LUBS5052 International Investment

Global Equity Valuation

Session 5

Professor Charlie X. Cai

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Introduction

In this session we cover: Major differences in national accounting standards

Trends in economic growth

Global industry analysis

Global financial analysis using the DuPont equation

Multifactor models in a global context

6 - 7

Introduction

We also develop a top-down approach to global equity investing. This is conducted in the following order:

Country analysis

Industry analysis

Equity analysis

Financial Analysis

Research on a company should produce two pieces of information:

Expected return

Risk exposure

What do you need?

Information and Data

Research Question: International difference in Earning information release and their market response (see, para3 in p205)

Techniques and Tools (Qualitative vs Quantitative)

1-9

Tenets of Sound Fundamental Analysis

One does not buy a stock, one buys a business.

When buying a business, know the business.

Value depends on the business model, the strategy.

Good firms can be bad buys.

Price is what you pay, value is what you get.

Part of the risk in investing is the risk of paying too much for a stock.

Ignore information at your peril.

Dont mix what you know with speculation.

Anchor a valuation on what you know rather than speculation.

Beware of paying too much for growth.

When calculating value to challenge price, beware of using price in the calculation.

Stick to your beliefs and be patient; prices gravitate to fundamentals, but that can take some time.

Chapter 1. Penman, S.H. (2013). Financial Statement Analysis and Security Valuation, 5th Ed., McGraw-Hill.

I. Accounting Standards

Differences in National Accounting Standards

In the Anglo-American model, accounting rules have historically been set in standards prepared by a well-established, influential accounting profession.

In the Continental model, accounting rules have been set in a codified law system. Governmental bodies write the law, and the accounting profession is less influential than in the Anglo-American model.

International Harmonization of Accounting Practices

International Accounting Standards Board (IASB) publishes both International Accounting Standards (IAS) and International Financial Reporting Standards (IFRS).

IAS is representative of the accounting profession (private).

International Organization of Securities Commission (IOSCO) is representative of government regulators, where members are the agencies regulating securities markets in all countries.

International Harmonization of Accounting Practices

A major step for the world-wide acceptance of IFRS has been the decision by the European Union (EU) to adopt them.

As of 2007, IFRS applies to the 27 EU members, plus members of the European Economic Area.

Despite most countries adopting IFRS, the United States retain US GAAP.

IFRS adoption by country, PWC resource http://www.pwc.com/en_US/us/issues/ifrs-

reporting/publications/assets/pwc-ifrs-by-country-2014.pdf

http://www.pwc.com/en_US/us/issues/ifrs-reporting/publications/assets/pwc-ifrs-by-country-2014.pdfhttp://www.pwc.com/en_US/us/issues/ifrs-reporting/publications/assets/pwc-ifrs-by-country-2014.pdfhttp://www.pwc.com/en_US/us/issues/ifrs-reporting/publications/assets/pwc-ifrs-by-country-2014.pdfhttp://www.pwc.com/en_US/us/issues/ifrs-reporting/publications/assets/pwc-ifrs-by-country-2014.pdfhttp://www.pwc.com/en_US/us/issues/ifrs-reporting/publications/assets/pwc-ifrs-by-country-2014.pdfhttp://www.pwc.com/en_US/us/issues/ifrs-reporting/publications/assets/pwc-ifrs-by-country-2014.pdfhttp://www.pwc.com/en_US/us/issues/ifrs-reporting/publications/assets/pwc-ifrs-by-country-2014.pdfhttp://www.pwc.com/en_US/us/issues/ifrs-reporting/publications/assets/pwc-ifrs-by-country-2014.pdfhttp://www.pwc.com/en_US/us/issues/ifrs-reporting/publications/assets/pwc-ifrs-by-country-2014.pdfhttp://www.pwc.com/en_US/us/issues/ifrs-reporting/publications/assets/pwc-ifrs-by-country-2014.pdfhttp://www.pwc.com/en_US/us/issues/ifrs-reporting/publications/assets/pwc-ifrs-by-country-2014.pdfhttp://www.pwc.com/en_US/us/issues/ifrs-reporting/publications/assets/pwc-ifrs-by-country-2014.pdf

II. Global Industry Analysis

Research question: Country or Industry factor which is more important to a securitys risk and

return?

