chapter 14 company analysis and stock valuation. financial leverage financial leverage = takes the...

Chapter 14Chapter 14

Company Analysis Company Analysis

and and

Stock ValuationStock Valuation

Financial LeverageFinancial Leverage

Financial leverage

= takes the form of a = takes the form of a loan or other or other borrowings (debt), the proceeds of which are (re)invested (debt), the proceeds of which are (re)invested with the intent to earn a greater rate of return with the intent to earn a greater rate of return than the cost of interest. than the cost of interest.

If the firm's rate of (ROA) is higher than If the firm's rate of (ROA) is higher than the rate of the rate of interest on the loan, then its (ROE) on the loan, then its (ROE) will be higher than if it did not borrow because will be higher than if it did not borrow because assets = equity + debt assets = equity + debt

Financial LeverageFinancial Leverage Degree Of Financial Leverage (DFL)Degree Of Financial Leverage (DFL) Financial Leverage acts as a double-edged sword. If the economic Financial Leverage acts as a double-edged sword. If the economic

conditions are favorable and conditions are favorable and EBIT is increasing, a higher financial is increasing, a higher financial leverage has a positive impact on the EPS. The DFL captures this leverage has a positive impact on the EPS. The DFL captures this relationship between EBIT and EPS. DFL is defined as the percentage relationship between EBIT and EPS. DFL is defined as the percentage change in EPS for a given percentage change in EBIT.change in EPS for a given percentage change in EBIT.

DFL = DFL = change in EPS change in EPS / / Change in EBITChange in EBITEPS EBITEPS EBIT

For different applications of leverage, analysts may include or exclude For different applications of leverage, analysts may include or exclude certain items, such as non-tangible balance sheet items, non-financial certain items, such as non-tangible balance sheet items, non-financial liabilities, and similar items, or may adjust the liabilities, and similar items, or may adjust the carrying value of other of other items. It is not uncommon to use only financial liabilities (long-term and items. It is not uncommon to use only financial liabilities (long-term and short-term borrowings), thereby excluding, for example, accounts short-term borrowings), thereby excluding, for example, accounts payable.payable.

Present Value of DividendsPresent Value of Dividends

Growth Rate EstimatesGrowth Rate Estimates

ADGR = ADGR = nn√√DDn - n - 11

DD00

If 1983 dividend was .02 a share and the If 1983 dividend was .02 a share and the 2004 dividend was .18. The ADGR was2004 dividend was .18. The ADGR was

2121√.√.1818 - - 1 = .11031 = .1103

.02.02

Present Value of Operating Free Cash FlowPresent Value of Operating Free Cash Flow

Also known as Also known as FCFFFCFF or or Entity DCF ModelEntity DCF Model To determine a value for the total firm and subtract the To determine a value for the total firm and subtract the

value of the firm’s debt obligations to arrive at a value value of the firm’s debt obligations to arrive at a value for the firm’s equityfor the firm’s equity

= EBIT (1-tax rate) + depreciation expense= EBIT (1-tax rate) + depreciation expense - capital expenditures- capital expenditures - - ∆ in working capital∆ in working capital - ∆ in other assets- ∆ in other assets

***the cash flow available to all capital suppliers***the cash flow available to all capital suppliers

Measure of Long Run GrowthMeasure of Long Run Growth

g = (RR) ( ROIC)g = (RR) ( ROIC)where RR = retention ratewhere RR = retention rate

ROIC = ROIC = EBIT (1-tax rate)EBIT (1-tax rate) total capitaltotal capitalSample:Sample:

Assume that the capital investments for two years were 7,985 Assume that the capital investments for two years were 7,985 and 9,264 with a tax rate of 38% for the taxable income of 2,176. and 9,264 with a tax rate of 38% for the taxable income of 2,176. What will be the ROIC?What will be the ROIC?

