Introduction to security valuation A summary Reminder Valuation always precedes the investment...
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Transcript of Introduction to security valuation A summary Reminder Valuation always precedes the investment...
Introduction to security valuationIntroduction to security valuation
A summary
ReminderReminder
Valuation always precedes the investment decision.
Always.
ObjectiveObjective
Describe the principles and summarize the process of security analysis & valuation.
OutlineOutline
• 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
Valuation philosophy, approaches, and techniquesValuation philosophy, approaches, and techniques
Valuation philosophyValuation philosophy
Acknowledges the basic principles that are important in estimating intrinsic values
Valuation approachValuation approach
Pertains to the valuation process in general
It spells out the steps of the selection process
Valuation techniques/methodsValuation techniques/methods
Refers to the quantitative methods used to estimate intrinsic values for individual securities, industries, and markets
Valuation philosophyValuation philosophy
Fundamental analysisFundamental analysis• Investors have rational expectations.• It is possible to forecast, hence to estimate intrinsic value as a
function of risk and required return
Technical analysisTechnical 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.
ImportantImportant
Valuation philosophy determines what approach and technique to use
Valuation approachesValuation approaches
Top-down (Three-step)
Valuing and selecting securities while accounting for the more general economic context
• Analysis of alternative economies and security marketsAnalysis of alternative economies and security markets• Industry analysis Industry analysis • Individual company analysis and stock selectionIndividual company analysis and stock selection
Bottom-up (Stock picking)
Valuing and selecting securities without accounting for the more general economic conditions
Valuations techniques for markets, industries and Valuations techniques for markets, industries and securitiessecurities
DCF techniquesDCF techniquesIntinsic value = PV of future cash flow
Relative valuation techniquesRelative valuation techniquesRequire the comparison of various market ratios
Both methods should be used in combination
Analysis of alternative economies and security Analysis of alternative economies and security marketsmarkets
Objective:Objective:
Estimate future macroeconomic performance
Evaluate the trend in corporate earnings and security prices
Prevailing view:Prevailing view:
General economic conditions are associated with firm performance
Markets determine individual security returns
How it is done in real lifeHow it is done in real life• Macro technique• Micro technique: DCF & relative valuation• Trend analysis & extrapolation
Macro techniqueMacro technique
Analyze macroeconomic indicators
Macroeconomic indicatorsMacroeconomic indicators
Leading indicatorsLeading indicators
Precede the economic cycle
Coincident indicatorsCoincident indicators
Synchronized with the economic cycle
Lagging indicatorsLagging indicators
Follow in the wake of the economic cycle
Leading indicatorsLeading 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.
Leading indicatorsLeading 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
Coincident indicatorsCoincident indicators
• Industrial production
• Employee’s payrolls
• Manufacturing sales
• Etc.
Lagging indicatorsLagging indicators
• Average UI duration
• Inventories
• Bank’s prime rate
• Etc.
Micro techniquesMicro techniques
Applied to the market as a whole
Often looks at an index of the most representative securities
Micro techniques: DCF methodMicro techniques: DCF method
Require :
• Expected growth rate in earnings/dividends/free cash flows
• Required rate of return
Estimating the market’s required return: S&P 500Estimating 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%
Micro techniques: Relative valuationMicro techniques: Relative valuation
Estimating future earnings (EPS)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)Estimating future earnings multipliers (P/E)• Changes in EPS are not always good predictors of returns
• Helps spotting bubbles
Industry analysisIndustry analysis
Objective
Evaluate industry trends and structural changes
Methods• Cross sectional performance analysis• Trend analysis• Comparative analysis of firms within an industry
Results of empirical studiesResults 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
Industry trends and the business cycleIndustry trends and the business cycle
Wide-held belief:
Industry performance is related to business cycle.
Industry trends and the business cycleIndustry trends and the business cycle
End of recessionFinance companies do well: more loans, investments in anticipation, etc.
Rock bottomConsumer durables improve: edging consumer confidence and expected income
Upward trendCapital goods improve: expanding to meet demand
PeakOil, gold, timber, etc do well
DeclineConsumer staples do well: one has to eat and live nevertheless
Structural changesStructural changes
• Demographics
• Lifestyles
• Technology
• Politics and regulation
Individual company analysis and stock selectionIndividual company analysis and stock selection
ObjectiveObjective
Identify candidates for the investment decision
Investment decisionInvestment decision
Buy: Intrinsic value > Market price
Individual company analysis and stock selectionIndividual company analysis and stock selection
Company Overall StrategyCompany Overall Strategy• Defensive vs. offensive• Low cost vs. differentiation• Etc.
Management assessmentManagement assessment• Current rivalries
• Threat from new entrants
• Potential substitutes
• Barganning power of suppliers & buyers
• Etc.
Prospects and ChallengesProspects and Challenges• Swot analysis
Financial PerformanceFinancial Performance
ValuationValuation
• DCF
• Relative
ConclusionsConclusions
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.