Fundamental Analysis Macroeconomics Analysis Industry Analysis Equity Valuation Model (Dividend Discount Model- DDM) Financial Statement Analysis

Macroeconomics Analysis Global Economy Analysis –affects export, price competition and profits –exchange rate: purchasing power and earnings Domestic Economy –The ability to forecast the macroeconomy can translate into great investment performance –outperform other analysts to earn extra profits Many variables can affect economy

–Gross Domestic Product (GDP ): measures the economy’s total output of goods and services – Employment rate: measures the extent that the economy is operating at full capacity – Inflation measures the general level of prices increase Phillip’s curve – Interest Rate high interest rate reduces PV of cashflows, thus stock values – Budget Deficit large deficit means more borrowing, which implies higher interest rate. – Sentiment consumers and producers confidence

Business Cycles business cycles: pattern of recession and recovery peak: the end of expansion and start of recession trough: the bottom of the recession stock returns are decreasing when at peak and increasing at trough cyclical industries: do well in expansionary periods but poorly in recession, e.g., durable goods such as automobile and wash machines defensive industries: little sensitive to business cycles, such food

Industry Analysis Select a good industry to invest. It is difficult for a firm to do well in a troubled industry Standard Industry Classification (SIC) code Value line Investment Survey - reports 1700 firms in 90 industries Two factors that determine the sensitivity of a firm’s earnings to business conditions: business risk, financial risk

Business risk Sales sensitivity to business condition some industries are robust (food) while others are not (movie) operating leverage: the division between fixed and variable costs. –firms with greater amounts of variable cost relative to the fixed cost are subject less to business fluctuations, thus profits are more stable Financial Risk the degree in using financial leverage (the amount of interest payment) leverage firm is more sensitive to business cycles

Industry cycles Start-up Build-up Maturity Decline Start-up: increasing growth Build-up/consolidation: stabilized growth maturity: slower growth Decline: shrinking growth

Equity Valuation Model Dividend Discount Model (DDM) V 0 = (D 1 +P 1 )/(1+k) = D 1 /(1+k) + D 2 /(1+k) D n /(1+k) n constant growth assumption V 0 = D1/(1+k) + D 1 (1+g)/(1+k) 2 +D 1 (1+g) 2 /(1+k) = D1/(k-g) or k = expected return = D 1 /P 0 + g

Multistage Growth Model Growth profile may not be constant such as: Expected Growth Time g1g1 g2g2 n V=D 0 (1+g 1 )/(1+k)+...+D 0 (1+g 1 ) n /(1+k) n + D 0 (1+g 1 ) n (1+g 2 )/(1+k) n and so on

Illustration of two-stage Growth Model A stock pays $1 dividend now and its g 1 =30% for 6 yrs. Thereafter, its g 2 =6%, its k=15% yr 1: $1(1+0.3) =1.13 yr 2: 1(1+0.3) 2 =1.69 yr 3: 1(1+0.3) 3 =2.20 yr 4: 1(1+0.3) 4 =2.86. yr 7: 1(1+0.3) 6 (1+6%) =5.12 yr 8: 1(1+0.3) 6 (1+6%) 2 =5.42.

Market Value (equity) Market value is the present value of its future dividends TimePV(Dt)Growth rate % At time 1: FV(Dividends) = 34.00(1.15) - 1.3= 37.8 At time 2: FV(dividends) = 37.80(1.15) =41.78 Expected return at time 0 (15%) = Yr end dividend/current price + growth rate = 1.3/ %

P/E Ratio Behaviors Price = No growth value/share P 0 = E 1 /k + PVGO or P 0 /E 1 = [1+ PVGO]/k E 1 /k Time P/E average

Pitfalls in P/E Analysis Denomination of P/E ratio is the accounting earnings (arbitrary rules or historical cost will distort the earnings figures) Earning should be based on economic earnings (i.e., net of economic deprecation) Earnings are future figures vs P/E ratio (which uses past accounting earnings)

Earnings Forecast Models for forecasting: E i,t = g i + E i,t-4 +a i (E i,t-1 -E i, t-5 ) where g: growth factor a: adjustment factor E: Earnings Time Series Analysis ARMA model Exponential smoothing professional institution forecast Performance Evaluation MSE or others

Financial Statement Analysis Preparation of Source/Use Fund Statement Ratio Analysis –Performance Analysis –Du Pont Analysis

Use/source of Fund Statement SourcesUses C. Paper $ 5.8 Cash $ 0.4 A/P 17.8A/R 16.2 Div/P 1.4Inv 34.8 S/T debt 4.6Prep. Ex 0.4 S/T Lease 3.8Lease 82.8 L/T Debt 20.6Others 3.6 L/T Lease 25.0Tax 1.0 C/S 3.2 P/I Cap 0.6 NI 54.4Div Depreciation 48.6 Total

Analysis of Use/Source Sales growth=3.5% Uses- major component A/R =8.72%; Inventory = 18.73%; Lease = 44.6% Dividend = 25.1% Sources A/P = 9.5%; L/T debt = 11.1%; L/T lease = 13.4% Operation profits = 55.4% (NI+depreciation) Why issue shares? S/T-/LT capital increases so much?

Ratio Analysis AssetsSalesProfit Liquidity Ratio Risk Ratio Du Pond Analysis ROE=Net Income(NI)/Equity (E) = NI Pretax Prof EBIT Sale TA P.Prof EBIT Sales TA E TB IBGPM TAT EM Pretax profit =EBIT - Interest TB = Tax burden IB = interest burden