Adv Invest Analysis & Manageme
Adv Invest Analysis & Manageme FIN 4514
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Advanced Investments Fin 4514 001 Jack S Rader CFA Primary Text Investment Valuation 2nd ed Damodaran VWey 2002 Additional readings necessary to the class on reserve in the library under the courseinstructor name Fall 2003 Course Outline Overview Stock Selection and Market Efficiency Qualitative Side Analysis of company s story Economy Industry and Firm Factors Quantitative Side The numbers Valuation inputs 0 Growth rates 0 Discount rates 0 Cash flows Valuation models 0 Dividend discount models for various growth scenarios 0 Free cash flow models for various growth scenarios 0 Multiples Technical analysis Other issues Option valuation approaches Introduction Stock Selection Techniques 0 market timing try to buy in at market lows sell at market highs may play the equity market versus cash cyclical defensive stocks and other rotationoriented strategies security selection 0 topdown vs bottomup o fundamental vs technical 0 technical pricevolume patterns created by investors with superior informationinvestor psychology 0 fundamental dividend yield priceearnings Dupont model dividendcash flow models growth and profitability models management quality etc o growthmomentum stocks attempt to identify companies with above average earningssales growth over a sustained period of time 0 value investing attempt to identify undervalued companies through such techniques as high dividend yields low pricetobook ratios low PE ratios Regardless of how the analyst selects stocks for analysis ultimately an intrinsic value calculation requires estimates of cash flows growth rates and discount rates Market Efficiency Beating the market implies generating consistently positive excess returns on a riskadjusted basis Beating the market requires inefficiencies in the way a market processes information about assets and asset classes Can the excess return of a money manager be consistently and predictably positive Informational ef ciency requires 0 random walk new events random 0 new information is quickly priced no frictions low transaction costs large investors no inherent advantage equal access to market s trading mechanism significant information is quickly and equally available Weak form information content of current and past prices does not provide useful forecasting 0 changes in price conform to a random process 0 price runsmechanical trading rules do not work Semistrong form prices adjust quickly to new public information 0 professional managers 6075 fail to do as well as the market before fees and taxes mutual funds do no better than randomly selected portfolios before costs 0 successful records are consistent with pure chance speed of adjustment prices adjust rapidly to revisions in expectations mergers stock splits secondary offerings Strong form all information is reflected in asset prices 0 corporate insiders specialists generate excess returns Note efficiency can only be tested by using a specific asset pricing model lfthe model does not adequately adjust for risk the test result is likely to come back inefficient The paradox can a market be informationally efficient if analysts have no incentive to collect costly information Implications for stock analysis Weak form technical analysis will not work Semistrong form fundamental analysis will not work Strong form if all available information is already reflected in security prices no investor even an insider has reason to substitute his own estimates for those of the market So what information will you develop that the market does not have or is not processing correctly Valuation An Overview chap 1 2 6 Myths objectivity timelessness precision quantification market inefficiency and product over process Types of Valuation fundamental franchise charting informed trading market timing and efficient market theory Approaches to Valuation 3 1 DCF fl Price PVeXpected future cash flows ZECFt lrt t1 ECF to rm or to shareholders equity WACC or re 2 Relative Valuation PE PB PS the use of o fundamentals DCFbased andor comparables w Real Options Contingent Claims 0 optionbased pricing approached o equity as a call option special situations What is the value of a share of stock Suppose an investor is considering purchasing Home Depot stock If she expects o to receive dividends of 024 026 and 028 over the next three years to be able to sell the stock for 40lshare in three years and believes she should receive a 10 return annually overall She will be willing to pay 24 x 111 26 x 1112 28 40 x 1113 3070 today vs a recent price of 3007 8403 Who will pay 40lshare in three years 0 Someone who has similar expectations of dividends and price Note the 40 price 3 years from now implies annual growth of about 92 in price from the fair value of 3070 For dividends to grow from 024 to 028 implies an annual growth rate in dividends of 52 Note Another way of looking at this is that if Value D1rg or g r D1V0 Then with V 3070 g 922 That