Company Analysis and Stock Valuation Chapter 14 Company Analysis and Stock Valuation

Financial Leverage Financial leverage = takes the form of a loan or other borrowings (debt), the proceeds of which are (re)invested with the intent to earn a greater rate of return than the cost of interest. If the firm's rate of (ROA) is higher than the rate of interest on the loan, then its (ROE) will be higher than if it did not borrow because assets = equity + debt

Financial Leverage Degree Of Financial Leverage (DFL) Financial Leverage acts as a double-edged sword. If the economic conditions are favorable and EBIT is increasing, a higher financial leverage has a positive impact on the EPS. The DFL captures this relationship between EBIT and EPS. DFL is defined as the percentage change in EPS for a given percentage change in EBIT. DFL = change in EPS / Change in EBIT EPS EBIT For different applications of leverage, analysts may include or exclude certain items, such as non-tangible balance sheet items, non-financial liabilities, and similar items, or may adjust the carrying value of other items. It is not uncommon to use only financial liabilities (long-term and short-term borrowings), thereby excluding, for example, accounts payable.

Present Value of Dividends Growth Rate Estimates ADGR = n√Dn - 1 D0 If 1983 dividend was .02 a share and the 2004 dividend was .18. The ADGR was 21√.18 - 1 = .1103 .02

Present Value of Operating Free Cash Flow Also known as FCFF or Entity DCF Model To determine a value for the total firm and subtract the value of the firm’s debt obligations to arrive at a value for the firm’s equity = EBIT (1-tax rate) + depreciation expense - capital expenditures - ∆ in working capital - ∆ in other assets ***the cash flow available to all capital suppliers

Measure of Long Run Growth g = (RR) ( ROIC) where RR = retention rate ROIC = EBIT (1-tax rate) total capital Sample: Assume that the capital investments for two years were 7,985 and 9,264 with a tax rate of 38% for the taxable income of 2,176. What will be the ROIC? ROIC = 2,176 x (0.62) = 1,349 = 15.64% (7,985 + 9,264)/2 8,624 g = (.82)(.1564) = 12.82%

Alternative Growth Models No Growth Firm =earnings are calculated after allowing for depreciation expense used to maintain the assets at their original value The value of the firm never changes, and investors continue to receive k on their investment. V= E/k or k=E/V

Alternative Growth Models Long Run Growth Model = assume that some of the earnings are reinvested E : level of net earnings expected from existing assets, without further net investments R : reinvestment of net earnings (E) and is equal to bE, where b is percent of retention between zero (no investment) and unity (total investment ; no dividends) G : r = mk r = reinvested funds m = relative rate of return operator k = expected rate of return If m is greater than 1, the projects that generate these returns are considered true growth investments (r > k). If m is less than 1, the investments are generating returns below the cost of capital (r < k)

Alternative Growth Models Simple Growth Model =assumes the firm has growth investment opportunities that provide rates of return equal to r V = D/k + bEm/k Present value of + present value of constant dividend growth investment

Alternative Growth Models Expansion Model V = (b) E / k where the value of b must be greater than zero 0

Alternative Growth Models Negative Growth Model =applies to firm that retain earnings (b>0) and reinvest these funds in projects that generate rates of return below the firm’s cost of capital (r<k or m<1) Poor performance may be difficult to uncover because the firm’s asset base will grow since it is retaining earnings and acquiring assets.

What determines the Capital Gain Component? 3 Factors: 1.) The amount of capital invested in growth investments 2.) The relative rate of return earned on the funds retained 3.) The time period for these growth investments

Economic Value Added (EVA) Measures a firm’s economic profit, rather than accounting profit Recognizes a cost of equity and a cost of debt EVA = (r-k) X C where: r = Operating return on assets k = Total cost of capital C = Amount of capital (Total Assets) invested in the firm

Economic Value Added (EVA) Example Problem: A firm has total assets of $1,000; 40% is financed with debt and 60% with equity. Interest on debt is 5% while opportunity cost is 15%. What will be the calculated EVA if the operating return on assets will be 16?

