Valuation Sec

8/13/2019 Valuation Sec

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Introduction to security valuation

A summary


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Reminder

Valuation always precedes the investment decision.

Always.


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Objective

Describe the principles and summarize the process of

security analysis & valuation.


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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


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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


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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.


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Important

Valuation philosophy determines what approach and technique to use


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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


Bottom-up (Stock picking)

Valuing and selecting securities without accounting for the moregeneral economic conditions


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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


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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


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Macro technique

Analyze macroeconomic indicators


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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


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Leading indicators

Initial UI claims

Construction of new houses

Manufacturers 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.


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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


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Coincident indicators

Industrial production

Employees payrolls

Manufacturing sales

Etc.


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Lagging indicators

Average UI duration

Inventories

Banks prime rate

Etc.


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Micro techniques

Applied to the market as a whole

Often looks at an index of the most representative securities


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Micro techniques: DCF method

Require :

Expected growth rate in earnings/dividends/free cash flows

Required rate of return


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Estimating the markets 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%


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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


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Industry analysis

Objective

Evaluate industry trends and structural changes

Methods

Cross sectional performance analysis

Trend analysis

Comparative analysis of firms within an industry


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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


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Industry trends and the business cycle

Wide-held belief:

Industry performance is related to business cycle.


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Industry trends and the business cycle

End of recessionFinance 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


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Structural changes

Demographics

Lifestyles

Technology

Politics and regulation


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Objective

Identify candidates for the investment decision

Investment decision

Buy: Intrinsic value > Market price


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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


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Conclusions

Intrinsic value is a very elusive concept, subject to personal

interpretation

Security valuation, although a very complex process, is not ascience.

The principles, approaches and techniques outlined above reflect

the prevailing view among security analysts and portfolio

managers.

Valuation Sec

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