ROIC = ROIC = 2,176 x (0.62)2,176 x (0.62) = = 1,3491,349 = 15.64% = 15.64% (7,985 + 9,264)/2 8,624(7,985 + 9,264)/2 8,624

g = (.82)(.1564)g = (.82)(.1564) = 12.82%= 12.82%

Alternative Growth Alternative Growth ModelsModels No Growth FirmNo Growth Firm=earnings are calculated after allowing for =earnings are calculated after allowing for

depreciation expense used to maintain the depreciation expense used to maintain the assets at their original valueassets at their original valueThe value of the firm never changes, and The value of the firm never changes, and investors continue to receive investors continue to receive kk on their on their investment.investment.

V= E/k or k=E/VV= E/k or k=E/V

Alternative Growth Alternative Growth ModelsModels

Long Run Growth ModelLong Run Growth Model = assume that some of the earnings are reinvested= assume that some of the earnings are reinvested E : level of net earnings expected from existing assets, without further net E : level of net earnings expected from existing assets, without further net

investmentsinvestments R : reinvestment of net earnings (E) and is equal to bE,R : reinvestment of net earnings (E) and is equal to bE, where b is where b is percent of retentionpercent of retention between between zerozero (no investment)(no investment) and and

unityunity (total(total investment ; no dividends) investment ; no dividends)

G : r = mkG : r = mk r = reinvested fundsr = reinvested funds m = relative rate of return operatorm = relative rate of return operator k = expected rate of returnk = expected rate of return

If m is greater than 1, the projects that generate these returns If m is greater than 1, the projects that generate these returns are considered true growth investments (r > k). If m is less than 1, the are considered true growth investments (r > k). If m is less than 1, the investments are generating returns below the cost of capital (r < k) investments are generating returns below the cost of capital (r < k)


Simple Growth ModelSimple Growth Model=assumes the firm has growth investment =assumes the firm has growth investment

opportunities that provide rates of return equal opportunities that provide rates of return equal to rto r

V =V = D/k D/k + + bEm/k bEm/k

Present value of Present value of + + present value ofpresent value of constant dividend constant dividend growth investmentgrowth investment


Expansion ModelExpansion Model

V = (b) E / kV = (b) E / k

where the value of b must be greater where the value of b must be greater than zero 0than zero 0


Negative Growth ModelNegative Growth Model

=applies to firm that retain earnings=applies to firm that retain earnings

(b>0) and reinvest these funds in projects that (b>0) and reinvest these funds in projects that generate rates of return below the firm’s cost of generate rates of return below the firm’s cost of capital (r<k or m<1)capital (r<k or m<1)

Poor performance may be difficult to uncover Poor performance may be difficult to uncover because the firm’s asset base will grow since it because the firm’s asset base will grow since it is retaining earnings and acquiring assets.is retaining earnings and acquiring assets.

What determines the Capital Gain Component?What determines the Capital Gain Component?

3 Factors:3 Factors:

1.) The amount of capital invested in 1.) The amount of capital invested in growth investmentsgrowth investments

2.) The relative rate of return earned on 2.) The relative rate of return earned on the funds retainedthe funds retained

3.) The time period for these growth 3.) The time period for these growth investmentsinvestments

Economic Value Added Economic Value Added (EVA)(EVA)

Measures a firm’s economic profit, rather than Measures a firm’s economic profit, rather than accounting profitaccounting profit

Recognizes a cost of equity and a cost of debtRecognizes a cost of equity and a cost of debt EVA = (r-k) X CEVA = (r-k) X Cwhere:where:r = Operating return on assetsr = Operating return on assetsk = Total cost of capitalk = Total cost of capitalC = Amount of capital (Total Assets) invested in C = Amount of capital (Total Assets) invested in

the firmthe firm


Example Problem:Example Problem:

A firm has total assets of $1,000; 40% is A firm has total assets of $1,000; 40% is financed with debt and 60% with equity. financed with debt and 60% with equity. Interest on debt is 5% while opportunity Interest on debt is 5% while opportunity cost is 15%. What will be the calculated cost is 15%. What will be the calculated EVA if the operating return on assets will EVA if the operating return on assets will be 16?be 16?