Economic Value Added (EVA) Solution: Cost of debt = 400 x .05 = $20 Cost of equity = 600 x .15 = $90 Total cost of capital ------ 110.00 or 110.00/1,000 = 11% EVA = (.16 - .11) x 1,000 = $50.00 Analysis: acceptable status since this has positive value. The higher the EVA, the more acceptable it will be for the firm.

Market Value Added (MVA) MVA = (Market Value of Firm) – Capital - Market Value of Debt - Market Value of Equity =can be impacted by market interest rates and by changes in future expectations for a firm not considered by EVA

Comparison of EVA & MVA EVA – does an outstanding evaluation of Management’s past performances in terms of adding value MVA – hopes that the superior past performance will continue

When to Sell? Doesn’t end when intrinsic value is computed or research report is written Indicators: If the key value drivers appear to have weakened When the stock becomes fairly priced If it already goes out of the original reason why you purchased the stock

Influences of Analysts Paralysis of Analysis = must have expectations that differ from consensus (and why do you differ?) Analyst Conflicts of Interest = separation of personal friendship and impersonal relationship Availability of Data = both a blessing and a curse - tendency to have Information overload Differential Accounting Conventions = accounting rules and practices differ around the world; financial statements differ in presentation

Influences of Analysts Currency Differences = exchange rates volatility Transaction Costs = commissions vary among countries Valuation Differences = earnings, cash flow and expected rate of return vary in countries

TECHNICAL ANALYSIS Chapter 15 examination of prior price and volume data to determine past market trends to predict future behavior of the market

Underlying Assumptions of Technical Analysis Market value of any good or service is determined solely by the interaction of demand and supply Supply and demand are governed by numerous rational and irrational factors The prices for individual securities and the overall value of the market tend to move in trends at appreciable lengths of time Ships in supply and demand relationships can be detected in the action of the market itself

Technical Trading Rules and Indicators Typical Stock Market Cycle

Technical Trading Rules Four Groups: I. Contrary-Opinion Rules = trading against the crowd II. Smart Money = emulating astute investors III. Popular Technical Indicators IV. Price and Volume Techniques

Technical Trading Rules Contrary-Opinion Rules Mutual Fund Cash Positions = high percentage of cash near a market trough – the time when they should be fully invested to take advantage of the impending market rise

Technical Trading Rules Contrary-Opinion Rules Credit Balances in Brokerage Accounts = investors sell stocks and leave the proceeds with their brokers = build up credit balances indicates increase in buying power and is a bullish signal

Technical Trading Rules Contrary-Opinion Rules Investment Advisory Opinion =If a large proportion of investment advisory services are bearish, this signals the approach of a market trough and the onset of a bull market

Technical Trading Rules Smart Money Confidence Index = measures the difference in yield spread between high grade bonds and a large cross section of bonds = a bullish indicator, during periods of high confidence, investors are willing to invest in lower quality bonds for the added yield, w/c causes a decrease in the yield for the large cross section of high grade bonds

Technical Trading Rules Smart Money T-Bill/Eurodollar Yield Spread = during international crisis, this spread widens as the smart money flows to safe-haven US T-bills which causes a decline in this ratio

Technical Trading Rules Smart Money Debit Balances in Brokerage Accounts (margin debts) = borrowing by investors from their brokers to engage in margin transactions = a bullish sign, but does not include borrowing by investors from other sources such as banks

Technical Trading Rules Popular Technical Indicators Breadth of Market = measures the number of issues that have increased each day and the number of issues that have declined = stock participation in the market

Technical Trading Rules Popular Technical Indicators Stocks above Their 200-day Moving Average = computation of moving averages of an index to determine the general trend = knowing stocks that are currently trading above their 200-day moving average index and will be used as indicator overbought – more than 80% of the stocks are trading above their 200-day moving average oversold – less than 20% of the stocks are selling above their 200d moving average

