Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Seventh Edition by Frank K. Reilly & Keith C. Brown Chapter 13

Chapter 13 Stock Market Analysis Questions to be answered: How do we apply the basic reduced form dividend discount model (DDM) to the valuation of the aggregate stock market? What would be the prevailing value of the market as presented by the S&P 400 based upon the reduced form DDM? What would be the prevailing value of the market (S&P 400) based upon the value of free cash flow to equity (FCFE) model?

Chapter 13 Stock Market Analysis What are the two components involved in the two-part valuation procedure? Given the two components in the valuation procedure, which is more volatile? What steps are involved in estimating the earnings per share for an aggregate market series? What variables affect the aggregate operating profit margin and how do they affect it?

Chapter 13 Stock Market Analysis What are the variables that determine the level and changes in the market earnings multiplier? How do you arrive at an expected market value and an expected rate of return for the stock market? What has happened to the values for the other relative valuation ratios - i.e., the P/BV, P/CF, and P/S ratios?

Chapter 13 Stock Market Analysis What additional factors must be considered when you apply this microanalysis approach to the valuation of stock markets around the world? What are some differences between stock market statistics for the U.S. versus other countries?

Applying the DDM Valuation Model to the Market The stream of expected returns The time pattern of expected returns The required rate of return on the investment

Applying the DDM Valuation Model to the Market Determinants of the Earnings Multiplier: 1. The expected dividend payout ratio 2. The required rate of return on the stock 3. The expected growth rate of dividends for the stock

Market Valuation Using the Reduced Form DDM Estimating k and g for the U.S. equity market The nominal risk-free rate The equity risk premium The current estimate of Risk Premium and k Estimating the growth rate of dividends (g) g = f(b,ROE) ROE = Net Income / Equity

Estimating Growth Rate Growth rate of dividends is equal to –Retention rate - the proportion of earnings retained and reinvested –Return on equity (ROE) – rate of return earned on investment  An increase in either or both of these variables causes an increase in the expected growth rate (g) and an increase in the earnings multiplier

Return on Equity (ROE) Profit Total Asset Financial Margin Turnover Leverage = xx

Market Valuation Using the Free Cash Flow to Equity (FCFE) Model FCFE is: + Net Income + Depreciation Expense - Capital Expenditures -  in Working Capital - Principal Debt Repayments + New Debt issues

Market Valuation Using the Free Cash Flow to Equity (FCFE) Model The Constant Growth FCFE Model The Two Stage Growth FCFE Model

Market Valuation Using Relative Valuation Approach The price-earnings ratio (P/E) The price-book value ratio (P/BV) The price-cash flow ratio (P/CF) The price-sales ratio (P/S)

Market Valuation Using Relative Valuation Approach Two-part valuation procedure

Market Valuation Using Relative Valuation Approach Importance of both components of value 1. Estimating the future earnings per share for the stock-market series 2. Estimating a future earnings multiplier for the stock-market series

Estimating Expected Earnings Per Share Estimating expected earnings per share Estimate sales per share for a stock-market series Estimate the operating profit margin for the series Estimate depreciation per share for the next year Estimate interest expense per share for the next year Estimate the corporate tax rate for the next year Estimating Gross Domestic Product Estimating sales per share for a market series

Estimating Expected Earnings Per Share Alternative estimates of corporate net profits –Direct estimate of the net profit margin based on recent trends –Estimate the net before tax (NBT) profit margin –Estimate an operating profit margin to obtain EBITDA; estimate depreciation and interest to arrive at EBT; estimate the tax rate (T) and multiply by (1-T) to estimate net income

Estimating Expected Earnings Per Share Estimating aggregate operating profit margins –Capacity utilization rate –Unit labor costs –Rate of inflation –Foreign competition

Estimating Expected Earnings Per Share Estimating depreciation expense –time series trends –estimate based on property, plant, and equipment sales and turnover depreciation

Estimating Expected Earnings Per Share Estimating interest expense –debt levels total assets expected capital structure –interest rates –subtract result from EBIT to estimate EBT

Estimating Expected Earnings Per Share Estimating the tax rate –depends on future political action –multiply (1-T) times the EBT per-share to estimate the net income per share

Estimating the Earnings Multiplier for a Stock Market Series Determinants of the earnings multiplier – Dividend payout ratio –required rate of return on common stock –the expected growth rate of dividends for the stocks

Estimating the Earnings Multiplier for a Stock Market Series Estimating the required rate of return (k) –inversely related to the earnings multiplier –determined by risk-free rate, expected inflation, and the risk premium for the investment Estimating the dividend payout ratio (D/E) –active decision or residual outcome? –time series plots –long-run perspective

Estimating the Earnings Multiplier for a Stock Market Series Estimating an Earnings Mutiplier: An Example –The Direction of Change Approach –Specific Estimate Approach Calculating an Estimate of the Value for the Market series

Other Relative Valuation Ratios Price to book value ratio (P/BV) Price to cash flow ratio (P/CF) Price to sales ratio (P/S)

Analysis of World Markets Individual country analysis –analyze economy and security markets before analyzing alternative industries or companies –macro techniques –micro techniques –technical analysis –top down approach

The Internet Investments Online

End of Chapter 13 –Stock Market Analysis

Future topics Chapter 14 Why do industry analysis? Competition and expected industry returns Estimating an industry earnings multiplier