Solution:Solution:Cost of debt Cost of debt = 400 x .05 = = 400 x .05 = $20$20Cost of equity = 600 x .15 = Cost of equity = 600 x .15 = $90$90 Total cost of capital ------ 110.00 or Total cost of capital ------ 110.00 or 110.00/1,000 = 110.00/1,000 = 11%11% EVA = EVA = (.16 - .11) x 1,000(.16 - .11) x 1,000 = $50.00 = $50.00

Analysis:Analysis: acceptable status since this has positive value. The acceptable status since this has positive value. The

higher the EVA, the more acceptable it will be for the higher the EVA, the more acceptable it will be for the firm.firm.

Market Value Added Market Value Added (MVA)(MVA)

MVA = (Market Value of Firm) – CapitalMVA = (Market Value of Firm) – Capital

- Market Value of Debt- Market Value of Debt

- Market Value of Equity- Market Value of Equity

=can be impacted by market interest rates =can be impacted by market interest rates and by changes in future expectations for and by changes in future expectations for a firm not considered by EVAa firm not considered by EVA

Comparison of EVA & Comparison of EVA & MVAMVA

EVA – does an outstanding evaluation EVA – does an outstanding evaluation of Management’s past performances in of Management’s past performances in terms of adding valueterms of adding value

MVA – hopes that the superior past MVA – hopes that the superior past performance will continueperformance will continue

When to Sell?When to Sell?

Doesn’t end when intrinsic value is Doesn’t end when intrinsic value is computed or research report is writtencomputed or research report is written

Indicators:Indicators: If the key value drivers appear to have If the key value drivers appear to have

weakenedweakened When the stock becomes fairly pricedWhen the stock becomes fairly priced If it already goes out of the original If it already goes out of the original

reason why you purchased the stockreason why you purchased the stock

Influences of AnalystsInfluences of Analysts

Paralysis of AnalysisParalysis of Analysis = must have expectations that differ from consensus = must have expectations that differ from consensus

(and (and why do you differ?)why do you differ?) Analyst Conflicts of InterestAnalyst Conflicts of Interest = separation of personal friendship and impersonal = separation of personal friendship and impersonal

relationshiprelationship Availability of DataAvailability of Data = both a blessing and a curse - tendency to have = both a blessing and a curse - tendency to have

Information overloadInformation overload Differential Accounting ConventionsDifferential Accounting Conventions = accounting rules and practices differ around the = accounting rules and practices differ around the

world; financial statements differ in presentationworld; financial statements differ in presentation

Influences of AnalystsInfluences of Analysts

Currency DifferencesCurrency Differences

= exchange rates volatility= exchange rates volatility Transaction CostsTransaction Costs

= commissions vary among countries = commissions vary among countries Valuation DifferencesValuation Differences

= earnings, cash flow and expected rate= earnings, cash flow and expected rate

of return vary in countriesof return vary in countries


TECHNICAL ANALYSISTECHNICAL ANALYSIS

- examination of prior price and examination of prior price and volume data to determine past volume data to determine past market trends to predict future market trends to predict future behavior of the marketbehavior of the market

Underlying Assumptions of Technical Underlying Assumptions of Technical AnalysisAnalysis

Market value of any good or service is Market value of any good or service is determined solely by the interaction of demand determined solely by the interaction of demand and supplyand supply

Supply and demand are governed by Supply and demand are governed by numerous rational and irrational factorsnumerous rational and irrational factors

The prices for individual securities and the The prices for individual securities and the overall value of the market tend to move in overall value of the market tend to move in trends at appreciable lengths of timetrends at appreciable lengths of time

Ships in supply and demand relationships can Ships in supply and demand relationships can be detected in the action of the market itselfbe detected in the action of the market itself

