Lecture 3

TOPIC 3 Equity Security Analysis 1

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Using Excel Matrix Operations

Lecture 2 Extra handout
You will need this handout again for this lecture for a review. You should have read the information about Excel and matrix operations provided in the Excel Tutor folder on the course home page. Practice is essential. =MMULT(TRANSPOSE(w), r) =MMULT(MMULT(TRANSPOSE(w), ), w)
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Equity Security Selection

Investment Management Process

Objectives and Constraints Formulate Investment Policy

Asset Allocation Security Selection

Construct Portfolio
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BANK 3004 Portfolio and Fund Management

Reading

Two broad tasks in the investment process are:

1. Security and market analysis - assess the risk and expected return attributes of the entire set of possible investment vehicles. 2. Formation of an optimal portfolio of assets determine the best risk-return opportunities available from the feasible investment portfolios and the choice of the best from the feasible set this is portfolio theory.
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Fundamental Analysis
Equity security analysis
Equity security analysis is the evaluation of a firm from the prospective of a current or potential investor in the firms stock. (Palepu, Healy & Bernard,
2004: 9-1)

Fundamental analysis
Fundamental analysis involves inferring the value of a business firms equity without reference to the prices at which the firms securities trade in the capital markets. (Bauman 1996 Journal of Accounting
Literature, 15: 1)

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The study of a stocks value using basic data, such as earnings and dividends prospects, expected interest rates, and risk evaluation. The analysis of information that focuses on valuation. Fundamental analysis is about forecasting payoffs and using financial statements and other information to develop those forecasts. (Penman 2001: 3) The study of a stocks value using basic data, such as earnings and dividends prospects, expected interest rates, and risk evaluation of the firm.
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Why equity security analysis?

Identification of mis-priced securities aim to generate returns that more than compensate investor for risk. Gaining knowledge of how security will affect risk of a portfolio and its suitability for the portfolio. Forecasting earnings or cash flows and valuation. Gain understanding to interpret new information as it arrives and infer its implications.

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Overview: Fundamental Analysis

TOP-DOWN APPROACH

FIRM
Determinants of value: DEVELOPING FORECASTS 1. Expected benefits: Earnings OR Dividends OR Cash flows 2. Risk attached to benefits: RRR (discount rate) OR multiplier (P/E ratio)
BY ANALYSING INFORMATION

KNOWING THE BUSINESS

Economic Analysis Key economic variables Government policy Supply and demand shocks Business cycles Industry Analysis Characteristics Life cycle Qualitative aspects Company Analysis Financial Statement Analysis Other information Specific factors/strategies

DDM Multiples DCF

VALUATION MODELS INTRINSIC VALUE

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Advantages of the top-down approach to fundamental analysis

1. Economic Analysis
Status of economy has major impact on overall stock prices. What are its implications for the stock market? Impact on earnings prospects of a company.

2. Industry Analysis
Which have the best prospects for the future? Industries respond to general market movements, but degree varies considerably.

3. Company Analysis
Whats its position in the industry? Any particular characteristics?
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BANK 3004 Portfolio and Fund Management

Economic Analysis
Corporate earnings Discount rates

Global Economy

FIRM
Domestic Economy Government Policy

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Demand Shocks
Demand shock - an event that affects demand for goods and services in the economy. Tax rate cut Increases in government spending

Supply Shocks
Supply shock - an event that influences production capacity and/or production costs. Commodity price changes Educational level of economic participants Natural disasters

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Business cycles
Reflects movements in economic activity as a whole, which is comprised of many parts. Recurring patterns of recession and recovery. Common features of business cycles:
Expansion of economy and peak Contraction of economy (recession) and trough

Indicators of business cycles

Monitor indicators of the economy.
Table 12.2 Indexes of economic indicators
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BANK 3004 Portfolio and Fund Management

Leading indicators tend to rise or fall in advance of the economy.

Business Cycles

Coincident indicators tend to change directly with the economy.

Lagging indicators tend to lag economic performance.

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Source: BKM, 2008: 579

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Industry Analysis
Industry relationship to business cycles
Not all industries are equally sensitive to business cycles.
Cyclical industries Sensitive to state of economy. Defensive industries Exhibit little sensitivity to business cycles. Growth industries Earnings are expected to be significantly above average for all industries, and such growth may occur regardless of setbacks in the economy.

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Implications for Investors Firms in cyclical industries tend to have high betas. Defensive firms tend to have low betas.

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Factors affecting sensitivity of earnings to business cycles:

Sensitivity of sales to business cycle Operating leverage
High OL --> small swings in economy have large impact on earnings.

Financial leverage What is their impact on sensitivity to business cycles?