is the longterm growth in dividends must be 922 for a 10 return to realized from a V 3070 Fl Value Price PV expected future cash flows 2 ECFt 1 rt t1 The rate of return an investor receives r is a function of current Price and Expected Cash Flows For P to increase 0 either ECF s must increase or o rmust decrease The firm and the factors that affect economic value Factor inputs The firm Buyers of suppliers of products or services labor Investment decisions businesses capital Cap Struct decisions people materials Dividend decisions government Stock Analysis Requires Two Parallel Tracks Quantitative side Qualitative side Determine a fair price Get the story behind the numbers DDM and FCF models How is the company affected by 0 economy 0 industry Multiplesbased models What will propel the firmthe stock in the future 0 Change 0 Continuance Optionsbased approaches What models best describes the company story What is the logic behind the selection of key model inputs Sensitivityscenar io analysis to test critical assumptionsstory elements Evaluate the numbers lt2 The Firm s Value External to the rm The economy The industryies Growth Structural Interest rates Competitive Inflation Life cycle I r I II AI I l The rm Projectstrategy decisions 2 Financing decisions ltgt Dividend policy allocation of resources payout and reinvestment NPVIRR Debtequity mix U U Projectsstrategies Financing Fmanmal 8k Cash flow from selected needs U C operations 2 Retention 2 New equity New debt U U U Project 8k 2 Cost of capital Earnings and Dividends cash flows Performance evaluation DuPont ROE EVA MVA ROIC other External to the rm The nancial equity market Market expectations of Cash flows Growth Risk Dividend payout U Riskadjusted return wrisk premium U Stock price Firm value The Qualitative Side Analyzing Economic and Fundamental Factors chap 22 23 31 various pages throughout Macroeconomic Factors At the very broadest level What economic factors are most likely to affect the performance of the rm and its bundle of projects 1 l 00 A l 00 Growth in economic activity what rates of growth in income markets revenues and costs are expected Is the overall economic pie growing Income allocation the wages and profits of an economy where do they go to what industries To food Technology Consumer durables to what firms is the allocation or share of the overall pie growing or shrinking Sensitivity ofthe firm to economic activity what cyclical factors economic cycles changes in disposable income capital spending are relevant to the industryfirm Autos housing Interest rates how sensitive is the industryfirm to changes in interest rates Consumer durables banks Energy prices how sensitive is the industryfirm to things like the price of oil Consumer spending about 23rds of the economy What is happening with per capita income wealth and personal debt How sensitive is firm to CS Unemployment what is the tradeoff between low labor costs and consumer spending Inflation what are possible impactslikelihoods of increases in factor inputs higherlower interest rates diminishing purchasing power Globalization what are the implications for competition expanding markets raw materials labor and capital 11 Industry Factors 1 What industryindustries will the firm compete in 2 Who buys the industries productsservices 3 What drives the demand for the servicesproducts 4 Who are the current and prospective competitors What are the industryspecific factors that affect the story behind the company 5 Structural what are the broad factors that affect the industry CD market size growth rates profit margins asset utilization leverage political factors tax treatment deregulation social preferences clean air consumer choice DIY technological typewriters word processors PC s web Competitive what is the likely reaction of competitors or suppliers to actions the firm takes See page 522 193 degree of rivalry threat of 0 new entrants o substitutes bargaining power 0 suppliers 0 buyers 7 What are the attributes of a successful competitor 8 Life cycle What stage is the industry company product in early low or negative margins profits earnings growth high when earnings become positive acceleration rapid growth high margins profits earnings growth high but at a diminishing rate mature normal growth somewhat stable normal profits stabilization andor decline three paths new products stable or liquidation growth possibly negative l 00 o A 0 01 F OOO Firm Speci c Factors What is the firm s price and priceearnings history What is the firm s productsenice mix by of revenue and profit What factors are unique to the firm that make it an unusually attractive or unattractive investment The Expected Cash Flows ECF are they Revenuebased Costbased The timing of ECFs Are they near or distant Are there cyclical effects Are they stable Rapidly growingEroding The growth of ECFs How high for how long Competition Risk What are the risks the company faces What risks are being managed What risks is the company willing to take Why Governance WN How strong