Chapter 14

Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition

Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 14-1Slide 14-1

Chapter 14

Security Security AnalysisAnalysis



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



Basic Types of Models Balance Sheet Models Dividend Discount Models Price/Earning Ratios

Estimating Growth Rates and Opportunities

Fundamental Analysis: Models of Equity Valuation



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



Summary Reminder





1tt

to

)k1(D

V

1tt

to

)k1(D

V

V0 = Value of Stock

Dt = Dividendk = required return

Dividend Discount Models:General Model



kD

Vo

Stocks that have earnings and dividends that are expected to remain constant

Preferred Stock

No Growth Model



E1 = D1 = $5.00

k = .15V0 = $5.00 / .15 = $33.33

kD

Vo

No Growth Model: Example



gk)g1(D

Voo

gk

)g1(DVo

o

g = constant perpetual growth rate

Constant Growth Model



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



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



)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



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



ROE = 20% d = 60% b = 40%

E1 = $5.00 D1 = $3.00 k = 15%

Partitioning Value: Example

g = .20 x .40 = .08 or 8%



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)



Summary Reminder





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



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



)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



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



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%



Pitfalls in P/E Analysis

Use of accounting earnings Historical costs May not reflect economic earnings

Reported earnings fluctuate around the business cycle



Summary Reminder





Other Valuation Ratios

Price-to-Book Price-to-Cash-Flow Price-to-Sales



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



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



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



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



Summary Reminder





Performance in countries and regions is highly variable

Political risk Exchange rate risk

Sales Profits Stock returns

Global Economic Considerations



Gross domestic product (GDP) Unemployment rates Interest rates & inflation International measures Consumer sentiment

Key Economic Variables



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



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



Business Cycle Peak Trough

Industry relationship to business cycles Cyclical Defensive

Business Cycles



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

Chapter 14

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