1. Company Analysis and Stock Valuation
Chapter 14
Company Analysis
and
Stock Valuation

2. 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

3. 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.

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

5. 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

6. 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, = %
(7, ,264)/ ,624
g = (.82)(.1564)
= 12.82%

7. 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

8. 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)

9. 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

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

11. 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.

12. 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

13. 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

14. 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?

15. Economic Value Added (EVA)
Solution:
Cost of debt = 400 x .05 = $20
Cost of equity = 600 x = $90
Total cost of capital or
110.00/1,000 = 11%
EVA = ( ) 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.

16. 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

17. 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

18. 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

19. 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

20. 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

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

22. 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

23. Technical Trading Rules and Indicators
Typical Stock Market Cycle

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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

35. 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”

36. 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

37. 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

38. 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

39. Technical Trading Rules
Price and Volume Techniques
Multiple-Indicator Charts

40. 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

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

42. Equity Portfolio Management
Chapter 16
Equity Portfolio Management
Strategies

43. 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

44. 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

45. 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

46. 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

47. 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

48. 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

49. 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

50. the end .