is the board of directors Are the directors independent Who is on the compensation committee What is the compensation structure for top management cap x P What problems does the firm face What opportunities are present What are the key strategies management is or intends to pursue How will these strategies affect the value of the firm Analyzing the Firm Ratio Analysis 3 library Types of ratios N 00 b 0quot F liquidity eg current quick cash flow ratios the firm s ability to meet its shortterm obligations asset utilization eg asset turnover inventory turnover the efficiency with which a firm uses its assets financial leverage eg debt to assets debt to equity EBIT to EBT the degree to which assets are financed with debt operating leverage eg unit contribution margin the relationship between fixed and variable costs at various levels of sales profitability eg various profit margins ROA ROE management s effectiveness at turning revenues into profits marketbased multiples eg PE PBV PS the price the market is willing to pay for 1 in earnings book value or sales Worksheet Title Describe Current Two One Industry Analysis calculation year years year average XY ago ago Liquidity Current 18 17 17 22 Quick 3 2 2 6 Asset Utilization Asset T0 21 22 23 22 Inventory TO 7 7 7 65 Financial Leverage LT Debt to 93 152 57 289 Capital Tot Liab To 298 351 278 534 Assets Times 2018 587 938 34 Interest earned Profitability Gross Margin 299 285 297 264 Net Margin 56 53 6 16 Things to remember No one ratio is sufficient to measure any characteristic always look at least two ratios that measure the same thing Many ratios may be too high or too low For example too low a current ratio suggests the company may not be able to meet its maturing obligations while too high a current ratio suggests too much money is tied up in low return assets or that the company is not using enough trade credit Look at a company s ratios over time are they improving or getting worse Look at a company s ratios relative to the industry average do the ratios compare favorably Remember numbers are an aid to judgment they are not a substitute Performance Metrics 3 32 Note There are a number of financial metrics that may help the analyst understand the company s performance Every financial metric has uses and problems The strength of a good metric is the analytical insight it provides Accounting Net IncomeROE NIOE vs Economic Cash Flow to EquityShare Price ROE N1 N1 S TA OEzTX X margin X turnoverx leverage Longterm earnings and longterm cash flow generally are consistent Earnings growth is important to the market Growth in earnings does not necessarily lead to increased share priceeconomic value Fundamental issues earnings exclude the firm s investment requirements earnings ignore the time value of money earnings do not address risk earnings may be manipulated calculated on book value not market value 0 From the five years 19951999 TECO had a ROE that ranged from 125160 per Value Line implying good returns to shareholders 0 With the 5year annual growth rate in TECO common stock at 17 based on yearend prices and a dividend yield that has averaged around 47 total returns over the past five years have been around 3 well below the return implied by the ROE 2 even high quality earnings at best tell about the success of past strategiespractices not about the future All accounting based performance measures ROA ROE PE etc share these shortcomings Economic Value Added EVA Return on Capital wacc X Economic Book Value of Assets in place EBlT 1t Economic Book Value of Assets in place wacc X Economic Book Value of Assets in place Economic Book Value of Assets in place a proxy for market value of assets add back in deferred tax resenes LIFO resenes cumulative good will amortization etc Using EVA Important Questions Is EVA positive or negative More importantly what is the change in EVA from year to year EVA may be of some use for divisional performance There is no persuasive evidence it does as well as stock price in valuing a firm Advantage Simple and appealing But EVA is still based on historical costs and thus is subject to the normal criticisms of accounting data In particular what has been invested ie sunk costs book value economic book value and market value are likely to be considerably different EVA encourages gaming the numbers less capital lower cost of capital etc Note Investors care only about the return they require on the market value of an investment in the firm today 19 Return on Invested Capital ROIC ROC EBT noncash charges X 1taX ratell debt equity ROC NOPAT average invested capital ROC NOPAT X Revenues Revenues average invested capital ROC margin X turnover 0 Is useful in looking at all capital notjust equity NOPAT investments Free Cash Flow to all providers of capital 0 May be used comparatively with wacc Economic profit ROIC wacc X average invested capital Differences from ROE 0 Moves the analysis closer to cash flow 0 Filters out the impact of leverage on return on capital source That said note the similarity