Technical Trading Rules Price and Volume Techniques Dow Theory = remains the basis for many technical indicators = describes stock prices as moving in trends analogous to the movement of water 1.) major trends – tides in the ocean 2.) intermediate trends – waves 3.) short run movements - ripples

Technical Trading Rules Price and Volume Techniques Volume Technique = price increase on heavy volume relative to the stock’s normal trading volume is an indication of a bullish activity Indicator of market momentum: volume of stock that increased volume of stock that decreased

Technical Trading Rules Price and Volume Techniques Support and Resistance Levels Support Level – will develop after a stock has enjoyed a meaningful price increase and the stock experiences profit taking Resistance Level – expectations to increase in the supply of stock and a price reversal = results to “overhanging stocks”

Technical Trading Rules Price and Volume Techniques Moving Average Line – shorter run 50day and large volume = If the overall price trend of a stock or the market has been down, the moving-average price line generally would lie above current prices. If prices reverse and breakthrough the moving average line from below accompanied by heavy trading volume, a positive change could signal a reversal of the declining trend

Technical Trading Rules Price and Volume Techniques Relative Strength If RS Ratio increases overtime, it shows that the stock or industry is outperforming the overall stock market and expect this superior performance to continue RS Ratio = price of stock/industry index value of some stock market index in S&P500

Technical Trading Rules Price and Volume Techniques Bar Charting = plotting the high and low prices and connects the two points vertically to form a bar - horizontal line across the vertical bar indicates the closing price

Technical Trading Rules Price and Volume Techniques Multiple-Indicator Charts

Technical Trading Rules Price and Volume Techniques Point-and-Figure - a form of heterodox economics used to attempt to predict financial market prices. - unique, does not plot price against time as all other techniques do. Instead in plots price against changes in direction by plotting a column of Xs as the price rises and a column of Os as the price falls

Samples of Point and Figure Triple Top Double Top Double bottom Triple Bottom

Equity Portfolio Management Chapter 16 Equity Portfolio Management Strategies

Passive versus Active Management Passive Equity Portfolio Management: = a long-term buy-and-hold strategy, generally referred as “indexing” Not to beat the target index but to match its performance Minimizes the deviation between the portfolio and index returns similar to the bond index portfolio manager

Passive versus Active Management Active Equity Portfolio Management: = attempt to outperform a passive benchmark portfolio – (beta, dividend yield, industry weighing and firm size match the risk-return objectives of the client) = controls the larger percentage of investor wealth

Index Portfolio Construction Techniques Basic Techniques for Passive Index Portfolio 1. Full Replication – stocks are purchased in proportion to the weights in the index 2. Sampling - buying only the representative stocks that comprise the index 3. Quadratic Optimization – a programming technique which utilizes the historical information on price changes and correlations between securities Completeness Funds – customized passive portfolios, constructed to complement the active portfolios that do not cover the entire market

Other Technical Strategies Contrarian Investment Strategy = belief that the best time to buy(sell) as stock is when the majority of other investors are the most bearish (bullish) about it. Price Momentum Strategy = recent trend in past prices will continue; assumes that stocks that have been hot will stay hot, while cold stocks will also remain so

Other Technical Strategies Earnings Momentum Strategy = more formal active portfolio approach that purchases and holds stocks that have accelerated earnings and sells (short sells) stocks with disappointing earnings

Asset Allocation Strategies Integrated Asset Allocation = separately examines: 1.) capital market conditions 2.) investor’s objectives and constraints Investors Assets, Liabilities And Networth Capital Market Conditions Prediction Procedure Investor’s Risk, Tolerance Function Expected Returns, Risks, And Correlations Investor’s Risk Tolerance Optimizer Investor’s Asset Mix Returns

Asset Allocation Strategies Strategic Asset Allocation – used to determine the long term policy asset weights in a portfolio Tactical Asset Allocation – constantly adjusts the asset class mix in the portfolio in an attempt to take advantage of changing market conditions Insured Asset Allocation – assumes that expected market returns and risks are constant over time while the investor’s objectives and constraints changes as his wealth position changes

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