1 Security Valuation and Analysis Macroeconomic/Industry Analysis Security valuation Ratio analysis MBA566: chapter 17-19

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Security Valuation and Analysis

Macroeconomic/Industry AnalysisSecurity valuationRatio analysis

MBA566: chapter 17-19

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Factors affecting firm valuation Global economic analysis Domestic Macro-economy Government Policies Industry analysis Company analysis

A top-down analysis

Fundamental Analysis


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Performance in countries and regions is highly variable.

Political risk Exchange rate risk (Figure 17.1, page 550)

Sales Profits Stock returns (Table 17.1, page 549)

Global Economic Considerations


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Gross domestic product Unemployment rates Interest rates & inflation Budget deficit Consumer sentiment

Check 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 service

Demand shock - an event that affects demand for goods and services in the economy. Tax rate cut Increases in government spending

Supply shock - an event that influences production capacity or production costs. Commodity price changes Educational 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 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 industries

Operating leverage Financial leverage

Industry life cycles

Industry Analysis


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Effect of Operating Leverage

See example 17.1 on page 567 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 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, 2009


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Slow growers

Stalwarts

Fast growers

Cyclicals

Turnarounds

Asset plays

(page 572)

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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Industry Structure and Performance

Threat of entry Rivalry between existing competitors Pressure from substitute products Bargaining power of buyers Bargaining power of suppliers


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Balance Sheet Models Book 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 approaches

Liquidation value Replacement cost


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

Market Price Consensus value of all potential traders

Trading Signal IV > MP Buy IV < MP Sell or Short Sell IV = MP Hold or Fairly Priced

Intrinsic Value and Market Price


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Value line investment survey report

Figure 18.2, page 598


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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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gk

gD

gk

DVo

o

)1(1

gk

gD

gk

DVo

o

)1(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 = $5.00 b = 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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Figure 19.2 Comparative Accounting Rules


Documents

1 Security Valuation and Analysis Macroeconomic/Industry Analysis Security valuation Ratio analysis MBA566: chapter 17-19