Security Valuation and Analysis

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

2. Fundamental Analysis Factors affecting firm valuation • Global economic analysis • Domestic Macro-economy • Government Policies • Industry analysis • Company analysis • A top-down analysis MBA566: chapter 17-19

3. Global Economic Considerations • 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) MBA566: chapter 17-19

4. Domestic Macroeconomy • Gross domestic product • Unemployment rates • Interest rates & inflation • Budget deficit • Consumer sentiment Check St. Louis Fed for this set of information MBA566: chapter 17-19

5. The Effect of Government Policy • 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 MBA566: chapter 17-19

6. Government Policies • 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 MBA566: chapter 17-19

7. Business Cycle • Peak • Trough • Cyclical industries • Defensive industries MBA566: chapter 17-19

8. Economic Indicators Economic indicators

9. Useful Economic Indicators MBA566: chapter 17-19

10. Industry Analysis • 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 MBA566: chapter 17-19

11. Effect of Operating Leverage • See example 17.1 on page 567 • Firms with lower operating leverage do better in recessions MBA566: chapter 17-19

12. Effect of Operating Leverage MBA566: chapter 17-19

13. DOL • Degree of operating leverage (DOL) =% change in profit/ % change in sales =1+Fixed costs / Profit • Computing DOL for firms A and B MBA566: chapter 17-19

14. Effect of Financial Leverage • Financial Leverage • Financial leverage hurts in bad years • See example 19.1 on page 639 (Table 19.4) MBA566: chapter 17-19

15. Figure 17.6 Returns on Equity, 2005 MBA566: chapter 17-19

16. Figure 17.7 Rate of Return, 2009 MBA566: chapter 17-19

17. Industry Life Cycles Slow growers Stalwarts Fast growers Cyclicals Turnarounds Asset plays (page 572) MBA566: chapter 17-19

18. Industry Life Cycle MBA566: chapter 17-19

19. 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 MBA566: chapter 17-19

20. Industry Structure and Performance • Threat of entry • Rivalry between existing competitors • Pressure from substitute products • Bargaining power of buyers • Bargaining power of suppliers MBA566: chapter 17-19

21. Equity Valuation Models • Balance Sheet Models • Book Value • Dividend Discount Models • Price/Earning Ratios MBA566: chapter 17-19

22. 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 MBA566: chapter 17-19

23. Intrinsic Value and Market Price • 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 MBA566: chapter 17-19

24. Value line investment survey report • Figure 18.2, page 598 MBA566: chapter 17-19

25. Dividend Discount Models: General Model V0 = Value of Stock Dt = Dividend k = required return

26. No Growth Model Stocks that have earnings and dividends that are expected to remain constant. Preferred Stock

27. No Growth Model: Example E1 = D1 = $5.00 k = .15 V0 =

28. Constant Growth Model g = constant perpetual growth rate

29. Constant Growth Model: Example E1 = $5.00 b = 40% k = 15% (1-b) = 60% D1 = $3.00 g = 8% V0 =

30. Estimating Dividend Growth Rates g = growth rate in dividends ROE = Return on Equity for the firm b = plowback or retention percentage rate (1- dividend payout percentage rate)

31. Specified Holding Period Model PN = the expected sales price for the stock at time N N = the specified number of years the stock is expected to be held

32. Example • Go through the example 18.1-18.3 from page 592 to 594 MBA566: chapter 17-19

33. P/E Ratio with Constant Growth b = retention ratio ROE = Return on Equity

34. Numerical Example with Growth Example 18.4 on page 598. MBA566: chapter 17-19

35. Summary of Key Financial Ratios MBA566: chapter 17-19

36. Table 19.10 Summary of Key Financial Ratios MBA566: chapter 17-19

37. Table 19.10 Summary of Key Financial Ratios MBA566: chapter 17-19

38. Table 19.10 Summary of Key Financial Ratios MBA566: chapter 17-19

39. Table 19.10 Summary of Key Financial Ratios MBA566: chapter 17-19

40. Figure 19.2 Comparative Accounting Rules MBA566: chapter 17-19