A NOTE ON ASSET VALUATION

Transcription

1 Study Session # 10, Reading # 34 A NOTE ON ASSET VALUATION 1 BENJAMIN GRAHAM & DAVID DODD Intrinsic Value Concept Focus on investing rather speculating. Most important factor earning power should provide margin of safety. Bond & preferred stock earning power in excess of interest & P. dividend. Common stock = earning power cap. factor. Applied to leading asset classes at that time. Now asset classes expanded rapidly & also used for speculation. John Burr Williams Discounting Concept PV of all future C.F. Work of Graham, Dodd & Burr blocking & tackling.

2 Study Session # 10, Reading # 35 EQUITY VALUATION: APPLICATION AND PROCESSES 1 MP = Market Price IV = Intrinsic Value C.F = Cash Flows FSA = Financial Statement Analysis DDM = Dividend Discount Model 1. INTRODUCTION Valuation is the estimation of asset s value based on Variables affecting future returns. Comparisons with similar assets. Estimates of immediate liquidation proceeds. FCFE =Free Cash Flows to the Equity FCFF = Free Cash Flows to the Firm PV= Present Value DCF =Discounted Cash Flow 2. VALUE DEFINITIONS AND VALUATION APPLICATIONS Context of valuation determine def. of value & affects selection of valuation approach. 2.1 What is Value? Several perspectives on value foundation for valuation models Intrinsic Value Intrinsic value value of asset given complete understanding of investment characteristics. If MP = I.V, market is efficient. Rational efficient markets formulation = returns generated by information processing are higher than cost of gathering information. Active mangers attempts to produce excess risk adjusted returns (Alpha). Two possible sources of mispricing. (V-P) = intrinsic value market price (true mispricing) = estimated value intrinsic value (estimation error) Mispricing may remain even after correct forecasts and valuation models (e.g. due to market conditions) Going Concern Value and Liquidation Value Going concern value = value of a company with foreseeable future. Liquidation value = value of a company in financial distress. Going concern value is normally greater then liquidation value Fair Market Value and Investment Value Fair market value = price at which willing & informed buyer & seller ready to exchange asset or liability. Investment value = value to a buyer after considering synergies & expectation Definitions of Value: Summary Intrinsic value under going concern assumption is important for equity valuation. 2.2 Applications of Equity Valuation Valuation concepts & models are used for Stock selection & extracting market expectations. Evaluating corporate events & business strategies. Fairness opinions & communication with analysts & shareholders. Appraising private businesses & share-based payment.

3 Study Session # 10, Reading # THE VALUATION PROCESS 3.1 Understanding the Business Evaluate company s performance in economy & industry context Industry & Competitive Analysis Industry analysis is important because similar factors affect all companies in industry. Various frameworks for industry & competitive analysis to organize thoughts about an industry. Sensitivity analysis to recognize aspects of company in which opportunity exist. Industry structure industry s economic & technical characteristics (porter s analysis). Consider qualitative factors & avoid extrapolating past results in strategic execution. Porter s three generic strategies Cost leadership Differentiation Focus Lowest cost producer Priced at or near industry avg. Unique product or services Premium prices Competitive advantage within a segment or segments. Cost or differentiation focus Analysis of Financial Reports The relevant aspects of financial report vary across companies & industries. Established companies ratio analysis. Newer companies or products nonfinancial measures Sources of Information Analyst can compare information provided by company to their own research. Company provided information regulatory filings, press releases & investor relation material. Analyst can use third party sources of information Considerations in Using Accounting Information Analysts rely on accounting information to forecast future performance. Quality of earnings analysis evaluate economic reality. Nonrecurring events low quality earnings. Compare company s net income with operating C.F. Growth of assets > growth of sales = aggressive accounting. Analysts must careful about future negative surprises. 3.2 Forecasting company Performance Two perspectives Economic environment Forecasting Approaches Company s own operating & financial characteristics Top-down forecasting approach Bottom-up forecasting approach Economy to industry to company. Macro to micro. Company to industry to economy. Micro to macro. Analysts combine industry & competitive analysis with FSA to forecast certain items.

4 Study Session # 10, Reading # Selecting the Appropriate Valuation Model Absolute & relative valuation models going concern assumption Absolute Valuation Models Specifies an asset s intrinsic value (PV models). PV or DCF Model Share holder level Company-level DDM Free C.F Asset based valuation Residual Income PV of dividends FCFE C.F net of payment to providers of debt FCFF C.F before provider of debt s payments MV of assets or resources Earnings in excess of opportunity cost of generating those earnings. PV approach can also applied for valuing bonds & has less uncertainty then stocks Relative valuation Models Assets value relative to another asset. Use price or enterprise multiples (method of comparables). Similar assets should sell at similar prices. Pairs trading utilize pairs of closely related stocks (buy undervalued, sell overvalued) Valuation of the Total Entity and Its Components Sum-of-the-parts valuation (break up value or private market value) estimated values of each of the company s businesses (each business is independent). Conglomerate discount market applies a discount to the stock of company operating in multiple, unrelated businesses Issues in Model Selection and Interpretation Consistent with the characteristics of the company being valued. Appropriate given the availability and quality of data. Consistent with the purpose of valuation, including the analyst s perspective. 3.4 Converting Forecasts to a Valuation Aspects of converting forecasts to valuation Sensitivity analysis Situational adjustments Sensitivity of output to an input. Some sensitivity analysis is common to most valuation. Control Premiums Lack of marketability Discount Illiquidity discounts Controlling value higher than otherwise non controlling position. Extra return for lack of public market. Prices of shares with less depth Blockage factor price for a block of trade is less then MP of smaller amount of stocks.