Technical Trading Rules Technical Trading Rules and Indicatorsand Indicators

Typical Stock Market CycleTypical Stock Market Cycle

Technical Trading RulesTechnical Trading Rules

Four GroupsFour Groups::

I. Contrary-Opinion RulesI. Contrary-Opinion Rules

= trading against the crowd= trading against the crowd

II. Smart Money II. Smart Money

= emulating astute investors= emulating astute investors

III. Popular Technical IndicatorsIII. Popular Technical Indicators

IV. Price and Volume TechniquesIV. Price and Volume Techniques


Contrary-Opinion RulesContrary-Opinion Rules Mutual Fund Cash PositionsMutual Fund Cash Positions

= high percentage of cash near a market = high percentage of cash near a market trough – the time when they should be trough – the time when they should be fully invested to take advantage of the fully invested to take advantage of the impending market riseimpending market rise


Contrary-Opinion RulesContrary-Opinion Rules Credit Balances in Brokerage AccountsCredit Balances in Brokerage Accounts

= investors sell stocks and leave the = investors sell stocks and leave the proceeds with their brokersproceeds with their brokers

= build up credit balances indicates = build up credit balances indicates increase in buying power and is a bullish increase in buying power and is a bullish signalsignal


Contrary-Opinion RulesContrary-Opinion Rules Investment Advisory OpinionInvestment Advisory Opinion

=If a large proportion of investment =If a large proportion of investment advisory services are bearish, this advisory services are bearish, this signals the approach of a market trough signals the approach of a market trough and the onset of a bull marketand the onset of a bull market


Smart MoneySmart Money Confidence IndexConfidence Index= measures the difference in yield spread = measures the difference in yield spread

between high grade bonds and a large cross between high grade bonds and a large cross section of bondssection of bonds

= a bullish indicator, during periods of high = a bullish indicator, during periods of high confidence, investors are willing to invest in confidence, investors are willing to invest in lower quality bonds for the added yield, w/c lower quality bonds for the added yield, w/c causes a decrease in the yield for the large causes a decrease in the yield for the large cross section of high grade bondscross section of high grade bonds


Smart MoneySmart MoneyT-Bill/Eurodollar Yield SpreadT-Bill/Eurodollar Yield Spread

= during international crisis, this spread = during international crisis, this spread widens as the smart money flows to safe-widens as the smart money flows to safe-haven US T-bills which causes a decline haven US T-bills which causes a decline in this ratioin this ratio


Smart MoneySmart MoneyDebit Balances in Brokerage AccountsDebit Balances in Brokerage Accounts (margin debts)(margin debts)= borrowing by investors from their brokers = borrowing by investors from their brokers

to engage in margin transactionsto engage in margin transactions= a bullish sign, but does not include = a bullish sign, but does not include

borrowing by investors from other borrowing by investors from other sources such as bankssources such as banks


Popular Technical IndicatorsPopular Technical Indicators Breadth of MarketBreadth of Market

= measures the number of issues that have = measures the number of issues that have increased each day and the number of increased each day and the number of issues that have declinedissues that have declined

= stock participation in the market= stock participation in the market


Popular Technical IndicatorsPopular Technical IndicatorsStocks above Their 200-day Moving AverageStocks above Their 200-day Moving Average= computation of moving averages of an index to = computation of moving averages of an index to

determine the general trenddetermine the general trend= knowing stocks that are currently trading above = knowing stocks that are currently trading above

their 200-day moving average index and will be their 200-day moving average index and will be used as indicatorused as indicator

overbought overbought – more than 80% of the stocks are – more than 80% of the stocks are trading above their 200-day moving averagetrading above their 200-day moving average

oversoldoversold – less than 20% of the stocks are selling – less than 20% of the stocks are selling above their 200d moving averageabove their 200d moving average