II.1 Country Analysis

In each country, economists try to monitor: Anticipated real growth Monetary policy Fiscal policy Wage and employment Rigidities Competitiveness Social and political situations Investment climate Questions: can you find the key macro measure of the above? If

you can, can you test their relationships with stock index return in different countries?

Country Analysis

Economists also focus on: the business cycle and long-term sustainable growth.

The main factors that interact with the countrys investment rate to affect GDP growth are: Rate of growth in employment Work hours Educational levels Technological improvements Business climate Politically stability the public/private nature of the investment

Country Analysis (continued)

Calverley (2003) classifies business cycle stages and attractive investment opportunities as: Recovery

Early upswing

Late upswing

Economy slows and goes into recession

Recession

Research question: can you identify which stage of a given country is in? Is their any direct link between business cycle and stock market return and/or volatility?

Business Cycle Synchronization

National business cycles are not fully synchronized.

The lack of perfect business cycle synchronization is an a priori argument in favor of international diversification.

The degree of business cycle synchronicity also varies over time depending on the pattern of regional shocks, and changes in economies propagation mechanisms.

Research question: what is the impact this non synchronization has on

international diversification.

Economic Data and Analysis

Market Impact Monitor

II.2 Industry Analysis: Return Expectation Elements

Demand Analysis: Usually surveys of demand as well as explanatory regressions are

used to try to estimate demand

The analysts will want to estimate the sensitivity of sales to global and national GDP changes

Research Question: Can you estimate the sensitivity of auto sales to global and national GDP changes? How about demand in other industry?

Research Resource: EBSCO Business Source Premier

http://0-search.ebscohost.com.wam.leeds.ac.uk/login.aspx?authtype=ip,athens,uid&profile=bsi&defaultdb=buh

Industry Analysis: Return Expectation Elements

Value Creation: value added at each transformation stage is partly a function of four major factors:

The learning (experience) curve (iPhone->iMac)

Economies of scale

Economies of scope (Think iPot->iPhone->iPad)

Network externalities (Think iPhone)

Research Question: Can you identify the global value chain for a given industry? For example, consumer electronic?

Industry Life Cycle

Stages involved (of varying length):

Pioneer stage

Rapid accelerating growth stage

Mature growth stage

Stabilization growth

Deceleration of growth

Research Question: Life cycle and PE ratio

Competition Structure

Two methods used:

N firm concentration ratio:

the combined market share of the largest N firms in the industry.

It provides an intuitive sense of industry competition.

the Herfindahl index:

has a value that is always smaller than one.

A small index indicates a competitive industry with no dominant players.

It has the advantage of greater discrimination because it reflects all firms in the industry and gives its greater weight to the companies with larger market shares.

Herfindahl index

An H below 0.1 indicates an unconcentrated industry.

An H of 0.1 0.18 indicates moderate concentration.

An H above 0.18 indicates high concentration.

An high Herfindahl index can also indicate the presence of a market leader with a higher share than others, another likely coordination as the leader might impose discipline on the industry.

Competitive Advantage (Qualitative)

National factors that can lead to a competitive advantage include:

Factor conditions such as human capital, perhaps measured by years of schooling.

Demand conditions such as the size and growth of the domestic market.

Related supplier and support industries such as the computer software industry to support hardware industry.

Strategy structure and rivalry such as the corporate governance, management practices and financial climate.

Competitive Strategies

Set of actions that a firm is taking to optimize its future competitive position.

Porter distinguishes three competitive strategies:

Cost leadership

Differentiation

Focus

Sector Rotation

A popular investment timing strategy.

Consumer cyclical industries (durables and non durables) correlate highly with the economy as a whole, these industries do well in the early and middle growth portion of the business cycle.

Defensive consumer staples maintain their profitability during recessions.

A successful sector rotation strategy depends on an intensive analysis of the industry and faces many pitfalls.

Research Question: Can you simulate an sector rotation investment strategy and examine its risk and return profile?

II.3 Industry Analysis: Risk Elements

Analysis should examine risk elements evidenced by:

market competition

value chain competition

Rivalry Intensity

Substitutes

Buyer and supplier power

New entrants

Government participation

Cash flow covariance

BLOOMBERG INTELLIGENCE PRIMARY INDUSTRIES (BIP)

Industry Analysis with

What Is Bloomberg Intelligence Primary Industries (BIP)?

BIP allows you to investigate the primary industry for a

selected ticker using hand-curated peers and company-specific information via a Bloomberg Intelligence dashboard.