5 Study Session # 10, Reading # Applying the Valuation Conclusion: The analyst s Role and Responsibilities Sell-Side analysts Buy-Side analysts Analysts at Corporations Analysts at independent vendors Analysts work at brokerage firms Analysts provide input to portfolio manager or investment committee for investment decisions. May perform some valuation similar to buyside analysts. Identify & value acquisition targets. Work for publicly distributed research reports. Focus on corporate information. 4. COMMUNICATING VALUATION RESULTS Research report share several common elements. 4.1 contents of a Research Report Consider the intended purpose of report reader. Assumptions and expectations are important for intrinsic value. Superior report address the uncertainty associated with investing. Focus should be on good investment rather Good Company. 4.2 format of Research Report Research report may present in several ways. Analyst s firm may specifies a fixed format for consistency & quality control. 4.3 Research Reporting Responsibilities Analysts have on obligation to provide substantive & meaning full report. Analysts who are CFA institute members will adhere code of Ethics & professional conduct standards.

6 Study Session # 10, Reading # 36 Equity: Markets & Instruments 1 1. MARKET DIFFERENCES: A HISTORICAL PERSPECTIVE Historical & cultural differences explain diff. in stock trading practices. Market organization Types Private Bourses Public Bourses Banker s Bourses Founded by private individuals. Not free of public regulation. Self-regulation dominance. Fixed commission & broker appointed by govt. Most have moved toward private bourse. Private or semipublic. Sometimes trading b/w banks without official bourse. Moved toward private bourse. Cash V/S Forward Markets Cash Market Forward Market Stocks are traded on cash basis. Settlement within a few days. Margin trading available. Periodic settlement system. Prices are fixed at time of transaction. Short-term speculation due to settlement. Price-Driven V/S Order-Driven Markets Price driven quote-driven or dealer market Auction or order-driven market Bid-ask prices. Ensure liquidity at any point in time. Market markers adjust their quotes continuously. Price, where demand & supply in equilibrium. Call auction or firing asset be traded once or few times per day. Highest limit bid & lowest limit offer act as ask prices Order Driven System Advantages Disadvantages Little human intervention. Less costly to run. Provide liquidity at low cost. Monitor liquidity. Inability to execute large trade. Lack of depth. Risk of being picked off (price no longer desired). Upstairs trading blocks trade away from order-drive system. Absence of market making. Transparency risk. ECNs Electronic Communication networks Electronic crossing networks Order-driven systems. Limit order book. Advantages of ECNs low transaction costs & anonymity. Disadvantages no trading immediacy. Generally market orders. Prices are taken from primary market (mid-market quote).

7 Study Session # 10, Reading # SOME STATISTICS Market cap weights are used in global benchmarks. Developed & emerging markets usually classified two different asset classes. Liquid market investors are more active & design arbitrage strategies. Degree of concentration of market cap is important consideration. 3. SOME PRACTICAL ASPECTS Uncertainty about company s information highly subjective judgment. Tax Aspects Two locations investor s country & investment s country. Areas of Taxes Transactions Capital Gains Income Eliminated or drastically reduced Normally taxed where investor resides Poses a conflict of jurisdiction. Taxes must paid at least in one country. Foreign tax credit against home taxes. 4. EXECUTION COSTS Can reduce expected return & diversification benefits. Components of Execution Costs Commission, Fees & Taxes Market Impact Opportunity Cost Commission depends on characteristics of trade & market mechanism. Fee for various services. These costs are explicit & measurable. Diff. b/w execution price & MP (benchmark price). Price-driven bid-ask spread. Order-driven estimated from market data. Order size, liquidity & spread of execution affect market impact. Cost of delay in or failure to complete a transaction. Significant in crossing networks or order driven. Slower the order completion, higher cost. Trade-off b/w market impact & opportunity cost. Estimation & uses of Execution Costs Global surveys of execution costs are available. Diff. b/w actual trade price & benchmark price (volume-weighted avg. price) = Execution cost. Implementation shortfall diff. b/w value of executed portfolio & value of same portfolio at time of decision. Execution cost models for expected execution cost. Some Approaches to reducing Execution costs Program trading manager offers a basket of securities for sale (less risky than a large trade for single stock).

8 Study Session # 10, Reading # 36 3 Internal Crossing Manager Cross order with an opposite order for another client Advantage Minimize costs Disadvantages Offsetting orders are rare. Problem in setting transaction price. Applied by large asset management firms specialized in passive strategies. External Crossing Manager sends order to an electronic crossing network Advantages Execution costs are low. Anonymity is assured. Disadvantages Difficulty in large block trade. Low speed execution. Principal Trade Dealer act as principal (opposite side of the order) Advantages Trading immediacy. Opportunity cost minimized. Disadvantages Large overall execution costs. Anonymity cannot be assured. Agency Trade Broker act as an agent Advantages Disadvantages Best execution. Compromise b/w opportunity cost & market impact. Large commission Anonymity can t be assured. Use of dealer indications of interest Poll IOIs from various dealers Advantages Low execution cost Use of futures Disadvantages Anonymity preserved but not trading interest. Slow trading speed. Use future to monitor the position Advantage Reduction in opportunity cost Disadvantages Risk if price of security is not correlated with future. Not suitable for single security.

