and the growth rate produce large differences in valuation. • Models do not reflect the value of underutilized assets.**Other Valuation Perspectives**• Price Earnings Ratio: The ratio of a firm’s stock price to its earnings per share. • Price-to-book value ratios • Price-to-Cashflow Ratios • Price-to-Sales**Working-out a Reasonable Discount Rate, aka RRR**• Maybe the most important metric in terms of sensitivity to intrinsic value. • Requires an appreciation of many obvious, and also some subtle, factors affecting investor sentiment and confidence. • Changes daily w/ the news. • But there are some tools.**Beta**• Betais the volatility, or risk, of a particular stock relative to the volatility of the entire stock market. • Beta is used to evaluate a stock’s expected rate of return. • Beta is one of the fundamentals that stock analysts consider when choosing stocks for their portfolios.**Beta**• The beta of the market is by definition 1.0 – the market moves with the market. • A beta of less than 1 means that the stock is less volatile, less risky than a diversified portfolio. • A beta greater than 1 means the stock is more volatile, more risky than a diversified portfolio.**Beta**• Look at the time frame chosen for calculating beta. • Provided betas are calculated with time frames unknown to their consumers. • Long-term investors will certainly want to gauge the risk over a longer time period than a position trader who turns over his or her portfolio every few months.**Beta**• Another problem may be the index used to calculate beta. • Most provided betas use the American standard of the S&P 500. • By calculating your own beta you can adjust for these differences and create a more encompassing view of risk. You can also gauge the beta's reliability by calculating the coefficient of determination, its R2.**Beta**• Beta looks backward and history is not always an accurate predictor of the future. • Beta also doesn’t account for changes that are in the works, such as new lines of business or industry shifts. • Beta suggests a stock’s price volatility relative to the whole market, but that volatility can be upward as well as downward movement. In a sustained advancing market, a stock that is outperforming the whole market would have a beta greater than 1.**Adjusted Closing Price**• Adjusted Closing PriceThe adjusted closing price is a useful tool when examining historical returns because it gives analysts an accurate representation of the firm's equity value beyond the simple market price. It accounts for all corporate actions such as stock splits, dividends/distributions and rights