investment analysis and portfolio management10_mba_kubs

8/8/2019 Investment Analysis and Portfolio Management10_mba_kubs

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INVESTMENT ANALYSIS ANDPORTFOLIO MANAGEMENT

EQUITY VALUATIONHow to find your bearing


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EQUITY VALUATION: How to find your bearing

Equity Analyst employ two kinds of Analyses:

Fundamental Analysis

Fundamental Analysts assess the fair market value of equity sharesby examining the assets, earning prospects, cash flow projections

and dividend potential

Technical Analysis

Technical Analyst essential rely on price and volume trends and

other market indicators to identify trading opportunities


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To determine the expected rates of return onalternative assets, it is necessary to estimate the futurevalue of the asset since a major component of the rateof return is the change in value for the asset over time.

Therefore, the crux of investments is valuation! The

value of any earning asset is the present value of theexpected cash flows generated by the asset.

Therefore, to estimate the value of an asset, you mustderive an estimate of

(1) the discount rate for the asset (your required rate of return) (2) its expected cash flows.

The point is, the main source of information that willhelp you make these two estimates is the financialstatements,


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Financial statements are also the mainsource of information when deciding

whether to lend money to a firm (invest inits bonds) or to buy warrants or options on a

firms stock. We first look into corporations major

financial statements and discuss why and

how financial ratios are useful. We will see how can internal liquidity,

operating performance, risk analysis, andgrowth analysis can be assessed.


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Financial statements are intended to provideinformation on the resources available tomanagement, how these resources were financed, andwhat the firm accomplished with them.

Corporate shareholder annual and quarterly reports

include three required financial statements:o the balance sheet,

o the income statement, and

o the statement of cash flows.

Information from the basic financial statements can beused to calculate financial ratios and to analyze theoperations of the firm to determine what factorsinfluence a firms earnings, cash flows, and riskcharacteristics.


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The Balance Sheet Ratios

The debt figure includes all long-term fixed obligations,

including lease obligations and subordinated convertiblebonds.

The equity typically is the book value of equity and includespreferred stock, common stock, and retained earnings.

Some analysts prefer to exclude preferred stock and

consider only common equity. Total equity is preferable if you are examining an industry in

which some of the firms being analyzed have preferredstock.


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The Balance Sheet Ratios

Book Value:

It is simply the net worth of the company (paid-upequity + reserves + surplus) divided by the number ofoutstanding equity shares.

Liquidation Value

It is value realized from liquidating all the assets of thefirm and subtracting from it amounts to be paid to allthe creditors and preference shareholders. Thus the

figure obtained divided by Number of outstandingequity shares provides the liquidation value.

Replacement Cost

It is obtained by estimating a replacement cost of asset

minus the liabilities.


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Valuation of Stock:

All of these valuation techniques are based on thebasic valuation model, which asserts that the value ofan asset is the present value of its expected futurecash flows as follows:


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Single Period Valuation Model:

To start it we assume that the investor is holding thestock for one year. Using the standard formula of stockvaluation we work it out as follows:

Vj = D1 P1-------- + --------(1+k) (1+k)

Where:D1 = Dividend expected in the forthcoming year

P1 = Price of the share at the end of year (investment)


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Single Period Valuation Model:D1 P1

Vj = -------- + --------(1+k) (1+k)

Consider a stock which is expected to give a dividendof Rs.2 and the stock price is expected to increase toRs.25. If the required rate of return of the investor is12% -- what s the current price of the stock.

Vj =


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Valuation of Stock:


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Valuation of Stock:


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Valuation of Stock:


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Mult-period Valuation Model


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Mult-period ValuationModel

The next estimate is the expected sale price (SP) forthe stock three years in the future. Assume anestimated sale price using the DDM of $34.


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Valuation of Stock:

If you anticipate holding the stock for several yearsand then selling it, the valuation estimate is harder.

You must forecast several future dividend paymentsand estimate the sale price of the stock several yearsin the future.

The difficulty with estimating future dividend paymentsis that the future stream can have numerous forms.

The exact estimate of the future dividends depends on

two projections. The first is your outlook for earnings growth because

earnings are the source of dividends.

The second projection is the firms dividend policy,which can take several forms.


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Valuation of Stock: The easiest dividend policy to analyze is

one where the firm enjoys a constantgrowth rate in earnings and maintains a

constant dividend payout. This set

of assumptions implies that the dividendstream will experience a constant growth

rate that is equal to the earnings growthrate.


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Valuation of Stock: Multi-period Growth ModelThe easiest dividend policy to analyze is one where

the firm enjoys a constant growth rate in earnings andmaintains a constant dividend payout. This set of

assumptions implies that the dividend stream willexperience a constant growth rate that is equal to theearnings growth rate.


