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Equity analysis b Value = PV of future benefits b EIC approach b Applied Valuation Dividend based modelsDividend based models Earnings based modelsEarnings based models b Financial Statement Analysis

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The EIC Approach b Economy - Industry - Company Performance of firm is conditioned by how its industry is expected to fare.Performance of firm is conditioned by how its industry is expected to fare. Performance of industry is conditioned by how the economy performsPerformance of industry is conditioned by how the economy performs Often called a “top-down” approachOften called a “top-down” approach Are you seeking relative or absolute performance?Are you seeking relative or absolute performance?

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Economic Analysis b Economic growth tied to (US) Monetary and Fiscal policy as well as Business Cycle b Fed has 4 goals: Stable prices (low inflation)Stable prices (low inflation) Low unemploymentLow unemployment Sustained real growth in GDPSustained real growth in GDP Reasonable balance in international paymentsReasonable balance in international payments

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Economic Analysis b Fed has material control over US monetary policy (reserve requirements, discount rate, open market operations) b Fed can move interest rates! b Fiscal policy: Gov’t ability to tax & spend (Deficit or surplus) b Relevance to an individual firm?

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Business Cycles b Economy does expand and contract b Helps to know where we are within a business cycle b NBER monitors economic variables that correlate with real GDP growth Leading indicatorsLeading indicators Coincident indicatorsCoincident indicators Lagging indicatorsLagging indicators

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Industry Analysis b Industry Life Cycle b Common considerations Nature of competitionNature of competition Market share for each firmMarket share for each firm Labor conditionsLabor conditions Regulatory environmentRegulatory environment Price elasticity of demand and supplyPrice elasticity of demand and supply Sensitivity of demand to economic conditionsSensitivity of demand to economic conditions

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Equity Analysis b Basic inputs financial statement datafinancial statement data position in industryposition in industry international investmentinternational investment rate of growthrate of growth breakdowns by product, division, subsidiariesbreakdowns by product, division, subsidiaries R&D effortsR&D efforts Major litigationMajor litigation

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Applied Valuation b Dividend discount model Value = PV of future DividendsValue = PV of future Dividends –need forecasts of Dividends (D), growth rate (g), and a required rate of return (k) b Example: KO D 0 = 0.68, EPS 0 = $1.25 (ttm)D 0 = 0.68, EPS 0 = $1.25 (ttm) g = 8.2% (five year div. growth)g = 8.2% (five year div. growth) g = ROE x RR =.3231 x.5440 = 17.58%g = ROE x RR =.3231 x.5440 = 17.58% k =.0351 + 0.70(.155 -.0351) = 11.90% (CAPM)k =.0351 + 0.70(.155 -.0351) = 11.90% (CAPM)

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Valuing KO b Constant dividend growth V 0 = D 1 /(k - g)V 0 = D 1 /(k - g) V = (0.68 x 1.082)/(.1190 -.0820)V = (0.68 x 1.082)/(.1190 -.0820) V = $19.89 < $45.90 (in July ‘01]V = $19.89 < $45.90 (in July ‘01] If dividend growth model is to work,If dividend growth model is to work, –change assumptions –modify model

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Valuing KO b Multiple stage dividend growth Suppose growth starts at 17.58% for the first 3 years and then settles out at a long term rate of 8.2%.Suppose growth starts at 17.58% for the first 3 years and then settles out at a long term rate of 8.2%. –D 1 = 0.800, D 2 = 0.940, D 3 = 1.105, D 4 = 1.196 V 3 = D 4 /(k - g) = 32.324V 3 = D 4 /(k - g) = 32.324 PV of D 1, D 2, D 3, V 3 = $25.324PV of D 1, D 2, D 3, V 3 = $25.324 Where have we gone wrong?Where have we gone wrong?

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Valuing KO b Earnings based models P/E approachP/E approach –P/E is measured using current price and either –Trailing 12 mo. EPS (P 0 /E 0 ) –EPS forecast for the next 12 mo. (P 0 /E 1 ) –Leading P/E is considered superior, but practitioners use both ratios. –V 0 = (EPS) x (P/E) –P/E = f( growth, retention rate, inflation)

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Valuing KO b Suppose D grows at 17.58% for 3 years and a (trailing) P/E of 40 will exist at that time D 1 = 0.800, D 2 = 0.940, D 3 = 1.105D 1 = 0.800, D 2 = 0.940, D 3 = 1.105 V 3 = 1.25(1.1758) 3 (40) = (2.032)(40) = $81.28V 3 = 1.25(1.1758) 3 (40) = (2.032)(40) = $81.28 PV of D 1, D 2, D 3, V 3 = $60.26PV of D 1, D 2, D 3, V 3 = $60.26 IF you can buy KO for$60.26 or less AND you think your assumptions are plausible, BUY!IF you can buy KO for$60.26 or less AND you think your assumptions are plausible, BUY!

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Valuing KO b KO’s actual P/E (using best data 7/3/01]: Trailing = 45.90/1.25 = 36.72Trailing = 45.90/1.25 = 36.72 Leading = 45.90/1.78 = 25.79Leading = 45.90/1.78 = 25.79 b Estimate of P/E may have been aggressive, but D and EPS growth may be conservative. b Forecasting EPS becomes paramount! b Other multipliers: P/S, P/B, P/CF,...

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Forecasting EPS b Two primary approaches: Trend analysisTrend analysis Fundamental approachFundamental approach b Trend Analysis Do EPS figures exhibit a trend over time?Do EPS figures exhibit a trend over time? Is recent growth expected to continue?Is recent growth expected to continue?

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Forecasting EPS for DELL b Forecast sales growth for DELL using trend analysis: Geometric average: 42.38%Geometric average: 42.38% b Forecast sales growth for industry! b Will DELL maintain market share? b Build a sales forecast from other data

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Forecasting EPS for DELL b Which Income Statement items drive EPS? b Focus on ratios! basis for comparison with other firmsbasis for comparison with other firms identifies strategies, competence, deficiencies when examined over timeidentifies strategies, competence, deficiencies when examined over time b Ratio Analysis LiquidityProfitabilityLiquidityProfitability Asset UtilizationLeverageAsset UtilizationLeverage

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Forecasting EPS for DELL b Let’s focus on Sales, NPM, and Payout. Industry Sales are forecast to increase by 15%. Assume DELL will hold their share.Industry Sales are forecast to increase by 15%. Assume DELL will hold their share. NPM? It has weakened in past years. Was 7.0% for FY01 and is 6.7% in trailing 4 quarters.NPM? It has weakened in past years. Was 7.0% for FY01 and is 6.7% in trailing 4 quarters. Dividend Payout? None paid currently. None expected in next 2 years.Dividend Payout? None paid currently. None expected in next 2 years.

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Forecasting EPS for DELL b EPS = (S x NPM)/#sh b S 1 = (32640.0)(1.15) = $37536.0 b EPS 1 = (37536.0)(.07)/2604 = $1.009 b Suppose we expect DELL to sell at a P/E of 39 next year. b P 1 = $1.009 x 39 = $39.35 b P 0 = $39.35/1.2989= $30.29 (>$26.48]

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Valuing DELL b Reality check Growth estimate?Growth estimate? Required return?Required return? P/E estimate?P/E estimate? Sensitivity analysisSensitivity analysis Qualitative adjustment of critical variablesQualitative adjustment of critical variables

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