Price and Volume TechniquesPrice and Volume TechniquesDow TheoryDow Theory = remains the basis for many technical = remains the basis for many technical

indicatorsindicators = describes stock prices as moving in trends = describes stock prices as moving in trends

analogous to the movement of wateranalogous to the movement of water 1.) major trends – tides in the ocean1.) major trends – tides in the ocean 2.) intermediate trends – waves2.) intermediate trends – waves 3.) short run movements - ripples 3.) short run movements - ripples

Technical Trading RulesTechnical Trading Rules Price and Volume TechniquesPrice and Volume TechniquesVolume TechniqueVolume Technique = price increase on heavy volume relative to the = price increase on heavy volume relative to the

stock’s normal trading volume is an indication stock’s normal trading volume is an indication of a bullish activityof a bullish activity

IIndicator of market momentum:ndicator of market momentum:

volume of stock that increasedvolume of stock that increased

volume of stock that decreasedvolume of stock that decreased

Technical Trading RulesTechnical Trading Rules Price and Volume TechniquesPrice and Volume TechniquesSupport and Resistance LevelsSupport and Resistance Levels

Support Level – Support Level – will develop after a stock has will develop after a stock has enjoyed a meaningful price increase and the enjoyed a meaningful price increase and the stock experiences profit takingstock experiences profit taking

Resistance LevelResistance Level – expectations to increase in – expectations to increase in the supply of stock and a price reversalthe supply of stock and a price reversal

= results to = results to “overhanging stocks”“overhanging stocks”


Price and Volume TechniquesPrice and Volume TechniquesMoving Average Line –Moving Average Line – shorter run 50day and shorter run 50day and

large volumelarge volume = If the overall price trend of a stock or the = If the overall price trend of a stock or the

market has been down, the moving-average market has been down, the moving-average price line generally would lie above current price line generally would lie above current prices. If prices reverse and breakthrough the prices. If prices reverse and breakthrough the moving average line from below accompanied moving average line from below accompanied by heavy trading volume, a positive change by heavy trading volume, a positive change could signal a reversal of the declining trendcould signal a reversal of the declining trend


Price and Volume TechniquesPrice and Volume Techniques Relative StrengthRelative Strength If RS Ratio increases overtime, it shows that If RS Ratio increases overtime, it shows that

the stock or industry is outperforming the the stock or industry is outperforming the overall stock market and expect this superior overall stock market and expect this superior performance to continueperformance to continue

RS Ratio = RS Ratio = price of stock/industry indexprice of stock/industry index value of some stock market index value of some stock market index in S&P500in S&P500


Price and Volume Price and Volume TechniquesTechniques

Bar ChartingBar Charting

= plotting the high and low = plotting the high and low prices and connects the prices and connects the two points vertically to two points vertically to form a barform a bar

- horizontal line across the - horizontal line across the vertical bar indicates the vertical bar indicates the closing priceclosing price


Price and Volume Price and Volume TechniquesTechniques

Multiple-Indicator Multiple-Indicator ChartsCharts


Price and Volume TechniquesPrice and Volume TechniquesPoint-and-Figure - Point-and-Figure - a form of a form of

heterodox economics used to attempt to used to attempt to predict financial market prices. predict financial market prices.

- unique, does not plot price against time as all - unique, does not plot price against time as all other techniques do. Instead in plots price other techniques do. Instead in plots price against changes in direction by plotting a against changes in direction by plotting a column of Xs as the price rises and a column column of Xs as the price rises and a column of Os as the price falls of Os as the price falls

Samples of Point and FigureSamples of Point and Figure

Triple Top Double Top

Double bottom Triple Bottom


Equity Portfolio Equity Portfolio Management Management

StrategiesStrategies

Passive versus Active ManagementPassive versus Active Management

Passive Equity Portfolio Management:Passive Equity Portfolio Management:

= a long-term buy-and-hold strategy, generally referred as= a long-term buy-and-hold strategy, generally referred as “indexing”“indexing”

