1 1 Ch17, 18, 19 – MBA 566 Security Valuation and Analysis Macroeconomic and Industry...

11Ch17, 18, 19 – MBA 566

Security Valuation and Analysis

Macroeconomic and Industry Analysis/Fundamental Analysis

Equity Valuation

Ratio analysis

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Factors affecting firm valuationGlobal economic analysis

Domestic Macro-economy

Government Policies

Industry analysis

Company 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 product

Unemployment rates

Interest rates & inflation

Budget deficit

Consumer 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 operations

Discount rate

Reserve requirements

Supply Side Policies

Policies on employment

Productivities

Economic growth

Government Policies

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Business Cycle

Peak

Trough

Cyclical industries

Defensive industries

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Economic Indicators

Economic 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 571

Firms 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 Leverage

Financial leverage hurts in bad yearsSee 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 growers

Stalwarts

Fast growers

Cyclicals

Turnarounds

Asset 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 firms

Contraction – defensive industries such as pharmaceuticals and food

Trough – capital goods industries

Expansion – cyclical industries such as consumer durables

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Balance Sheet ModelsBook Value

Dividend Discount Models

Price/Earning Ratios

Equity Valuation Models

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Limitations of Book Value

Book value is an application of arbitrary accounting rules

Can book value represent a floor value?

Better approachesLiquidation value

Replacement 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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VD

ko

t

tt

( )11

VD

ko

t

tt

( )11

V0 = Value of Stock

Dt = Dividend

k = required return

Dividend Discount Models: General Model

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VD

ko

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 = .15

V0 =

VD

ko

No Growth Model: Example

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VoD g

k g

o

( )1Vo

D g

k g

o

( )1

g = constant perpetual growth rate

Constant Growth Model

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VoD g

k g

o

( )1Vo

D g

k g

o

( )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 ROE b

g = growth rate in dividends

ROE = Return on Equity for the firm

b = plowback or retention percentage rate (1- dividend payout percentage rate)

Estimating Dividend Growth Rates

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

21

10

kPD

kD

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

ROEbk

b

E

P

ROEbk

bE

gk

DP

)(

1

)(

)1(

1

0

110

ROEbk

b

E

P

ROEbk

bE

gk

DP

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