Financial Markets Management 183 Economics 173A. Equity Valuation. Updated 5/13/17

Transcription

1 Financial Markets Management 183 Economics 173A Equity Valuation Updated 5/13/17

2 Perspective and Objective 1. Diversification: Risk reduction. 2. Speculation: I ve got a feeling. 3. Long term: Buy & Hold. 4. Short term: Momentum Ride the wave. 5. Supply & Demand: I ve seen this before.

3 Book Value Market value Liquidation Value Concepts of Value Fair Market Value, Intrinsic Value a) Market Value given a thorough appreciation of the Company, its prospects, and the market b) Look for mispricing c) Alpha = E(HPR) less Market RRR

4 Equity Analysis 1. Determine a value. 2. Compare with the market price. 3. Consider comparable investment opportunities. 4. Decide: Buy, Sell or, if already in, then Hold?

5 Analytical Perspectives 1. Proprietary modeling: always evolving. 2. Fundamental Analysis: mispriced securities. 3. Technical Analysis: using reliable patterns. 4. Diversification: relative returns correlations.

6 The Valuation Approach & Method 1. Cost = De Novo or M&A 2. Income = Revenues, Earnings, Cash flows 3. Market = Comparable Companies or comparable stocks?

7 Analysis Fundamental Analysis: Research to find the appropriate time, place, company, and stock. Technical Analysis: Research to find recurrent and predictable stock price patterns, proxies for buy or sell pressure in the market.

8 Fundamental Analysis Looking for Intrinsic Value Business model. Determinants of Sales. Inherent Risks. Macro influences.

9 Fundamental Valuation Top down Macroeconomic Analysis Sector Selection Industry Analysis Market Company Selection Security Analysis Technical Analysis

10 Fundamental Analysis Includes a) DCF magnitude and timing of CF s b) Market Method Guideline companies c) Financial Ratio Analysis d) Risk assessment

11 Fundamental Analysis Evaluate the financial condition and operating results of a specific company Competitive position Composition and growth in sales Profit margins and dynamics of earnings Asset mix (i.e. cash balance, inventory, accounts receivable, fixed assets) Financing mix ( i.e. debt, stock)

12 Technical Analysis Research to find recurrent and predictable stock price patterns, proxies for buy or sell pressure in the market. Time series patterns in stock prices Use of Charts Assumes useful systematic information in price trends. Theorizing with hindsight. Self defeating in big numbers.

13 Intrinsic Valuation Models Intrinsic Value: the present value of a the future cash flows that are likely to accrue to the owner of the asset. Return on a stock investment is comprised of cash dividends and capital gains or losses. Three Factors required for intrinsic value: Magnitude of the expected cash flows Timing of those future cash flows Proper( risk adjusted ) discount rate

14 Intrinsic Valuation Forecast Earnings and Cash Flows a) Growth rates b) Dividend payout rate Model Selection Discount Rate a) Exogenous or endogenous considerations Conclusion& Recommendation a) Under or over Valued: Buy, Sell, Hold

15 Financial Statements Empirical Creating and Using Financial Ratios Fundamental analysis is often the most demanding and most time consuming phase of stock selection.

16 Valuation Models Dividend Discount Model D.C.F. C.A.P.M.

17 Discount Rates Build up Method a) Risk free Rate + b) Equity risk premium + c) Company risk premium P/E implied C.A.P.M. a) Risk free Rate + b) Non systematic risk premium

18 This image cannot currently be displayed. Intrinsic Valuation Methods Shifting Growth Rate Model or Multistage DDM g 1 g 2 = first growth rate = second growth rate T = number of periods of growth at g 1

19 Intrinsic Valuation Methods Dividend Discount Models (DDM): General Model V 0 1 t D t D t (1 k ) k t If a no growth company V 0 = Intrinsic value of Stock D t = Dividend; use D 1 k = required rate of return ( RRR ) a risk adjusted discount rate

20 Intrinsic Valuation Methods Simplified versions of the DDM: Assume a resale price criterion: V 0 D1 (1 k) 1 D2 (1 k) 2... D N P (1 k) N N 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

21 Intrinsic Valuation Models Intrinsic Value: the present value of a the future cash flows that will accrue to the owner of the asset. Return on a stock investment is comprised of cash dividends and capital gains or losses. Factors in valuing equities Magnitude of the cash flows Timing of those future cash flows Proper discount rate

22 Intrinsic Valuation Methods Dividend Discount Models (DDM): General Model D t V 0 (1 k ) t 1 t V 0 = Intrinsic value of Stock D t = Dividend k = required return

23 Intrinsic Valuation Methods Gordon s constant growth model V 0 where D0 1 g k g D 0 D 1 is is the D k 1 g the current dividend the dividend to be paid next year g is the expected dividend growth rate k is the discount factor according to riskiness the stock The model assumes that the dividend stream is perpetual and that the long term growth rate is constant. of

24 This image cannot currently be displayed. Example: Intrinsic Valuation Methods If a common stock is expected to pay a dividend of $3.00 next year, has a long term growth rate of 5%, and should be priced to provide a return of 15%, it is worth:

25 Intrinsic Valuation Methods The Gordon growth model can also be used to get an idea of how risky the market thinks a particular stock is at that moment or shareholders required rate of return. Use the current price as the P 0 and solve for k. k D 0 1 P 0 g g

26 Intrinsic Valuation Methods Shifting Growth Rate Model or Multistage DDM g 1 = first growth rate g 2 = second growth rate T = number of periods of growth at g 1 T T T t t t k g k g D k g D V ) )(1 ( ) (1 ) (1 ) ( T T T t t t k g k g D k g D V ) )(1 ( ) (1 ) (1 ) (

27 Intrinsic Valuation Methods Advantages of DDM Simplicity Disadvantages of DDM Apply only to dividend paying stocks. Risk is not an explicit variable; it is implied. Estimates of the discount rate and the growth rate may be in error. Small changes in the discount rate and the growth rate produce large differences in valuation. Models do not reflect the value of underutilized assets.