BIP offers real-time research and analysis that leverages Bloomberg's consensus, price, target, ratings, and estimates.

BIP

Analysis - Understand the industry

Data Library Peers analysis

Monitor Following the latest update

II.4 Equity Analysis

Equity analysis needs to be carried out within the context of the country and the industry.

Most large corporations derive a significant amount of their cash flows from foreign sales and operations.

Most empirical studies have found that industry factors have grown in importance in stock price valuation.

Global industry factors tend now to dominate country factors.

Question: Discuss the relative importance of country and industry analysis for equity analysis.

6 - 37

Industry Valuation Approaches

Two approaches are traditionally used:

ratio analysis

discounted cash flow models

Global Financial Ratio Analysis

The DuPont model is to explain ROE or return on assets (ROA) in terms of its contributing elements.

The five elements reflect the financial and operating portions of the income statement as linked to the assets on the balance sheet and the equity supporting those assets.

DuPont formula

EQUITYASSETS

ASSETSSALES

SALESEBIT

EBITEBT

EBTNI

EQUITYNI

Tax Burden

Debt Burden Profit Margin Assets

Turnover Leverage ROA

DuPont Model

The DuPont model was originally intended to dissect company performance as due to such factors as operating efficiency and asset utilization.

DuPont analysis serves as a framework for making forecasts.

Research question: Using DuPont analysis to forecast stock return.

6 - 40

Role of Market Efficiency in Individual Stock Valuation

One of the most common discounted cash flow models used is the dividend discount model (DDM):

Where P0 = current price

D1 = dividend forecast for Year 1

r = required rate of return

g = growth rate of dividend

gr

DP

10

Dividend Discount model other approaches

A more realistic DDM approach is to decompose the future in three phases (the nonconstant DDM approach): In the near future (e.g. next two years) forecast earnings on an

individual basis,

In the second phase (e.g. years 3-5), a general growth rate of the companys earnings is forecast,

In the final stage, the growth rate in earnings reverts to the sustainable growth rate.

Franchise Value and the Growth Process

Leibowitz and Kogelman (2000)

Franchise value is the present value of growth opportunities divided by next years earnings.

Growth rate depends on relevant country GDP growth rates, industry growth rates and the companys sustainable competitive advantage.

The intrinsic P0/E1 ratio equals 1/r plus the franchise value, where r is the nominal required rate of return on the stock.

Franchise Value and the Growth Process

The franchise value is further divided into franchise factor (FF) and a growth factor (G) to give

Research Question: Can FF and G help us in understanding PE ratio better?

GFFrE

P

gr

g

rROE

rROE

rE

P

ROEbr

ROEb

rROE

rROE

rE

P

ROEbr

b

E

P

1

1

1

...

)1(

1

0

1

0

1

0

1

0

FA

Consensus overview (EEO)

Finding Cost of Capital

Require rate of return=risk-free rate+beta*equity risk premium

Beta

Equity risk premium

Analysts Estmiates

What is Apples growth aspect, learning from P/E

ROE0 =33.61% (Sep 2014) Estimates for Year 2015

EPS1=8.573 DPS1 =1.978 Retain ratio b=(8.573-1.978)/8.573=0.77

Cost of capital r=2.05%+0.774*7.5% =7.86%

Tangible PE=? 1/0.0786=12.72

Franchise Factor FF=1/0.0786-1/0.3361=9.75

What is Apples Growth factor P/E1=14.78=12.72+9.75*GF GF=0.21 g=Gr/(1+G)=0.21*0.0786/1.21 =0.014

Sustainable growth? g=b*ROE=0.77*0.3361=0.26

II. 5 Empirical Model Practical Uses of Factor Models

Used in risk-management and in selecting stocks.

A manager can estimate the risks taken and the exposure of the portfolio to various sources of risk.

Managers can also use factor models to tilt the portfolio along some factor bets.

Research Question: What is an optimal factor model for your countrys stock market?

Other Risk Factors: Styles

Value stocks: a company whose stock price is cheap in relation to its book value, or in

relation to the cash flows it generates.

Size effect: measured by stock market capitalization. Small firms do not exhibit the

same behavior as large firms.

Relative strength effect: also known as the momentum or success effect. In the short run, winners

tend to repeat.

Fama and French 3 factor model

Exercises from Solnik

Chapter 6.

Questions: 1, 2, 8,9, 11, 12, 18

Questions in the Appendix of DuPont analysis