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Valuation of Stock:

The infinite period constant growth ratemodel can be simplified to the followingexpression:

To use this model for valuation, youmust estimate:

the required rate of return (k) and

the expected constant growth rate of dividends

(g).

After estimating g, it is a simple matter toestimate D1, because it is the currentdividend (D

0

) times (1 + g).


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Derivation of Constant Growth Dividend Discount

Model (DDM)


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Model (DDM)


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Model (DDM)


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Valuation of Stock:Consider the example of a stock with a current dividend of $1 a

share, which you expect to rise to $1.09 next year. You believe that,over the long run, this companys earnings and dividends willcontinue to grow at 9 percent; therefore, your estimate ofgis 0.09.

For the long run, you expect the rate of inflation to decline, so youset your long-run required rate of return on this stock at 13 percent;your estimate ofkis 0.13.

To summarize the relevant estimates:


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Valuation of Stock:


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Valuation of Stock:

These examples show that as small a changeas 1 percent in eithergorkproduces a largedifference in the estimated value of the stock.

The crucial relationship that determines thevalue of the stock isthe spread between the required rate of return(k) and

the expected growth rate of dividends (g).

Anything that causes a decline in the spreadwill cause an increase in the computed value,whereas any increase in the spread willdecrease the computed value of the stock.


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Valuation with Temporary Supernormal Growth As noted, the assumptions of the model make

it impossible to use the infinite period constantgrowth model to value true growth companies.

A company cannot permanently maintain a

growth rate higher than its required rate ofreturn because competition will eventuallyenter this apparently lucrative business, whichwill reduce the firms profit margins andtherefore its ROE and growth rate.

Therefore, after a few years of exceptionalgrowththat is, a period of temporarysupernormal growtha firms growth rate isexpected to decline.


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Valuation with Temporary Supernormal Growth

To determine the value of a temporary supernormalgrowth company, you must combine the previousmodels.

In analyzing the initial years of exceptional growth, youexamine each year individually.

If the company is expected to have two or three stagesof supernormal growth, you must examine each yearduring these stages of growth.

When the firms growth rate stabilizes at a rate belowthe required rate of return, you can compute the

remaining value of the firm assuming constant growthusing the DDM and discount this lump-sum constantgrowth value back to the present.

The technique should become clear as you workthrough the following example.


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The XYZ Company has a current dividend (D0)of $ 2 a share. The following are the expectedannual growth rates for dividends.


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Valuation of Stock: RELATIVEVALUATIONTECHNIQUES

The relative valuation techniques implicitly contendthat it is possible to determine the value of aneconomic entity (i.e., the market, an industry, or acompany) by comparing it to similar entities on thebasis of several relative ratios that compare its stockprice to relevant variables that affect a stocks value,such as

a. earnings,b. cash flow,c. book value; andd. sales.

Therefore, following relative valuation ratios:a. price/earnings (P/E),b. price/cash flow (P/CF),c. price/book value (P/BV); andd. price/sales (P/S).


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We will discuss the P/Eratio, also referredto as the earnings multiplier model,because it is the most popular relative

valuation ratio. In addition, we will show that the P/Eratio

can be directly related to the DDM in a

manner that indicates the variables thataffect the P/Eratio


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M

any investors prefer to estimate the value of common stock usingan earnings multiplier model. The reasoning for this approach recalls the basic concept that the

value of any investment is the present value of future returns. In the case of common stocks, the returns that investors are entitled

to receive are the net earnings of the firm. Therefore, one way investors can estimate value is by determining

how many dollars they are willing to pay for a Rupee of expectedearnings.

This computation of the current earnings multiplier (P/Eratio)indicates the prevailing attitude of investors toward a stocks value.

Investors must decide if they agree with the prevailing P/Eratio (thatis, is the earnings multiplier too high or too low?) based upon how itcompares to the P/Eratio for the aggregate market, for the firmsindustry, and for similar firms and stocks.


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The infinite period dividend discount model canbe used to indicate the variables that shoulddetermine the value of the P/Eratio as follows:

If we divide both sides of the equation by E1(expected earnings during the next 12 months),

the result is


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Valuation of Stock: RELATIVEVALUATIONTECHNIQUES After estimating the earnings multiple, you would apply it to your

estimate of earnings for the next year (E1) to arrive at an estimatedvalue.

In turn, E1 is based on the earnings for the current year (E0) and yourexpected growth rate of earnings.

Using these two estimates, you would compute an estimated value ofthe stock and compare this estimated value to its market price.

