Introduction to security valuation

1. Introduction to security valuation A summary

2. Reminder • Valuation always precedes the investment decision. • Always.

3. Objective • Describe the principles and summarize the process of security analysis & valuation.

4. Outline • Introduction to valuation principles, approach & techniques • Discussion of approaches and techniques • Analysis of alternative economies and security markets • Industry analysis • Individual company analysis and stock selection

5. Valuation philosophy, approaches, and techniques • Valuation philosophy • Acknowledges the basic principles that are important in estimating intrinsic values • Valuation approach • Pertains to the valuation process in general • It spells out the steps of the selection process • Valuation techniques/methods • Refers to the quantitative methods used to estimate intrinsic values for individual securities, industries, and markets

6. Valuation philosophy • Fundamental analysis • Investors have rational expectations. • It is possible to forecast, hence to estimate intrinsic value as a function of risk and required return • Technical analysis • Investors are biased, slow in responding to new information, and overreact • There are recurrent price patterns to be exploited. • It is more meaningful to find trends than to forecast sales, earnings, risk, return, etc.

7. Important • Valuation philosophy determines what approach and technique to use

8. Valuation approaches • Top-down (Three-step) • Valuing and selecting securities while accounting for the more general economic context • Analysis of alternative economies and security markets • Industry analysis • Individual company analysis and stock selection • Bottom-up (Stock picking) • Valuing and selecting securities without accounting for the more general economic conditions

9. Valuations techniques for markets, industries and securities • DCF techniques • Intinsic value = PV of future cash flow • Relative valuation techniques • Require the comparison of various market ratios • Both methods should be used in combination

10. Analysis of alternative economies and security markets • Objective: • Estimate future macroeconomic performance • Evaluate the trend in corporate earnings and security prices • Prevailing view: • General economic conditions are associated with firm performance • Markets determine individual security returns • How it is done in real life • Macro technique • Micro technique: DCF & relative valuation • Trend analysis & extrapolation

11. Macro technique • Analyze macroeconomic indicators

12. Macroeconomic indicators • Leading indicators • Precede the economic cycle • Coincident indicators • Synchronized with the economic cycle • Lagging indicators • Follow in the wake of the economic cycle

13. Leading indicators • Initial UI claims • Construction of new houses • Manufacturer’s new orders • Stock market indices • M2 Shifts in the money supply propagate through the bond market and stock market (liquidity transition) • Consumer and business credit outstanding • Consumer confidence • Etc. • Most important indicators are bundled and used as indices: Unemployment Index, Inflation Index, Consumer confidence Index, etc.

14. Leading indicators • Are the most scrutinized • Not always easy to interpret and use • Ex: • Relationship between interest rates and bond prices: clear • Relationship between interest rates and stock prices: murky • Higher interest rates: • Increase the cost of borrowing • Signal increased demand, higher prices, and higher corporate earnings

15. Coincident indicators • Industrial production • Employee’s payrolls • Manufacturing sales • Etc.

16. Lagging indicators • Average UI duration • Inventories • Bank’s prime rate • Etc.

17. Micro techniques • Applied to the market as a whole • Often looks at an index of the most representative securities

18. Micro techniques: DCF method • Require : • Expected growth rate in earnings/dividends/free cash flows • Required rate of return

19. Estimating the market’s required return: S&P 500 • Risk-free rate: • from T-bills to 30-year government bonds • Equity risk premium: • Arithmetic mean (Requities - RT-bill) = approx 9.2% over 75 years • Geometric mean (Requities - RT-bill) = approx 7.6% over 75 years • Rozeff: dividend yield = 1.5% (when above 6% is time to buy) • Bottom line: • According to different opinions, required return ranges from 6% to 12%

20. Micro techniques: Relative valuation • Estimating future earnings (EPS) • 1. Forecast GDP • 2. Project corporate sales as a function of GDP • 3. Forecast operating profit: • Capacity utilization rate (+) • Unit labor costs(+/-) • Inflation (+/-) • Foreign competition (-) • 4. Forecast EPS • Estimating future earnings multipliers (P/E) • Changes in EPS are not always good predictors of returns • Helps spotting bubbles

21. Industry analysis • Objective • Evaluate industry trends and structural changes • Methods • Cross sectional performance analysis • Trend analysis • Comparative analysis of firms within an industry

22. Results of empirical studies • Returns vary across industries • No patterns of return as a function of time • Returns vary within each industry: differentiation • Consistent pattern of risk differences among industries

23. Industry trends and the business cycle • Wide-held belief: • Industry performance is related to business cycle.

24. Industry trends and the business cycle • End of recession • Finance companies do well: more loans, investments in anticipation, etc. • Rock bottom • Consumer durables improve: edging consumer confidence and expected income • Upward trend • Capital goods improve: expanding to meet demand • Peak • Oil, gold, timber, etc do well • Decline • Consumer staples do well: one has to eat and live nevertheless

25. Structural changes • Demographics • Lifestyles • Technology • Politics and regulation

26. Individual company analysis and stock selection • Objective • Identify candidates for the investment decision • Investment decision • Buy: Intrinsic value > Market price

27. Company Overall Strategy Defensive vs. offensive Low cost vs. differentiation Etc. Management assessment Current rivalries Threat from new entrants Potential substitutes Barganning power of suppliers & buyers Etc. Prospects and Challenges Swot analysis Financial Performance Valuation DCF Relative Individual company analysis and stock selection

28. Conclusions • Intrinsic value is a very elusive concept, subject to personal interpretation • Security valuation, although a very complex process, is not a science. • The principles, approaches and techniques outlined above reflect the prevailing view among security analysts and portfolio managers.