9 Study Session # 10, Reading # 36 4 s 5. INVESTING IN FOREIGN SHARES LISTED AT HOME Motivation for multiple listing More access to foreign ownership & amount of funds. Reduce the risk of a domestic takeover. More financing & advertisement of product brands. Attractive for developing & remote countries. People are less shaky by bad domestic news & keep their capital invested at home (home bias). Foreign listing & ADRs (American Depository Receipt) Foreign stocks to local markets listing regulations can be quite lenient or though. Certificate representing share ownership of a foreign company ADRs. Under ADRs foreign company s shares are deposited with U.S.banks which in turn issues ADRs Unsponsored ADR = ADR program created without company s involvement (traded through pink sheets). Sponsored ADRs Classification Level I Level II Level III Not comply with SEC registration & reporting requirements. Share traded in over the counter (but not NASDAQ). Register & complies with SEC. Listed on official U.S. exchange. Same as under level II plus raise capital through IPO. Capital is raised through private placement under level I ADRs. Company must supply all information necessary to comply with U.S.GAAP. Global depositary receipts (GDRs) = simultaneously listed on several markets. Valuation of ADRs (American Depository Receipt) Share price should same after adjusting exchange rate & transaction costs. Dominant-satellite market relationship price in the foreign market simply adjusts to the home market price. Arbitrage costs b/w ADR & original share can be sizeable. Consider influence of time zones. Advantages/Disadvantages of ADRs Advantages Disadvantages Easy & direct investment in foreign firm. Suitable for retail investor More costly than direct purchase. Limited no. of issuers (no full diversification). Closed-end country fund Definition & Motivation Close-end fund investment vehicle that buy stocks; in turn its shares are traded in stock market. Fund market price = NAV + Premium Country fund fund whose assets consist stocks of a particular country. Motivation for country fund investing Simple way to access local market & benefit from international diversification. Overcome foreign investment restrictions

10 Study Session # 10, Reading # 36 5 The Pricing of country funds Price of country fund is seldom equal to its NAV (Net Assets Value). in market price of fund = in NAV + in premium (discount). Foreign investment restrictions are binding fund sell at premium over NAV. Volatility in value of premium volatile underlying assets. Large discount on fund large management fee & lack of liquidity. Fund s value is often correlated with U.S. stock market (inconsistent with market efficiency). Advantage/Disadvantage Advantage Disadvantage Better diversified than ADRs High cost & volatility Open-End Funds Publicly offered & can be purchased & redeemed at the NAV. Attractive for shareholders (known NAV), risky for portfolio managers (difficult to realize NAV). Investors decide to buy/ redeem shares before NAV calculation. Foreign shares time lag couple of days & large bid-ask spread. Many of these funds are index tracking or take the form of ETFs. Exchange Traded Funds (ETFs) Trade like shares of company (but these are shares of portfolio) & can be sold short or margined. Used in international diversification strategies. Definition & Motivation ETF is an open end fund with management cost advantage (no shareholder accounting) Redemption in-kind process through authorized participants, no capital gain. Individual ETF shareholder can require in-cash redemption based on NAV (it is discouraged through large fee & delay in NAV calculation) Listed price remain close to the NAV through arbitrage. Transaction cost of ETF = commission + Half of Bid-ask spread. International ETF holding stocks from numerous countries high bid-ask spreads Consider effect of non-overlapping time zones & currency fluctuations. Advantage/Disadvantage of ETFs Advantages Disadvantages International diversification. Excellent liquidity & low cost Tax efficient. Useful in international portfolio strategy. Used in active asset allocation. Not provide active returns.

11 Study Session # 10, Reading # 37 RETURN CONCEPTS 1 ERP = Equity Risk Premium RR= Required Return RF = Risk Free AM = Arithmetic Mean GM = Geometric Mean FFM = Fama-French Model 1. INTRODUCTION Investors compare expected return with fair return. Analysts specify the discount rate. WACC = Weighted Avg. Cost of Capital MVD = Market Value of Debt Rd = Return on Debt MVCE = Market Value of Common Equity 2. RETURN CONCEPTS 2.1 Holding Period Return Return earned over a specified time period. Consider dividend reinvestment if received b/w holding period. Return Components Investment Income Price Appreciation 2.2 Realized & Expected (Holding Period) Return Returns Realized Return Expected Return Holding period in the past. Selling price & dividend are known. Expected dividend & selling price. Price valuation models. Different investors have different expected returns. 2.3 Required Return Minimum level of expected return an investor requires given the asset s riskiness. It is opportunity cost for investing in the asset. If expected return > required return = security under valued (positive ex- ante alpha) & vice versa. Realized or ex- post alpha = actual holding period return-required return. Estimates of required return are essential for present value models. 2.4 Expected Return Estimates from intrinsic Value Estimates When an asset is mispriced, price convergence takes place. When investor s value estimate is more accurate than market return has two components required return & return from convergence. Convergence component of E(R) is quite risky (e.g. time horizon problem or inaccurate estimates).