Consider the following estimates for an example firm:

D/E= 0.50 k= 0.12 g= 0.09 E0 = $2.00

Using these estimates, you would compute an earnings multiple of:

Given current earnings (E0) of $2.00 and a gof 9 percent, you wouldexpect E1 to be $2.18. Therefore, you would estimate the value (price)of the stock as V= 16.7 $2.18 = $36.41


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Valuation of Stock: RELATIVEVALUATIONTECHNIQUESP

rice to Cash-Flow


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rice toB

ookValue


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rice toS

ales Turnover The advocates consider this ratio meaningful and useful for two

reasons.

First, they believe that strong and consistent sales growth is arequirement for a growth company. Although they note theimportance of an above-average profit margin, they contend that thegrowth process must begin with sales.

Second, given all the data in the balance sheet and incomestatement, sales information is subject to less manipulation than anyother data item. The specific P/Sratio is:


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MACROECONOMIC AND INDUSTRY ANALYSIS

Understanding the BroadPicture


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We analyze economies because of the strong link

between the overall economic environment in acountry and the performance of its security markets.

Security markets reflect what is expected to go on in

an economybecause the value of an investment is

determined by its expected cash flows and its futurerequired rate of return, and both of these factors areinfluenced by its expected aggregate economicenvironment.

Therefore, if you want to estimate cash flows, interestrates, and risk premiums for securities, you need toconsider aggregate economic analysis.


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Three major techniques are available for analyzing

securities markets. First, the macroeconomic approach attempts to project

the outlook for securities markets based on theunderlying relationship between the aggregate economyand the securities markets.

Second, the microanalysis approach involves using thepresent value of cash flows and the relative valuationratios to estimate a value for a countrys aggregate stockmarket.

Finally, the technical analysis approach assumes thatthe best way to determine future changes in securitymarket values is to examine past movements in interestrates, security prices, and other market variables.


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There are two possible reasons why stock prices lead the

economy. One is that stock prices reflect expectations of earnings,

dividends, and interest rates. As investors attempt toestimate these future variables, their stock price decisionsreflect expectations forfuture economic activity, not current

activity. A second possible reason is that the stock market reacts to

various leading indicator series, the most important beingcorporate earnings, corporate profit margins, interest rates,

and changes in the growth rate of the money supply. Because these series tend to lead the economy, when

investors adjust stock prices to reflect expectations forthese leading economic series, it makes stock prices aleading series as well.


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Government Policy:

Fiscal Policy: Fiscal policy is concerned with the spending and taxinitiatives of the government. It is perhaps the most direct tool tostimulate and dampen the economy. An increase to governmentspending stimulates the demand for goods and services.

Monetary Policy: Many academic and professional observershypothesize a close relationship between stock prices and various

monetary variables that are influenced by monetary policy.The best-known monetary variable in this regard is the moneysupply. The money supply can be measured in several ways,including currency plus demand deposits (referred to as the M1money supply) and the M1 money supply plus time deposits(referred to as the M2 money supply). There are other measures of

the money supply, but M1 and M2 are the best known. The Satebank of Pakistan controls the money supply through various tools,the most useful of which is open market operations.

Supply Side Policy: While the demand-siders focus on the impactof taxes on consumption demand, supply-siders look at the effect oftaxes on incentives to work and invest.


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Macroeconomic Analysis:

The key variables commonly used to describe the state of the macroeconomy are:

Growth in GDP

Industrial growth rate

Agriculture and rainfall

Savings and investments

Government budget and deficit

Price level and inflation

Interest rates

Balance of Payment, forex reserves, and exchange rate

Infrastructure facilities and arrangements

Sentiments



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Industry Analysis: Investment practitioners perform industry analysis because they believe it

helps them isolate investment opportunities that have favorable return-riskcharacteristics.

it is part of our three-step, top-down plan for valuing individual companiesand selecting stocks for inclusion in our portfolio.

What exactly do we learn from an industry analysis?

Can we spot trends in industries that make them good investments?

Are there unique patterns in the rates of return and risk measures over time indifferent industries?.

The industry analysis can be divided into three parts:

o The business cycle and industry sectors

o Industry life cycle analysis

o Study of the structure and characteristics of an industry

o Profit potential of industries



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Industry Analysis:

THESTOCKMARKETAND THEBUSINESSCYCLE



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Industry Analysis:


Toward the end of a recession, financial stocks rise invalue because investors anticipate that banks earningswill rise as both the economy and loan demand recover.

Brokerage houses become attractive investmentsbecause their sales and earnings are expected to rise asinvestors trade securities, businesses sell debt andequity, and there is an increase in mergers during theeconomic recovery.

These industry selections assume that when therecession ends there will be an increase in loan demand,housing construction, and security offerings.