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Industry Life Cycles Stages through which firms typically pass as they mature
Stage Start-up Consolidation Maturity Relative Decline Sales Growth Rapid and increasing Stable Slowing Minimal or negative

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What about their risk-return profiles?

Portfolio Management: Sector rotation

Portfolio is adjusted by selecting companies that should perform well for the stage of the business cycle. Peaks natural resource extraction firms Contraction defensive industries such as pharmaceuticals and food Trough capital goods industries Expansion cyclical industries such as consumer durables

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Qualitative Aspects of Industry Analysis

Industry structure, conduct and performance Competition Strategy Government regulations Business Partners

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Focus on competitive environment

Threat of entry (contestability?) Rivalry between firms in industry (oligopoly?) Substitutes available (elasticity of demand) Bargaining power
Suppliers (monopoly power on input side) Customers (monopoly power on output side)
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Sources of Information
Economic and financial markets
Reserve Bank of Australia (RBA)
RBA Bulletin

Australian Bureau of Statistics (ABS) Bureau of Economic Research Web sites: Yahoo!Finance, others Publications and news media

Industry
Industry associations Economic research bodies For example, resources industry and others
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Equity valuation
Valuation
The process of converting a set of forecasts (or observations) of company and economic variables into an estimate of the value of the firm.
Forecasts are made of value determinants such as earnings or dividends. Forecasts provide a forward-looking view. Forecasts require the business/economic analysis we considered earlier (and accounting information analysis).

IN FIRM Capital budgeting Strategic planning

OUTSIDE FIRM Buy/sell decisions Acquisitions IPOs Others

An estimate of the firms value is our best attempt to reflect in a single number the managers or analysts view of the firms prospects.

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1. Amounts 2. Timing 3. Risk

ASSET

Expected Stream of Cash Flows

PV Framework Used By Investors

Investors required rate of return

INTRINSIC VALUE

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Equity valuation models

Models are used to estimate the fundamental value of the share (share price) using:
Observable data and forecasts from markets Financial statements for firm and its competitors

Models need some theoretical foundation.

Theory tells us what data are needed

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BANK 3004 Portfolio and Fund Management

Basic types of models

Cash Flow Based
Discounted dividends firm value in terms of PV of forecast future dividends Discounted cash flows - multiple year forecasts of free cash flows are discounted at firms cost of capital to arrive at an estimated present value.

Accounting Information Based

Net book value (book value of equity) using the balance sheet Discounted abnormal earnings firm value as sum of its book value and discounted forecasts of abnormal earnings.
Ohlsons valuation using combination of earnings and book value (accounting information) in valuation

Using Price Multiples

Current or forecast measure of performance is converted into value by using price multiple from comparable firms or determined otherwise. Price-to-earning ratios Price-to-book ratios

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Intrinsic Value
Intrinsic value (V0) of a share = present value of all cash payments to the investor, discounted at the appropriate riskadjusted rate (k). The value of any financial claim is the PV of the cash payments that its claimholders expect to receive. Self assigned value Variety of models are used for its estimation

The return on a stock investment comprises cash dividends and capital gains or losses
Assuming a one-year holding period

E(HPR) = E(r) =
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E(D 1 ) + E(P1 ) - P0 P0

Market Value
Market price Consensus value of all potential traders Current market price will reflect intrinsic value estimates This consensus value of the required rate of return, k, is the market capitalization rate

k = r + [E(R ) - r ]
f M f

If the stock is priced correctly, then Required return should equal expected return

Provide trading signals by comparing intrinsic value (V0) and market price (MP)
V0 > M P V0 < M P V0 = M P Stock considered undervalued Stock is considered fairly priced.

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Discounted cash flow models

Key Idea
The value of a share is equal to the present value of the cash flow that the shareholder expects to receive from it. This is equivalent to the present value of all future dividends. Dividend discount model (DDM)

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DDM: General Model

Vo =

Dt t t =1 (1 + k)

V0 = Value of Stock Dt = Dividend (expected to be paid in each future period) k = Required Rate of Return (market capitalisation rate) = market consensus of RRR = cost of equity capital
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How can the equation be used?

1. 1. To compute value (V0) based on estimates of future dividends and the appropriate discount rate.
1. Compare with actual market price

2. 2. Use market price for V0, estimates of future dividends, and solve for k.
1. Decide if k is warranted by the risk of the stock

3. 3. Convert to the P/E ratio by dividing each side by earnings.

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Problems
Stream of dividends has to be forecast into the indefinite future. Dividend stream is uncertain.

Solution
Make simplifying assumptions about expected growth rate of dividends.