12 Study Session # 10, Reading # Discount Rate (D.R) Rate used to find PV of future C.F. D.R depends on characteristics of investment. Different D.R. for distinct expected future C.F. 2.6 Internal Rate of Return IRR is the DR that equates PV of expected future CF to the asset s price. When markets are efficient IRR is required return on equity. 3. THE EQUITY RISK PREMIUM Incremental return for holding equities rather risk-free assets. ERP depends on expectations. RR on equity = current expected RF +ERP RR on share i = current expected RF + βi (ERP). Or Current expected RF + ERP ± other risk premia/discounts. ERP for national equity markets (global CAPM then world equity premium). 3.1 Historical Estimates Mean value of difference b/w equity index returns & govt. debt return. No systematic errors in expectations Avg. returns are unbiased estimates. In developing historical ERP estimate include the selection of : Equity index for equity market return. Time period for computing estimate. Type of mean calculated & proxy for RF return. Extending the length of data increase precision but decrease assumption of stationarity. High ERP during bad times but low during good times. Two choices for historical mean return calculations are AM & GM. RF rates can be long term or short term govt.debt return Arithmetic Mean or Geometric Mean GM is always less then A.M given any variability in returns. AM returns best represent mean rerun in a single period. If AM is known expected terminal value can be found by compounding at AM. GM is a compounded growth rate logical in multiperiod context. ERP based on GM tend to be closer to supply & demand-side estimates from economic theory. G.M is preferred than A.M Long-Term Government Bond or Short-Term Government Bills In normal yield curve, ERP is smaller under bond-based estimate as compared to bill-based. Inverted yield curve ERP higher under bill-based estimate Adjusted Historical Estimates Historical ERP may be adjusted through offsetting effect of Biases or independent estimate of ERP. Survivorship bias inflate ERP should be adjusted downward. Unexpected positive & negative events & surprises may require ERP adjustment (upward or downward).

13 Study Session # 10, Reading # Forward-Looking Estimates Based on expectations for economic & financial variables (ex ante estimates). Less subject to non stationary or data biases. Subject to potential behavioral biases & model errors Gordon Growth Model Estimates Model assumptions are met in mature developed equity markets. GGM Equity RP = expected dividend yield on index +long term growth ratecurrent long-term govt. bond yield. Multiple earnings growth stages calculate IRR which is required return on equity r and than subtract govt. bond yield to arrive ERP as. Equity index price = PV fast growth (r) + PV transition (r) + PV mature (r). GGM assume P/E ratio is constant, analyst make adjustment to P/E expansion or contraction Macroeconomic Model Estimates More reliable when public equities represent large share of economy. Focus on supply-side variable. ERP = {[(1+EINFL)(1+EGREPS)(1+EGPE) -1.0]+EINC} expected risk free return. EGREPS = expected growth in real earnings per share sum of labour productivity growth & labour supply growth. EGPE = expected growth in P/E ratio baseline value is zero current P/E level show overvaluation or undervaluation. EINC = expected income component expected dividend yield Survey Estimates Ask people (experts) what they expect about capital market, then premium can be inferred. 4. THE REQUIRED RETURN ON EQUITY The choices include The CAPM. Multifactor models. Build-up method. 4.1 The Capital Asset Pricing Model Provide equilibrium required return. Required return on share i = RF + β i (ERP). β i is sensitivity of asset returns to the return on the market portfolio of risky assets. If markets are segmented, two issues with same risk can have different required returns if trade in different markets. If markets are integrated international CAPM is used Beta Estimation for a Public Company Unadjusted or raw beta regression of return on stock on the return on market. Choice of index & length & frequency of observations are important considerations. Beta in future period closer to mean value of 1.0, so we adjust raw beta as adjusted beta = (2/3) (unadjusted beta) + (1/3) (1.0). Infrequently traded securities beta will be too small & required return will be underestimated.

14 Study Session # 10, Reading # Beta Estimation for Thinly Traded Stocks and Nonpublic Companies Analyst estimate beta of nonpublic company on basis of public peer s beta. Consider differences in financial leverage. Unlever the benchmark (public company) beta for beta of asset (debt is high quality) If subject company has debt & equity levels D & E then subject company s equity beta is Sometimes median or avg. industry beta is used as benchmark beta. CAPM is simple, widely accepted, theory based method & can be estimated easily. For individual securities idiosyncratic risk overwhelm market risk beta may be poor indicator of future returns. 4.2 Multifactor Models CAPM beta describes risk incompletely; evidence suggests multiple factors drive returns. Multifactor models are complex & expensive which does not ensure greater explanatory power. APT models express required return as r=r f +(Risk premium) 1 + (Risk premium) (Risk premium) k where Risk premium = (factor sensitivity or beta) i (factor risk premium) i factor risk premium is expected return in excess of Rf The Fama-French Model return of value weighted index in excess of one month T-bill. SMB (small minus big) = Avg return of three small-cap portfolios avg. return of three large size portfolios. HML (high minus low) = avg return on two high book-to-market portfolios minus Avg return on two low book-to-market portfolios. Each of the factors can be viewed as mean return to zero-net investment, long-short portfolio. FFM market β could be above or below CAPM β. FFM include equity market factor (systematic risk) & company factors (e.g. size & value). FFM views size & value premiums as compensation for systematic risk, practitioners believe it as market inefficiency Extensions to the Fama-French Model Investors demand a return premium for illiquid assets. Pastor-stambaugh model adds to the FFM a fourth factor (liquidity). Avg. liquidity equity, liquidity β of 0, below-avg liquidity positive β & vice versa. Liquidity relates to prices impact due to size, depth & breadth of market & block trading. Marketability relates to right to sell an asset.

