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Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Chapter 14
Security Security AnalysisAnalysis
Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Chapter Summary
Objective: Introduction to fundamental stock analysis. This chapter introduces different types of valuation models and shows how economic conditions affect the results.
Dividend discount models Price-Earnings ratios Other methods and issues Macroeconomic analysis
Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Basic Types of Models Balance Sheet Models Dividend Discount Models Price/Earning Ratios
Estimating Growth Rates and Opportunities
Fundamental Analysis: Models of Equity Valuation
Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Intrinsic Value 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
Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Summary Reminder
Objective: Introduction to fundamental stock analysis. This chapter introduces different types of valuation models and shows how economic conditions affect the results.
Dividend discount models Price-Earnings ratios Other methods and issues Macroeconomic analysis
Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
1tt
to
)k1(D
V
1tt
to
)k1(D
V
V0 = Value of Stock
Dt = Dividendk = required return
Dividend Discount Models:General Model
Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
kD
Vo
Stocks that have earnings and dividends that are expected to remain constant
Preferred Stock
No Growth Model
Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
E1 = D1 = $5.00
k = .15V0 = $5.00 / .15 = $33.33
kD
Vo
No Growth Model: Example
Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
gk)g1(D
Voo
gk
)g1(DVo
o
g = constant perpetual growth rate
Constant Growth Model
Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
gkD
gk)g1(D
Vo 1o
gk
Dgk
)g1(DVo 1o
E1 = $5.00 b = 40% k = 15%
(1-b) = 60%D1 = $3.00 g = 8%
V0 = 3.00 / (.15 - .08) = $42.86
Constant Growth Model: Example
Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
bROEg bROEg
g = growth rate in dividendsROE = Return on Equity for the firmb = plowback or retention percentage rate = (1- dividend payout percentage rate)
Estimating Dividend Growth Rates
Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
)k1(PD
)k1(D
)k1(DV N
NN2
21
10
...
PN = the expected sales price for the stock
at time NN = the specified number of years the stock is expected to be held
Specified Holding Period Model
Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
kE
)gk()g1(D
PVGO
PVGOkE
V
1o
1o
kE
)gk()g1(D
PVGO
PVGOkE
V
1o
1o
PVGO = Present Value of Growth OpportunitiesE1 = Earnings per share for period 1
Partitioning Value: Growth and No Growth Components
Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
ROE = 20% d = 60% b = 40%
E1 = $5.00 D1 = $3.00 k = 15%
Partitioning Value: Example
g = .20 x .40 = .08 or 8%
Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
52.9$33.33$86.42$PVGO
33.33$15.5
NGV
86.42$)08.15(.
3V
o
o
52.9$33.33$86.42$PVGO
33.33$15.5
NGV
86.42$)08.15(.
3V
o
o
Vo = value with growthNGVo = no growth component valuePVGO = Present Value of Growth Opportunities
Partitioning Value: Example (cont’d)
Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Summary Reminder
Objective: Introduction to fundamental stock analysis. This chapter introduces different types of valuation models and shows how economic conditions affect the results.
Dividend discount models Price-Earnings ratios Other methods and issues Macroeconomic analysis
Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
P/E Ratios are a function of two factors Required Rates of Return (k) Expected growth in Dividends
Uses Relative valuation Extensive Use in industry
Earnings, Growth and Price-Earnings Ratios
Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
k1
EP
kE
P
1
0
10
k1
EP
kE
P
1
0
10
E1 - expected earnings for next year E1 is equal to D1 under no growth
k - required rate of return
P/E Ratio: No Expected Growth
Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
)ROEb(kb1
EP
)ROEb(k)b1(E
gkD
P
1
0
110
)ROEb(kb1
EP
)ROEb(k)b1(E
gkD
P
1
0
110
b = retention ratio ROE = Return on Equity
P/E Ratio with Constant Growth
Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
E0 = $2.50 g = 0 k = 12.5%
P0 = D/k = $2.50/.125 = $20.00
PE = 1/k = 1/.125 = 8
Numerical Example: No Growth
Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
E1 = $2.50 (1 + (.6)(.15)) = $2.73
D1 = $2.73 (1-.6) = $1.09
P0 = 1.09/(.125-.09) = $31.14PE = 31.14/2.73 = 11.4PE = (1 - .60) / (.125 - .09) = 11.4
Numerical Example with Growth
b = 60% ROE = 15% (1-b) = 40%k = 12.5% g = 9%
Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Pitfalls in P/E Analysis
Use of accounting earnings Historical costs May not reflect economic earnings
Reported earnings fluctuate around the business cycle
Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Summary Reminder
Objective: Introduction to fundamental stock analysis. This chapter introduces different types of valuation models and shows how economic conditions affect the results.
Dividend discount models Price-Earnings ratios Other methods and issues Macroeconomic analysis
Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Other Valuation Ratios
Price-to-Book Price-to-Cash-Flow Price-to-Sales
Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
The Free Cash-Flow Approach
Fundamental idea: the intrinsic value of a firm is the present value of all its net cash-flows to shareholders
Estimate the value of the firm as a whole It equals the present value of cash-flows,
assuming all-equity financing plus the net present value of tax shields created by using debt;
Derive the value of equity by subtracting the market value of all non-equity claims
Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Inflation and Equity Valuation
Inflation has an impact on equity valuations
Historical costs underestimate economic costs
Empirical research shows that inflation has an adverse effect on equity values Research shows that real rates of return are
lower with high rates of inflation
Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Potential Causes of Lower Equity Values with Inflation
Shocks cause expectation of lower earnings by market participants
Returns are viewed as being riskier with higher rates of inflation
Real dividends are lower because of taxes
Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Growth or Value Investing
Growth Investing – picking companies that are considered to have superior growth prospects
Value Investing – choosing companies for which fundamental analysis reveals unrecognized value
The Graham technique
Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Summary Reminder
Objective: Introduction to fundamental stock analysis. This chapter introduces different types of valuation models and shows how economic conditions affect the results.
Dividend discount models Price-Earnings ratios Other methods and issues Macroeconomic analysis
Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Performance in countries and regions is highly variable
Political risk Exchange rate risk
Sales Profits Stock returns
Global Economic Considerations
Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Gross domestic product (GDP) Unemployment rates Interest rates & inflation International measures Consumer sentiment
Key Economic Variables
Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Fiscal Policy - Government spending and taxing actions
Monetary Policy - manipulation of the money supply to influence economic activity
Tools of monetary policy Open market operations Discount rate Reserve requirements
Government Policy
Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
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
Demand and Supply Shocks
Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Business Cycle Peak Trough
Industry relationship to business cycles Cyclical Defensive
Business Cycles
Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition
Leading Indicators - tend to rise and fall in advance of the economy. Examples: Average work week New orders - durables Residential construction Stock Prices
Lagging Indicators - indicators that tend to follow the lag economic performance
Cyclical Indicators