2 Outline Valuation Philosophies Investors’ Understanding of Risk Premiums The Time Value of Money The Importance of Cash Flows The Tax Factor EIC Analysis Value vs. Growth Investing The Value Approach to Investing The Growth Approach to Investing How Price Relates to Value Value Stocks and Growth Stocks: How to Tell by Looking
3 Outline Some Analytical Factors Growth Rates The Dividend Discount Model The Multistage DDM Caveats about the DDM False Growth A Firm’s Cash Flows Small-Cap, Mid-Cap, and Large-Cap Stocks Ratio Analysis Cooking the Books
4 Valuation Philosophies Fundamental analysts believe securities are priced according to fundamental economic data. Technical analysts think investor behavior and supply and demand factors play the most important role.
5 Valuation Philosophies Investors’ understanding of risk premiums: Investors are almost always risk-averse. The time value of money: Everyone agrees on this basic principle. The importance of cash flows: Most investment research deals with predicting future corporate earnings. The tax factor: The tax code is complicated and not all investments are taxed equally.
6 Valuation Philosophies Economy, Industry, and Company (EIC) analysis: The analyst first considers conditions in the overall economy (market risk), then determines which industries are the most attractive in light of the economic conditions (using Porter’s competitive strategy analysis framework, for example), and finally identifies the most attractive companies within the attractive industries.
7 Value vs. Growth Investing A value investor believes that securities should be purchased only when the underlying fundamentals (macroeconomic information, industry news, and a firm’s financial statements) justify the purchase. Value investors believe in a regression to the mean. The Value Approach to Investing
8 Regression to the Mean Most of the time a security’s long- term return is consistent with its risk. Over the long run, a security cannot survive with a cumulative return that is negative. Cumulative Return Time in the Long Term 0 + - x x x x x x x x x x x x x x x Undervalued stock: Buy Overvalued stock: Sell
9 Value vs. Growth Investing Growth investors seek steadily growing companies. There are two factions: Information traders are in a hurry; they believe information differentials in the marketplace can be profitably exploited. True growth investors are more willing to wait, but they share the belief that good investment managers can earn above- average returns for their clients. The Growth Approach to Investing
10 Value vs. Growth Investing In the early days of the market, before the Great Crash of 1929, price played a minor role: “A stock with good long-term prospects is always a good investment.” How Price Relates to Value The modern perspective is that value is inextricably intertwined with price. $ 8
11 Value vs. Growth Investing No precise definition exists. Classification by Morningstar Mutual Funds: Value Stocks and Growth Stocks: How to Tell by Looking relative price to book ratio relative price-earnings ratio +
12 Value vs. Growth Investing The price to book ratio: book value per share is an accounting concept synonymous with equity per share. The price-earnings ratio (PE) is computed by dividing the current stock price by the firm’s earnings per share. Because of differences among industries, relative ratios are commonly computed for both statistics.
Some Analytical Factors: Growth Rates Growth rates from historical data: Growth rates from earnings retention: 13
14 Some Analytical Factors: Growth Rates Financial analysts typically calculate a number of growth rates using different ways to determine a likely range for the statistic. Recent data may be more reliable than data from the more distant past. Company statements regarding company targets may be considered too. Choosing a Growth Rate
15 Some Analytical Factors: Growth Rates Another important source of growth rate estimates is from other security analysts. Two popular services that monitor and report these estimates are Zacks and the Institutional Brokerage Estimate Service (I/B/E/S). Growth Rate Estimates from Other Analysts
16 The Dividend Discount Model (DDM) Also called Gordon’s growth model. The model assumes that the dividend stream is perpetual and that the long- term growth rate is constant.
17 The Dividend Discount Model (DDM) The variable k is sometimes called the shareholders’ required rate of return. Note that the shareholder’s required rate of return is the sum of the expected dividend yield and the expected stock price appreciation.
18 The Multistage DDM Often, initial high growth levels cannot be sustained. Suppose the growth rate g is expected to persist from the third year:
19 Some Analytical Factors Caveats about the DDM: The DDM is at most a useful tool in security analysis - it requires certain assumptions and it has shortcomings. False growth: False growth occurs when a firm acquires another firm with a lower price-earnings ratio - historical data should always be scrutinized carefully when used to determine a growth rate.
20 Some Analytical Factors A firm’s cash flow: The statement of cash flows is a useful analytical tool - the cash flow from operations figures are widely used as a check on a firm’s earnings quality. Small-cap, mid-cap, and large-cap stocks: Another consideration in fundamental stock analysis relates to the size of the firm - for example, the small firm effect.
21 Some Analytical Factors: Ratio Analysis The fundamental analyst is necessarily interested in the firm’s accounting statements and in the prevailing general economic conditions. To assist in the analysis, several organizations publish comparative statistics for industry groups. e.g. Dun and Bradstreet’s Industry Norms & Key Business Ratios, which includes solvency, efficiency and profitability ratios.
22 Some Analytical Factors: Cooking the Books All publicly traded firms in the United States must have their financial statements audited to ensure they fairly present the company’s financial position. Still, every year there is at least one story of accounting fraud at a major firm. Unfortunately, there is not much the analyst can do about fraud.
23 Review Valuation Philosophies Investors’ Understanding of Risk Premiums The Time Value of Money The Importance of Cash Flows The Tax Factor EIC Analysis Value vs. Growth Investing The Value Approach to Investing The Growth Approach to Investing How Price Relates to Value Value Stocks and Growth Stocks: How to Tell by Looking
24 Review Some Analytical Factors Growth Rates The Dividend Discount Model The Multistage DDM Caveats about the DDM False Growth A Firm’s Cash Flows Small-Cap, Mid-Cap, and Large-Cap Stocks Ratio Analysis Cooking the Books