15 Study Session # 10, Reading # Macroeconomic & Statistical Multifactor Models Macroeconomic factor models variables that affect future C.F and/or D.R to determine PV. Statistical factor Models statistical methods that applied to historical returns. Five-factor macroeconomic BIRR (Burmeister, Roll, & Ross) model with factor definitions as. 1. Confidence risk (C.R): unanticipated change in return difference b/w 20 year risky & Govt. bond. 2. Time horizon risk (T.H.R): unanticipated change in return difference b/w 20 year govt. bond & 30-day T-bill. 3. Inflation risk (I.R): unexpected change inflation rate (stocks have negative exposure to this factor). 4. Business cycle risk (B.C.R): unexpected change in level of real business activity. 5. Market timing risk (M.T.R): portion of return unexplained by first four risk factors. Example of required return under this model is as. 4.3 Build-Up Method Estimates of the Required Return on Equity Specific beta adjustments not applied to factor risk premiums Build-Up Approaches for Private Business Valuation Two additional considerations (adjustment in firm value rather R.R). Controlling V/S minority interests. Lack of ready marketability. So-called modified CAPM formulation Bond Yield Plus Risk Premium (BYPRP) Can be viewed as build-up method for companies with publicly traded debt. BYPRP cost of equity = YTM (long term debt) + risk premium. YTM include real rate + inflation + Default risk premium. Risk premium compensate for additional equity risk. 4.4 The Required Return on Equity: International Issues Global context required return issues are exchange rates. Data & model issues in emerging markets. Exchange rate G/L from equity component not exactly offset by G/L from govt. security component of ERP. Country spread model ERP = ERP for developed market + country premium. Country premium (typically sovereign bond yield spread) represents additional risk of emerging markets. Country risk rating model regression based estimate of ERP (developed countries). Used that equation for less developed markets to predicat required return for those markets.

16 Study Session # 10, Reading # THE WEIGHTED AVERAGE COST OF CAPITAL Required return of company s suppliers of capital is usually referred to cost of capital. Analyst can use total firm value approach for equity valuation. Corporations may deduct net interest expense from income in calculating taxes owed (just corporate taxes). If suppliers of capital are creditors & common equity holders then expression for WACC Appropriate to use marginal tax rate (better reflect future cost of fund raising) rather effective tax rate. Analyst use targets weights instead of current market weights. Before-tax required return on debt is typically YTM of company s debt. 6. DISCOUNT RATE SELECTION IN RELATION TO CASH FLOWS When discounting C.F to equity required return to equity is appropriate. Discounting C.F to firm cost of capital is appropriate. Real C.F should be discounted at real rate while nominal C.F should be discounted at nominal rate. Nominal approach is exact for equity valuation.

17 Study Session # 11, Reading # 38 EQUITY: CONCEPTS & TECHNIQUES 1 b = retention ratio r = required return on stock g = growth rate of earning E 1 = next year s earnings ρ = real required return λ = inflation flow through D 1 = next year s dividend GGM = Gordon growth model 1. APPROACHING INTERNATIONAL ANALYSIS Analysts must take foreign variables in evaluating domestic firms. Firms that exports extensively & foreign subsidiaries global firms. Research on a company produce two pieces of information Expected return rate of return including price appreciation. Risk exposure how much company s value responds to certain key factors (interest rates, currency risk etc). Find securities with superior expected returns for given risk. Qualitative analysis should be consistent for every security. The Information Problem Information on foreign firms difficult to obtain. Other problems language & presentation of financial reports. A vision of the World Objective of security analysis is to detect relative misvaluation. Sectoral analysis is important due to common factors affecting securities. Three Approaches to International Research Global Industrial Factors Domestic Factors Particular Attributes of Firms Companies are valued relative to other within the industry. Research should be country-by-country or region-by-region basis. Style investing e.g. value stocks & growth stocks. 2. DIFFERECNCES IN NATIONAL ACCOUNTING STANDARDS Optional segment 3. GLOBAL INDUSTRY ANALYSIS Company belongs to global industry & based in a country country & industry analysis. Companies compete within industry studying company is primary approach to stock valuation. Country analysis Companies favor some countries for their sales & production. In the long run real economic growth major influence on national stocks market.