28 Intrinsic Valuation Methods Simplified versions of the DDM: Assume a resale price criterion: V 0 D1 (1 k) 1 D2 (1 k) 2... D N P (1 k) N N 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

29 Intrinsic Valuation Methods Gordon s constant growth model V 0 where D0 1 g k g D 0 D 1 is is D k the current dividend the dividend to be paid next year the riskiness of 1 g g is the expected dividend growth rate k is the discount factor according to the stock The model assumes that the dividend stream is perpetual and that the long term growth rate is constant.

30 Discount Rates Build up Method a) Risk free Rate + b) Equity risk premium + c) Company risk premium P/E implied C.A.P.M. a) Risk free Rate + b) Non systematic risk premium

31 Value Vs. Growth Investing Two factions within Fundamental analysis Value investors believes that securities should be purchased only when the underlying fundamentals (macroeconomic information, industry news, and a firm s financial statements) justify the purchase. Growth investors seek steadily growing companies. Growth traders are willing to pay more than might seem reasonable because they like the stock s future prospects; they are buying future earnings that may or may not develop.

32 Price to Book Ratio The price to book ratio is computed by dividing the current stock price by the firm s book value per share. Book value per share is an accounting concept synonymous with equity per share or net asset value. Share price is rarely equal to book value, but closest for banks because of depreciation, uncollectible debts, goodwill, etc. economic obsolescence intangible assets

33 Price to Book Ratio The price to book ratio is computed by dividing the current stock price by the firm s book value per share. Book value per share is an accounting concept synonymous with equity per share or net asset value. Share price is not normally equal to book value because of depreciation, uncollectible debts, goodwill, etc. economic obsolescence intangible assets

34 Price to Earning Ratio The price earnings ratio (PE) is computed by dividing the current stock price by the firm s earnings per share. Trailing PE Forward PE Growth stocks tend to have higher PE ratios than average

35 Price to Earning s Growth The P/E ratio divided by the company s growth rate of its earnings for a specified time period. P/E ratio Annual EPS Growth The PEG ratio brings the earnings growth rate into the valuation process. A more complete picture than the P/E ratio because, while a high P/E ratio may make indicate the attractiveness of a stock, by factoring in the company's growth rate can tell a different story. The lower the PEG ratio, the more the stock may be undervalued given its earnings performance.

36 Price to Earning s Growth A broad rule of thumb is that a PEG ratio below one is desirable. Why? Interpretive value is sensitive to inputs used. Using historical growth rates, for example, may provide an inaccurate PEG ratio if future growth rates are expected to deviate from historical growth rates. Distinguish between future growth and historical growth by using "forward PEG" and "trailing PEG" are sometimes used.

37 Price to Earning s Growth Example - Calculating the PEG Let\'s look at two hypothetical stocks to see how the PEG ratio is calculated: ABC Industries has a P/E of 20 times earnings. The consensus of all the analysts covering the stock is that ABC has an anticipated earnings growth of 12% over the next five years. 20 (x times earnings) / 12 (n % anticipated earnings growth) = 20/12 = 1.66 XYZ Micro is a young company with a P/E of 30 times earnings. Analysts conclude that the company has an anticipated earnings growth of 40% over the next five years. 30 (x times earnings) / 40 (n % anticipated earnings growth) = 30/40 = 0.75

38 Analytical Factors: Growth Rates Choosing a Growth Rate Financial analysts typically calculate a number of growth rates using different ways to determine a likely range for the statistic. Recent data may be more reliable than data from the more distant past. Company statements regarding company targets may be considered too. Other analysts Zacks, First Call and I/B/E/S Whisper Number thewhispernumber.com

39 Other Valuation Perspectives Price Earnings Ratio: The ratio of a firm s stock price to its earnings per share. Price to book value ratios Price to Cash flow Ratios Price to Sales

40 Finding a Reasonable Discount Rate, aka RRR Maybe the most important metric in terms of sensitivity to intrinsic value. Requires an appreciation of many obvious, and also some subtle, factors affecting investor sentiment and confidence. Changes daily w/ the news. But there are some tools.

41 Beta Beta is the volatility, or risk, of a particular stock relative to the volatility of the entire stock market. Beta is used to evaluate a stock s expected rate of return. Beta is one of the fundamentals that stock analysts consider when choosing stocks for their portfolios.

42 Beta Look at the time frame chosen for calculating beta. Provided betas are calculated with time frames unknown to their consumers. Long term investors will certainly want to gauge the risk over a longer time period than a position trader who turns over his or her portfolio every few months.

43 Beta Another problem may be the index used to calculate beta. Most provided betas use the American standard of the S&P 500. By calculating your own beta you can adjust for these differences and create a more encompassing view of risk. You can also gauge the beta's reliability by calculating the coefficient of determination, its R 2.

44 Beta Beta looks backward and history is not always an accurate predictor of the future. Beta also doesn t account for changes that are in the works, such as new lines of business or industry shifts. Beta suggests a stock s price volatility relative to the whole market, but that volatility can be upward as well as downward movement. In a sustained advancing market, a stock that is outperforming the whole market would have a beta greater than 1.

45 Other Valuation Methods Price Earnings Ratio: The ratio of a firm s stock price to its earnings per share. Price to book value ratios Price to Cash Flow Ratios Price to Sales