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Industry Analysis:


Once the economy begins its recovery, consumerdurable firms that produce expensive consumer items,such as cars, personal computers, refrigerators, lawntractors, and snow blowers, become attractiveinvestments because a reviving economy will increaseconsumer confidence and personal income.

Once businesses recognize the economy is recovering,they begin to think about modernizing, renovating, or

purchasing new equipment to satisfy rising demand andreduce costs. Thus, capital goods industries such asheavy equipment manufacturers, machine tool makers,and airplane manufacturers become attractive.



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Industry Analysis:

THESTOCKMARKETAND THEBUSINESSCYCLE Cyclical industries whose sales rise and fall along with

general economic activity are attractive investments duringthe early stages of an economic recovery because of theirhigh degree of operating leverage, which means that they

benefit greatly from the sales increases during an economicexpansion. Industries with high financial leverage likewisebenefit from rising sales volume.

Traditionally, toward the business cycle peak, the rate ofinflation increases as demand starts to outstrip supply. Basic

materials industries such as oil, metals, and timber, whichtransform raw materials into finished products, becomeinvestor favorites. Because inflation has little influence on thecost of extracting these products and they can increase

prices, these industries experience higher profit margins.



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Industry Analysis:


During a recession, some industries do better thanothers. Consumer staples, such as pharmaceuticals,food, and beverages, outperform other sectors during arecession because, although overall spending maydecline, people still spend money on necessities sothese defensive industries generally maintain theirvalues.

Similarly, if a weak domestic economy causes a weak

currency, industries with large export components togrowing economies may benefit because their goodsbecome more cost competitive in overseas markets.



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Industry Analysis:

Industry Life Cycle Analysis:

The number of stages in this industry life cycleanalysis can vary based on how much detail

you want. A five-stage model would include: 1. Pioneering development 2. Rapid accelerating growth 3. Mature growth

4. Stabilization and market maturity 5. Deceleration of growth and decline



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Industry Analysis:




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Industry Analysis:




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Industry Analysis:



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Understanding the BroadPictureIndustry Analysis:Study of the structure and characteristics of an industry :

Structure of the Industry and Nature ofCompetition Nature and Prospects of Demand Cost Efficiency and Profitability Technology and Research

During any time period, the returns for different industries vary within a wide range,which means that industry analysis is an important part of the investment process.

The rates of return for individual industries vary over time, so we cannot simplyextrapolate past industry performance into the future.

The rates of return of firms within industries also vary, so analysis of individualcompanies in an industry is a necessary follow-up to industry analysis.

During any time period, different industries risk levels vary within wide ranges, so wemust examine and estimate the risk factors for alternative industries.

Risk measures for different industries remain fairly constant over time, so thehistorical risk analysis is useful when estimating future risk.



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Industry Analysis:

Threat of new entrants

Rivalry among the existing firms

Pressure from substitute products

Bargaining power of buyers

Bargaining power of sellers



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Industry Analysis:



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Industry Analysis:



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Industry Analysis:



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Industry Analysis:

Profit Potential of Industries:








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Industry Analysis:









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Industry Analysis:



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COMPANY ANALYSIS

Establishing the Value Benchmark

COMPANY ANALYSIS


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COMPANY ANALYSISEstablishing the Value Benchmark

Industry Analysis:


The basic SWOT analysis, is intended to

articulate a firms strengths, weaknesses,opportunities, and threats. These two analyses should provide a

complete understanding of a firms overall

strategicapproach. Given this background, we review the

financials

COMPANY ANALYSIS


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COMPANY ANALYSISEstablishing the Value Benchmark

Industry Analysis:

Profit Potential of Industries: Analysts use two general approaches to valuation. The techniques

that serve each of these approaches follow:

PresentValue ofCash Flows (PVCF)

1. Present value of dividends (DDM

)2. Present value of free cash flow to equity (FCFE)

3. Present value of free operating cash flow to the firm(FCFF)

Relative Valuation Techniques

1. Price/earnings ratio (P/E)2. Price/cash flow ratio (P/CF)

3. Price/book value ratio (P/BV)

4. Price/sales ratio (P/S)

COMPANY ANALYSIS


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CO S SEstablishing the Value Benchmark

Present Value of Dividends

For simplicity, we will initially discuss theconstant growth DDM. We saw that when

dividends grow at a constant rate, a stocks priceshould equal next years dividend, D1, divided bythe difference between investors required rateof return on the stock (k)and the dividend

growth rate (g)

COMPANY ANALYSIS


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Present Value of Dividends

COMPANY ANALYSIS


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Present Value of Free Cash Flow

COMPANY ANALYSIS


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Present Value of Operating Free Cash Flow

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