18 Study Session # 11, Reading # 38 2 Real Economic Growth Short Run Long Run Business cycle Sustainable growth Turning points are difficult to predict. Complex control system. Investor would benefit from buying stocks at trough & bonds at peak. Perfect market timing is impossible concentrate on long term growth. High growth in GDP. Saving & investment rates must closely analyzed. If ratio of investments to GDP is low replacement investments, if ratio is high expansion. More privatization, less regulation conducive to investment. Business Cycles Stages Recovery Early upswing Late upswing Economy slows Recession Good investments are cyclical stocks & commodities Confidence is up. Good investments are stocks & property. Boom mentality. Not good time for stocks & property. Time to buy bonds & interest sensitive stocks. Economy is decaling. Good investments are bonds & interest sensitive stocks. Monetary policy relaxed but lag before recovery. Good investments are stocks & commodities. Inflation is generally associated with late upswing & deflation with recession. Business Cycle Synchronization Business cycles are not fully synchronized. Lack of synchronization international diversification. If long term GDP growth & business cycles perfectly synchronized then high degree of correlation b/w markets. Growth Theory Growth theory explains the rate of GDP growth in different countries. Countries with equal risk, overweight the country with sustainable GDP growth. Economic Theories Neoclassical growth Theory Endogenous growth Theory Marginal productivity of capital declines as more capital is added. Level of GDP depends on saving rate but growth in GDP not depends on saving rate. Steady state is reached. Increase in dividend level but not dividend growth. Marginal productivity of capital not necessity decline as capital added. Long term growth rate in GDP depends on saving rate. Steady state may never reach. Increase in dividend level & growth. Steady state is the condition of no change in capital per capita. Input-driven growth is limited as compared to growth through efficiency gains.

19 Study Session # 11, Reading # 38 3 The limitation of the Country Concept in Financial Analysis Multinational company s valuation should be based on global industry analysis rather based on their home economy. Industry Analysis: Return Expectation Elements Find companies that can earn ROE > required rate of return. Examine sources of growth & sustainability of competitive advantage. Demand Analysis Surveys as well as explanatory regression are used to estimate demand. Global context demand means world wide demand. Analyst estimate sensitivity of sales to global & national GDP changes. Country analysis is important for demand analysis due to region focus. Value creation Value chain transformations in moving from raw material to product or service delivery. Factors that contributes in value addition are Learning curve (cost per unit produced declines as companies gain experience). Economies of scale (fixed cost spread over larger output). Economies of scope (reputation with one product may spill over to another product). Network externalities (products & services gain value as more consumer use them). Industry life cycle Stages of Growth Pioneering development Rapid accelerating growth Mature Growth Stabilization Declaration of growth Low sales growth. Substantial development cost. Low profit margins &limited product acceptance. Sales growth modest & rapidly increasing. May face barriers to entry so high profit margins. High but modest increasing sales growth. Competition decrease margins but ROE is higher. High but slow increase in growth rate. ROE decline to Avg. ROE in economy. Decreasing sales growth. Overcapacity. Margins eroded. Somewhere in stage 2or3 industry sales growth rate is above GDP growth rate. In stage 5 industry sales growth rate would fall back to GDP growth rate. Competition Structure If industry is fragmented many firms compete. Methods to analyze industry concentration N firm concentration ratio Herfindahl index Combined market share of the largest N firms in industry. Provide intuitive sense of industry competition. Sum of squared market shares of the firms in industry. More precise measure. Small index competitive industry. Reflect all firms in the industry. H <0.1 = unconcentrated industry = moderate concentration >0.18 = high concentration. High H index may also indicate presence of market leader.

20 Study Session # 11, Reading # 38 4 Competitive Advantage Some national factors can lead to competitive advantage. Factor conditions such as human capital. Demand condition. Related supplier & support industries. Strategy, structure & rivalry. Competitive Strategies Set of actions a firm is taking to optimize its future competitive position. Analyst will consider company s commitment to a strategy. Generic Competitive Strategies Cost leadership Differentiation Focus Low Cost Producer Benefit that other firm do not provide Either a cost or differentiation focus in a niche Co-opetition & the Value Net Co-opetition cooperation along the value chain. Value net set of participants involved in producing value along value chain. In a poor economy co-opetition may become competition. Sector Rotation Industries behave differently over business cycle. Consumer cyclical industries do well in early & middle growth portion of business cycle Defensive consumer staples maintain profitability during recessions. Industry Analysis: Risk Elements To achieve excess risk-adjusted basis return investors must be able to distinguish sources of risk. The risks can differ b/w firms in same industry but also across industries. High- risk strategy in risky industry higher ex ante market risk. Market Competition Limit pricing pricing below avg. cost to deter entry. Predatory pricing pricing below to drive others out of the industry. Value Chain Competition Suppliers can choose to compete rather than cooperate. A major issue in value chain analysis is whether labour is unionized. Co-opetition risks possibility that supply may be held up or distributors may find other sources of products & services.

21 Study Session # 11, Reading # 38 5 Rivalry Intensity Degree of competition among companies in the industry. Coordination can make rivalry much less intense. Similar sized firms Rivalry is generally more intense. Variability in demand creates more rivalry within an industry. Substitutes Threat of products or services that are substitutes for products or services of the industry. Substitutes constrain the ability to raise their prices. Industries without excess capacity or intense rivalry can present attractive investment opportunities. Buyer Power Bargaining power of buyers of the producer s products or services. Larger number of buyers & smaller individual purchases less bargaining power. Standardization increase buyer power. If buyers can integrate backwards increase bargaining power. Greater buyer power less attractive equity investment in producer. Supplier Power Power of suppliers to the producers. More suppliers less supplier s power. Standardized raw materials less supplier power. If buyers can integrate backwards reduce supplier power. Greater supplier power less attractive equity investment in producer. New Entrants Threat of new entrants into the industry. Higher payoffs more likely the entry. Barriers to entry, high exit cost, cost curve steepness entry is less likely. Excess capacity & learning curve effects deter entry. Government Govt. subsidies seed companies in early stages. Govt. participate indirectly by their involvement in social contract. Govt. control competition. Risks & Covariance Uncertainty about future stock prices. Two levels of risks: Total risk as measured by standard deviation. Second level of risk is measured by covariance with economy (measured by beta from regression).

