1Ch17, 18, 19 – MBA 566

Security Valuation and Analysis

Macroeconomic and Industry Analysis/Fundamental AnalysisEquity ValuationRatio analysis

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Factors affecting firm valuationGlobal economic analysisDomestic Macro-economyGovernment PoliciesIndustry analysisCompany analysis

Fundamental Analysis

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Performance in countries and regions is highly variable.Political riskExchange rate risk (Figure 17.1, page 554)

SalesProfitsStock returns (Table 17.1, page 554)

Global Economic Considerations

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Gross domestic productUnemployment ratesInterest rates & inflationBudget deficitConsumer sentimentCheck St. Louis Fed for this set of information

Domestic Macroeconomy

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Either affect the demand side (fiscal policy, monetary policy) or the supply side (improving the incentive of production) of goods and serviceDemand shock - an event that affects demand for goods and services in the economy.

Tax rate cutIncreases in government spending

Supply shock - an event that influences production capacity or production costs.

Commodity price changesEducational level of economic participants

The Effect of Government Policy

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Fiscal Policy - government spending and taxing actions.Monetary Policy - manipulation of the money supply to influence economic activity.

Open market operationsDiscount rateReserve requirements

Supply Side PoliciesPolicies on employmentProductivitiesEconomic growth

Government Policies

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Business Cycle

PeakTroughCyclical industriesDefensive industries

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Economic IndicatorsEconomic indicators

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Useful Economic Indicators

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Factors affecting sensitivity of earnings to business cycles:

Sensitivity of sales of the firm’s product to the business cycles

Typically varying across industriesOperating leverageFinancial leverage

Industry life cycles

Industry Analysis

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Effect of Operating Leverage

See example 17.1 on page 571Firms with lower operating leverage do better in recessions

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Effect of Operating Leverage

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DOL

Degree of operating leverage (DOL)=% change in profit/ % change in sales=1+Fixed costs / Profit

Computing DOL for firms A and B

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Effect of Financial Leverage

Financial LeverageFinancial leverage hurts in bad years

See example 19.1 on page 639 (Table 19.4)

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Figure 17.6 Returns on Equity, 2005

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Figure 17.7 Rate of Return, 2005

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Slow growersStalwartsFast growersCyclicalsTurnaroundsAsset plays

(page 592)

Industry Life Cycles

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Industry Life Cycle

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Sector Rotation

Portfolio is adjusted by selecting companies that should perform well for the stage of the business cycle

Peaks – natural resource extraction firmsContraction – defensive industries such as pharmaceuticals and foodTrough – capital goods industriesExpansion – cyclical industries such as consumer durables

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Balance Sheet ModelsBook Value

Dividend Discount ModelsPrice/Earning Ratios

Equity Valuation Models

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Limitations of Book Value

Book value is an application of arbitrary accounting rulesCan book value represent a floor value?Better approaches

Liquidation valueReplacement cost

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Intrinsic Value (page 606)Self assigned ValueVariety of models are used for estimation

Market PriceConsensus value of all potential traders

Trading SignalIV > MP BuyIV < MP Sell or Short SellIV = MP Hold or Fairly Priced

Intrinsic Value and Market Price

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V Dk

ot

tt

( )11

V0 = Value of Stock

Dt = Dividend

k = required return

Dividend Discount Models: General Model

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V Dk

o

Stocks that have earnings and dividends that are expected to remain constant.

Preferred Stock

No Growth Model

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E1 = D1 = $5.00

k = .15V0 =

V Dk

o

No Growth Model: Example

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Vo D gk go

( )1

g = constant perpetual growth rate

Constant Growth Model

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Vo D gk go

( )1

E1 = $5.00b = 40% k = 15%

(1-b) = 60% D1 = $3.00 g = 8%

V0 =

Constant Growth Model: Example

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g ROE b

g = growth rate in dividendsROE = Return on Equity for the firmb = plowback or retention percentage rate

(1- dividend payout percentage rate)

Estimating Dividend Growth Rates

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)1()1()1(...2

21

10 k

PDkD

kDV N

NN

PN = the expected sales price for the stock at time N

N = the specified number of years the stock is expected to be held

Specified Holding Period Model

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Example

Go through the example 18.1-18.3 from page 592 to 594

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)(1

)()1(

1

0

110

ROEbkb

EP

ROEbkbE

gkDP

b = retention ratio ROE = Return on Equity

P/E Ratio with Constant Growth

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Example 18.4 on page 598.

Numerical Example with Growth

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Summary of Key Financial Ratios

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Table 19.10 Summary of Key Financial Ratios

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Table 19.10 Summary of Key Financial Ratios

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Table 19.10 Summary of Key Financial Ratios

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Table 19.10 Summary of Key Financial Ratios

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Figure 19.2 Comparative Accounting Rules