- Not to beat the target index but to match its Not to beat the target index but to match its performanceperformance

- Minimizes the deviation between the portfolio and Minimizes the deviation between the portfolio and index returns similar to the bond index portfolio index returns similar to the bond index portfolio managermanager

Passive versus Active ManagementPassive versus Active Management

Active Equity Portfolio Management:Active Equity Portfolio Management:

= attempt to outperform a passive= attempt to outperform a passive benchmark portfolio – benchmark portfolio – ((beta, dividend yield, beta, dividend yield, industry weighing and firm size match the risk-return industry weighing and firm size match the risk-return objectives of the client)objectives of the client)

= controls the larger percentage of investor = controls the larger percentage of investor wealthwealth

Index Portfolio Construction TechniquesIndex Portfolio Construction Techniques

Basic Techniques for Passive Index PortfolioBasic Techniques for Passive Index Portfolio

1. 1. Full Replication –Full Replication – stocks are purchased in proportion to the weights stocks are purchased in proportion to the weights in the indexin the index

2. 2. Sampling - Sampling - buying only the representative stocks that comprise the buying only the representative stocks that comprise the indexindex

3. 3. Quadratic Optimization – Quadratic Optimization – a programming technique which utilizes thea programming technique which utilizes the historical information on price changes and historical information on price changes and correlations between securitiescorrelations between securities

Completeness FundsCompleteness Funds – customized passive portfolios, constructed to – customized passive portfolios, constructed to complement the active portfolios that do not cover thecomplement the active portfolios that do not cover the entire market entire market

Other Technical StrategiesOther Technical Strategies

Contrarian Investment StrategyContrarian Investment Strategy

= belief that the best time to buy(sell) as stock = belief that the best time to buy(sell) as stock is when the majority of other investors are the is when the majority of other investors are the most bearish (bullish) about it.most bearish (bullish) about it.

Price Momentum StrategyPrice Momentum Strategy

= recent trend in past prices will continue;= recent trend in past prices will continue;

assumes that stocks that have been hot willassumes that stocks that have been hot will

stay hot, while cold stocks will also remain sostay hot, while cold stocks will also remain so

Other Technical StrategiesOther Technical Strategies

Earnings Momentum StrategyEarnings Momentum Strategy

= more formal active portfolio approach = more formal active portfolio approach that purchases and holds stocks that that purchases and holds stocks that have accelerated earnings and sells have accelerated earnings and sells (short sells) stocks with disappointing (short sells) stocks with disappointing earningsearnings

Asset Allocation StrategiesAsset Allocation Strategies

Integrated Asset AllocationIntegrated Asset Allocation

= separately examines: 1.) capital market conditions= separately examines: 1.) capital market conditions

2.) investor’s objectives and constraints2.) investor’s objectives and constraints

Capital Market Conditions

Prediction Procedure

Expected Returns, Risks,And Correlations

Investors Assets, LiabilitiesAnd Networth

Investor’s Risk, Tolerance Function

Investor’s Risk Tolerance

Optimizer

Investor’s Asset Mix

Returns

Asset Allocation StrategiesAsset Allocation Strategies

Strategic Asset AllocationStrategic Asset Allocation – used to determine – used to determine the long term policy asset weights in a portfoliothe long term policy asset weights in a portfolio

Tactical Asset AllocationTactical Asset Allocation – constantly adjusts – constantly adjusts the asset class mix in the portfolio in an attempt the asset class mix in the portfolio in an attempt to take advantage of changing market conditionsto take advantage of changing market conditions

Insured Asset AllocationInsured Asset Allocation – assumes that – assumes that expected market returns and risks are constant expected market returns and risks are constant over time while the investor’s objectives and over time while the investor’s objectives and constraints changes as his wealth position constraints changes as his wealth position changeschanges

the endthe end

..

chapter 14 company analysis and stock valuation. financial leverage financial leverage = takes the...

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