22 Study Session # 11, Reading # EQUITY ANALYSIS Reasonable prediction of cash flows & risk is required to provide useful inputs to the valuation process. Industry Valuation or Country Valuation Whether a company should be valued relative to global industry or relative to home stock market. Can be judged through financial analysis & relative valuation. Global industry factors tend to dominate country factors (country factors should not be neglected). Global Financial Ratio Analysis Global industry financial analyses examine each company in the industry against the industry average. Approach of this type of analysis is DuPont model. Depending on the analyst s focus the ratios can be combined in different ways (five, three or two factors). Due to national accounting differences, earnings figures should sometime reconciled. DuPont analysis also serves as a framework for making forecasts. The Role of Market Efficiency in individual Stock Valuation Efficient markets new information would be immediately & fully reflected in prices. Investor might use surprise information about a company. Perfectly efficient market asset prices reflect fundamental value. Valuation Models Investors rely on discounted C.F analysis for intrinsic value or justified price through PV model. Dividend discount model (GGM). Intrinsic price-to-earnings (P/E) ratio. Rf rate, P/E & stock price. More realistic DDM approach decomposes future in three phases (near future, transit & long term). Franchise Value & the Growth Process Growth rate (g) depends on GDP growth rates, industry growth rate & company s competitive advantage. Intrinsic P/E = Tangible P/E + Franchise P/E. Tangible P/E is no growth P/E while franchise P/E is related to PV of growth opportunities. Franchise value P/E further broken down into franchise factor & growth factor. Growth factor PV of opportunities for new investments (growth in BV of equity). Franchise factor return level associated with new investment (ROE > r). Sales-driven franchise value deal with multinational corporations. if ROE = r or b = 0 then intrinsic price to earning equals 1/r. We can simplify the above equation as. Where FF = G =

23 Study Session # 11, Reading # 38 7 The Effects of Inflation on Stock Prices Historical costs are used in accounting distorting affect on earnings. Dep. at historical cost & FIFO inventory accounting system overstatement of earnings. Borrowing costs at historical rates understatement of reported earnings. Analysts try to determine what part of inflation flow through to a firm s earnings. The intrinsic P/E using prospective earnings is Higher the flow-through rate, higher the price of company. P/E ratio ranges a high of 1/ρ to a low of 1/r. Higher the inflation rate negative the influence on stocks prices. The Inflation Like Effects of Currency Movements on Stock Prices Some firms cannot fully pass exchange rate movements due to certain reasons. Home currency depreciation effect local importers as. Price increase reduces demand. Locally produced goods will become more attractive. 5. GLOBAL RISK FACTORS IN SECURITY RETURNS To structure a portfolio properly understanding of factors influencing risk & return of each security is essential. Factor models allow better understanding of risks that affect stock returns. Risk-Factor Model: Industry & Country Factors Factor model may be written as R = rate of return on a security. α = constant f f k are k factors common to all securities. Β β k represent risk exposure. ε random term specific to this security. Global risk-factor model use industry & country as factors. Factors are measured as the return on some index portfolio representative of the factor. Risk-factor exposure can follow one of two techniques or combination of two. Exposure can be assessed a priori. Exposure can be estimated using multiple regression approach. If companies are reacting differently to currency movements, currencies could be added as risk factor. Other Risk Factors: Styles Value stocks do not behave like growth stock. Value stocks are a company whose stock price is cheap in relation to its BV or C.F it generates. Growth stocks have the opposite attribute this is known as value effect. Small firm s stock price behavior is different then large firms (size effect). In short run winners tend to repeat (momentum, success or relative strength effect). The observation of these effects led to style investing.

24 Study Session # 11, Reading # 38 8 Other Risk Factors: Macroeconomic Macro economic factors must be logical choice, easy to interpret & able to explain significant percentage of variation in stock returns. Burmeister, roll & Ross proposes a set of five factors as: Confidence factor (diff. in return of corporate & govt. bond). Time horizon factor (diff. b/w return on 20-year govt. bond & 1-month T-bill). Inflation factor (diff. b/w actual inflation & its expected value computed the month before). Business cycle factor monthly variation in a business activity index. Market-timing factor. Part of return not explained by other factors. Common criticism β estimated from past data & not stable. Practical Use of Factor Models Risk-factor models are used in risk management & in selecting stocks. Exposure of the portfolio to various factors is the weighted avg. of the exposure of stocks making up portfolio. Managers use factor models to tilt portfolio along some factor bets

