Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 14-1 Chapter 14
Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 14-2 Chapter Summary Objective: Introduction to fundamental stock analysis. This chapter introduces different types of valuation models and shows how economic conditions affect the results. Dividend discount models Price-Earnings ratios Other methods and issues Macroeconomic analysis
Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 14-3 Basic Types of Models Balance Sheet Models Dividend Discount Models Price/Earning Ratios Estimating Growth Rates and Opportunities Fundamental Analysis: Models of Equity Valuation
Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 14-4 Intrinsic Value Self assigned Value Variety of models are used for estimation Market Price Consensus value of all potential traders Trading Signal IV > MP Buy IV < MP Sell or Short Sell IV = MP Hold or Fairly Priced Intrinsic Value and Market Price
Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 14-5 Summary Reminder Objective: Introduction to fundamental stock analysis. This chapter introduces different types of valuation models and shows how economic conditions affect the results. Dividend discount models Price-Earnings ratios Other methods and issues Macroeconomic analysis
Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 14-6 V 0 = Value of Stock D t = Dividend k = required return Dividend Discount Models: General Model
Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 14-7 Stocks that have earnings and dividends that are expected to remain constant Preferred Stock No Growth Model
Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 14-8 E 1 = D 1 = $5.00 k =.15 V 0 = $5.00 /.15 = $33.33 No Growth Model: Example
Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide 14-9 g = constant perpetual growth rate Constant Growth Model
Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide E 1 = $5.00b = 40% k = 15% (1-b) = 60%D 1 = $3.00 g = 8% V 0 = 3.00 / ( ) = $42.86 Constant Growth Model: Example
Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide g = growth rate in dividends ROE = Return on Equity for the firm b = plowback or retention percentage rate = (1- dividend payout percentage rate) Estimating Dividend Growth Rates
Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide P N = the expected sales price for the stock at time N N = the specified number of years the stock is expected to be held Specified Holding Period Model
Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide PVGO = Present Value of Growth Opportunities E 1 = Earnings per share for period 1 Partitioning Value: Growth and No Growth Components
Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide ROE = 20% d = 60% b = 40% E 1 = $5.00 D 1 = $3.00 k = 15% Partitioning Value: Example g =.20 x.40 =.08 or 8%
Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Vo = value with growth NGVo = no growth component value PVGO = Present Value of Growth Opportunities Partitioning Value: Example (cont’d)
Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Summary Reminder Objective: Introduction to fundamental stock analysis. This chapter introduces different types of valuation models and shows how economic conditions affect the results. Dividend discount models Price-Earnings ratios Other methods and issues Macroeconomic analysis
Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide P/E Ratios are a function of two factors Required Rates of Return (k) Expected growth in Dividends Uses Relative valuation Extensive Use in industry Earnings, Growth and Price-Earnings Ratios
Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide E 1 - expected earnings for next year E 1 is equal to D 1 under no growth k - required rate of return P/E Ratio: No Expected Growth
Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide b = retention ratio ROE = Return on Equity P/E Ratio with Constant Growth
Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide E 0 = $2.50 g = 0 k = 12.5% P 0 = D/k = $2.50/.125 = $20.00 PE = 1/k = 1/.125 = 8 Numerical Example: No Growth
Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide E 1 = $2.50 (1 + (.6)(.15)) = $2.73 D 1 = $2.73 (1-.6) = $1.09 P 0 = 1.09/( ) = $31.14 PE = 31.14/2.73 = 11.4 PE = (1 -.60) / ( ) = 11.4 Numerical Example with Growth b = 60% ROE = 15% (1-b) = 40% k = 12.5% g = 9%
Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Pitfalls in P/E Analysis Use of accounting earnings Historical costs May not reflect economic earnings Reported earnings fluctuate around the business cycle
Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Summary Reminder Objective: Introduction to fundamental stock analysis. This chapter introduces different types of valuation models and shows how economic conditions affect the results. Dividend discount models Price-Earnings ratios Other methods and issues Macroeconomic analysis
Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Other Valuation Ratios Price-to-Book Price-to-Cash-Flow Price-to-Sales
Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide The Free Cash-Flow Approach Fundamental idea: the intrinsic value of a firm is the present value of all its net cash-flows to shareholders Estimate the value of the firm as a whole It equals the present value of cash-flows, assuming all-equity financing plus the net present value of tax shields created by using debt; Derive the value of equity by subtracting the market value of all non-equity claims
Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Inflation and Equity Valuation Inflation has an impact on equity valuations Historical costs underestimate economic costs Empirical research shows that inflation has an adverse effect on equity values Research shows that real rates of return are lower with high rates of inflation
Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Potential Causes of Lower Equity Values with Inflation Shocks cause expectation of lower earnings by market participants Returns are viewed as being riskier with higher rates of inflation Real dividends are lower because of taxes
Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Growth or Value Investing Growth Investing – picking companies that are considered to have superior growth prospects Value Investing – choosing companies for which fundamental analysis reveals unrecognized value The Graham technique
Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Summary Reminder Objective: Introduction to fundamental stock analysis. This chapter introduces different types of valuation models and shows how economic conditions affect the results. Dividend discount models Price-Earnings ratios Other methods and issues Macroeconomic analysis
Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Performance in countries and regions is highly variable Political risk Exchange rate risk Sales Profits Stock returns Global Economic Considerations
Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Gross domestic product (GDP) Unemployment rates Interest rates & inflation International measures Consumer sentiment Key Economic Variables
Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Fiscal Policy - Government spending and taxing actions Monetary Policy - manipulation of the money supply to influence economic activity Tools of monetary policy Open market operations Discount rate Reserve requirements Government Policy
Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Demand shock - an event that affects demand for goods and services in the economy Tax rate cut Increases in government spending Supply shock - an event that influences production capacity or production costs Commodity price changes Educational level of economic participants Demand and Supply Shocks
Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Business Cycle Peak Trough Industry relationship to business cycles Cyclical Defensive Business Cycles
Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Copyright © McGraw-Hill Ryerson Limited, 2003 Slide Leading Indicators - tend to rise and fall in advance of the economy. Examples: Average work week New orders - durables Residential construction Stock Prices Lagging Indicators - indicators that tend to follow the lag economic performance Cyclical Indicators