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DDM: No-growth model

Vo =

D k

Dividends are expected to remain constant in dollars. Useful to value a preference share

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DDM: Constant-growth model

Vo = Do (1 + g) D1 = k g k-g

g = constant perpetual growth rate Price of stock is equal to next years expected dividend divided by the difference between the appropriate discount rate for the stock and its expected long-term growth rate.
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Multistage growth model

(1 + g1 )t DT (1 + g 2 ) V0 = D0 + t (k g 2 )(1+ k)T t =1 (1 + k)
T
Motivation: A period of extraordinary growth continues for T years, after which the growth will change to a level that continues indefinitely g1 = first growth rate g2 = second growth rate T = number of periods of growth at g1
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Where do we get information on these variables?

Capitalisation rates (k)
Monetary policy (rf) Co-movement of returns with the market () Use of CAPM, other models

Growth rates (g)

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Business cycle analysis Industry analysis Maturity of firm/its products (life cycle) Analyst forecasts Firms financial statements
Analysing trends in growth Using ROE and payout ratio

When DDM works best

When payout is permanently tied to the value generation in the firm; for example, when the firm has a fixed payout ratio.

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Growth
Where does g come from?
The value of a firm is determined by its profitability (or earnings) and growth which are influenced by its product market and financial market strategies. ROE and dividend payout policy determine the pool of funds available for growth. Book value measures shareholders investment. This investment is applied by firms in operations to add value for shareholders. Value added to book value over the cost of capital.
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Return on Equity (ROE)

ROE is a comprehensive indicator of a firms performance.
How well are managers employing the funds invested by the shareholders to generate returns.

ROE=

Net Profit Shareholders' Equity

In the long run, the value of the firms equity is determined by the relationship between its ROE and its cost of equity capital.
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Determining ROE
Requires financial analysis of companys accounting data We use financial indicators ( in the form of financial ratios) ROE is one of these indicators. Use financial statements to:
Explore the sources of the firms profitability and evaluate the value relevance of its earnings Popular breakdown is via the use of the Du Pont system (many versions exist) Helps us to estimate intrinsic value

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Refer to FSA

BANK 3004 Portfolio and Fund Management

Behaviour of ROE
The behaviour of ROE over time tends to be meanreverting. Firms with above-average or below-average rates of return tend to revert to a normal level.
That is what we would expect, in general, based on the economics of competition.

Sustainable growth rate

The rate at which a firm can grow while keeping its profitability and financial policies unchanged. Acts as a benchmark against which the firms growth plans can be evaluated.

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Estimating g

g = ROE b
g = growth rate in dividends ROE = Return on Equity for the firm b = plowback ratio (or earnings retention ratio) = 1 - dividend payout ratio. Payout ratio = Total Dividends/Net Profit (Earnings) (Percentage of earnings paid out as dividends)
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Suppose the required rate of return on equity is k = 15%. What is the growth rate?

No Growth Company
Pays all its earnings as dividends. b=0 g = ROE x b = 0

Growth Company
Pays 40% of its earnings, and reinvests retained earnings in new investments to earn ROE = 20% b = 60% ROE = 20% g = ROE x b =12%

Normal Growth Company

Pays 40% of its earnings, and reinvests retained earnings in new investments to earn ROE = 15% b = 60% ROE = 15% g = ROE x b = 9%

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Free cash flow valuation

Free cash flow
P P P P P Cash flows from operations over time, Ct Cash investment over time, It All projects in firms operations

FIRM

Cash flow from all operations

Cash flow from operations

Cash outlays on investments

Capital expenditure or cash investment

Free cash flow

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Ct It

Remember capital budgeting?

Free cash flow

Part of the cash from operations that is free after the firm reinvests in new assets. FCFF = free cash flow to the firm FCFE = free cash flow to equity The value of the firm is the value of its investing and operating activities. This value is divided among the claim holders equity and debt holders.

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DCF model
The value of the firm is PV of expected cash flows from all the projects in the firms operations. Discount FCFF using the WACC, and subtract value of debt.
The discount rate is appropriate for the riskiness of the cash flows from all projects.

Discount FCFE using the cost of equity.

Textbook example for Honda
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When it works best

When the investment pattern produces positive constant or positive constant-growth free cash flow a cash cow business.

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References
Bodie, Zvi, Alex Kane and Alan J. Marcus, 2008 Investments, Seventh Edition, McGraw-Hill/Irwin, Boston. Elton, Edwin J., Martin J. Gruber, Stephen J. Brown and William N. Goetzmann, 2007 Modern Portfolio Theory and Investment Analysis, Seventh Edition, John Wiley & Sons, NJ. Palepu, Krishna G., Paul M. Healy and Victor L. Bernard, 2004 Business Analysis and Valuation: Using Financial Statements, Third Edition, Thompson/South-Western, Mason, USA. Penman, Stephen H., 2007 Financial Statement Analysis and Security Valuation, Third Edition, McGraw-Hill/Irwin, Boston, USA.

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BANK 3004 Portfolio and Fund Management