25 Study Session # 11, Reading # 39 The Five Competitive Forces That Shape Strategy 1 To sustain long-term profitability you must respond strategically to competition. Competitive forces that hurt profits Established Rivals Savvy Customers Powerful Suppliers Aspiring Entrants Substitute offerings The Idea in Practice Develop a strategy for enhancing your company s long-term profits. Porter suggest: Position your company where the forces are weakest. Exploit changes in the forces. Reshape the forces in your favor. 1. INTRODUCTION Five forces define an industry s structure & shape the nature of competitive interaction within an industry. If forces are intense no company earns attractive returns. Industry structure drives competition & profitability. Factors effecting industry profitability. Short run business cycle, weather etc. Long run industry structure. 2. FORCES THAT SHAPE COMPETITION The configuration of five forces differs by industry. Threat of Entry New entrants bring new capacity & desire to gain market share. Threat of entry puts a cap on profit potential of an industry. Threat of entry depends on height of entry barriers. Supply side economies of scale low cost per unit deter new entry. Demand-side benefits of scales discourage entry by limiting the willingness of customers to buy form a newcomer. Customer switching costs fixed costs that buyers face when they change suppliers larger the cost harder the new entry. Larger financial resources needed deter new entrants. Incumbents may have cost or quality advantages not available to potential rivals. Limited the wholesale or retail channels more the existing competitors tied them up tougher the entry. Govt. policy can hinder or aid new entry. Expected retaliation how potential entrants believed incumbents may react will also influence their decision to enter.

26 Study Session # 11, Reading # 39 2 The Power of Suppliers Powerful suppliers charge higher prices or shifting costs to industry participants. A supplier group is powerful if It is more concentrated then the industry it sells to. Does not depend heavily on industry for its revenue. Industry participants face switching cost in changing suppliers. Suppliers offer products that are differentiated. There is no substitute for what the supplier group provides. The supplier group can credibly threaten to integrate forward into the industry. The Power of Buyers Powerful customers capture more value by forcing down prices, demanding better quality or more service. Buyers are powerful if negotiating leverage relative to industry participants. A customer group has negotiating leverage if: Few buyers or large volume buyers. Industry s products are standardized or undifferentiated. Buyers face few switching costs in changing vendors. Buyers can integrate backward if vendors are too profitable. A buyers group is price sensitive if: Purchases represent a significant fraction of its cost structure or procurement budget. The quality of buyers products or services is little affected by the industry s product. The industry s product has little effects on the buyer s other cost. Intermediate customers can be analyzed the same way as other buyers. Producers often attempt to diminish channel clout. The Threat of Substitutes Substitute performs same or a similar function as an industry s product by a different means. Downstream or indirect threat of substitution substitute replaces a buyer industry s product. When threat of substitute is high industry profitability suffers. The threat of substitute is high if: If offers an attractive price-performance trade-off to the industry s product. Buyer s cost of switching to the substitute is low. Strategists should be alert to changes in other industries that may make them attractive substitute (improvement in plastic material, substitute for steel). Rivalry among Existing Competitors High rivalry limits the profitability of industry. Degree to which rivalry drivers down industry s profit depends. Intensity with which companies compete. Basis on which they compete. The intensity of rivalry is greatest if: Competitors are numerous or roughly equal in size & power. Industry growth is slow (fight for market share). Exit barriers are high. Rivals are highly committed to the business. Firms can t read each other s signals well. Price competition transfers profits directly from an industry to its customers. Sustained price competition trains customers to pay less attention to product features. Price competition is most liable to occur if: Products or services of rivals are nearly identical & few switching cost for buyers. Fixed costs are high & marginal costs are low. Capacity must be expanded in large increments to be efficient. Product is perishable. Competition other than prices less likely to erode profitability. Competitors aim to meet same needs or compete on same attributes zero sum competition. Rivalry cans positive sum or profitability if each competitor aims to serve the needs of different customer segments.

27 Study Session # 11,s Reading # 3 3. FACTORS, NOT FORCES Industry Growth Rate Fast growth can put suppliers in a powerful position. High growth rate will not guarantee profitability if customers are powerful or substitute are attractive. Fast-growth businesses least profitable in recent years. Technology & Innovation Advanced technology or innovations are not by themselves enough to make an industry structurally attractive or unattractive. Government Govt. involvement is neither inherently good nor bad for industry profitability. To understand the influence of govt. on competition analyze how specific govt. policies affect the five forces. Complementary Products & Services Complements products or services used together with an industry s product (combined benefit is greater than individual benefits). Strategist must trace positive or negative influence of complements on all five forces to ascertain their impact on profitability. Presence of complements can raise or lower barriers to entry & affect threat of substitutes. Complements can affect industry rivalry either positively (raise switching costs) or negatively (neutralize product differentiation). 4. CHANGES IN INDUSTRY STRUCTURE Industry structure proves to be relatively stable & industry profitability differences are remarkably persistent. Shifts in structure may from outside an industry or from within. Shifting Threat of New Entry Changes to barriers can raise or lower the threat of new entry. Strategic decisions of leading competitors often have major impact on threat of entry. Changing Supplier or Buyer Power As the factors underlying the power of suppliers & buyers change with time, there clout rises or declines. Shifting Threat of Substitution The common reason substitutes become more or less threatening over time is that advances in technology creates new substitutes or shift price-performance comparisons. New Bases of Rivalry Rivalry often intensifies naturally over time (trend toward price competition is inevitable). The nature of rivalry in an industry is altered by mergers & acquisitions that introduce new capabilities & ways of competing. Technological innovation can reshape rivalry. Eliminating rivals is a risky strategy.