to ROE both focus on the interaction of margin and turnover 20 Accounting Net Income vs Economic Cash Flow to Equity Problems 1 managerial discretionjudgment 2 smoothing 3 fraud Some specifics l 2 00 A 01 CD I 00 9 early recognition of revenues Sunbeam Cendant RJR etailers false revenues Enron Global Crossing deferred recognition of expenses AOL capitalizing marketing costs depreciation accelerated vs straight line selection of n and terminal value inventory FIFO vs LIFO impact of taxes accounts receivables and sales quality vs write downs market value of assets vs book value pension expenses and liabilities discount rates expected returns funding vs expense economic liability vs ABOPBO extraordinary items expected smoothing 10financial and asset restructuring biting the bullet Cisco writing off inventory in April 2001 to reduce future expenses 11 Off balance sheet financing special purpose entities even high quality earnings at best tell about the success of past strategiespractices not about the future 21 Management Decisions Corporate Strategy and Firm Value 31 3 Areas 1 investmentdivestment 2 capitalfinancial structure and 3 dividend policy 1 InvestmentDivestment Value firm Present value of projects present value of growth opportunities 0 highest NPV projects all that are positive 0 market share 0 Increased growth 0 divest projectsdivisions that are more valuable to outsiders or have negative NPV s 0 return cash to shareholders if no acceptable projects are available 0 competition suggests NPV projects become scarce creatingprotecting franchise value requires barriers to entry cost differentiation proprietary technology control over materials distribution 22 2 Capital Structure Changes MampM capital structure does not affect value alternative view lower WACC means higher PV given any set of FCFF s Value of Levered Firm Value of Unlevered Firm PV of Tax Savings FCFFreu g tD Note what happens to ras D increases 3 Dividend Policy MampM dividend policy does not affect value alternatives 1 increasing dividends is bad tax disadvantage and cash shortfalls 2 increasing dividends is good clientele effect signaling wealth transfer from bondholders Note what is impact of new dividend tax rate Dividends as a residual after all NPV projects are taken 4 Other Corporate Restructuring through investments divestments capital structure or dividend policy what is the impact of change on 0 growth in earningscash flowdividends 0 risk 0 required rate of return Bottom line run the NEW numbers through the various valuation models 23 Valuation Inputs Growth 11 12 Sources of growth Growth in the economy Market growth Market share growth New productsservices New uses of existing productsservices New markets Other Threats to growth 0 Marketsaturation 0 Competition 0 Substitutes o Fundamental reduction in demand market shrinkage o Other Growth implies 0 Investment in existing businesses 0 investment in new projects Or 0 Divestitures of projects that destroy value Or 0 Lower costs Or 0 Higher productivity Or 24 Forecasting Growth and Cash Flow Historical Growth Estimating Historical Growth Rates 0 arithmetic vs geometric 0 linear vs loglinear regression 0 negative earnings Predicting Growth by using the past to predict the future 0 variability size cyclicality fundamental change earnings quality time series analysis 25 Sustainable growth the growth rate that can be maintained by reinvesting cash flow in the firm s existing productive capacity necessary to sustain productive capacity Sustainable growth ROE 1 payout A function of profit margins asset utilization and leverage Pro t Margins Ef ciency and Leverage the DuPont model ROE N1 N1 S TA OEX X Alternatively ROE ROA DE ROA i 1t where ROA EBIT 1tBook Value of Assets 26 Examples for an all equity rm that pays out 70 of earnings ROE 5 X 25 X1 125 Growth 125 X 3 375 1 Actions that improve margin to 6 shift the product mix to higher margin products lower costs ROE6X25X 1 15 Growth 15 X 3 45 2 Actions that improve turnover to 3 times assets dispose of inefficient assets improve marketing ROE5X3X115 Growth 15 X 3 45 Interactions Consider improving turnover by reducing price If margin falls from 5 to 4 turnover must increase to at least 3125 X s for ROE to stay the same ROE 4 X 3125 X1 125 o if margin falls sales must increase proportionately or ROE and growth will fall Consider improving margin by raising price If turnover falls from 25X s to 2X s margin must increase to at least 625 for ROE to stay the same ROE 625 X 2X1 125 o ifturnover falls profits must increase proportionately or ROE and growth will fall 27 DuPont Analysis for HD 20001 1999 19989 2000 Net income 2581 2320 1614 Revenues 45738 38434 30219 Profit margin 564 60 534 Revenues 45738 38434 30219 Average total assets 19233 15273 12347 Turnover 238 252 245 Average total assets 19233 15273 12347 Average equity book 13679 105405 7919 Equity multiplier 141 145 156 189 2201 204 ROEPMTOEM Profit margin rose in 1999 fell in 2000 0 Costs 0 Competition 0 Both Turnover fell 0 Revenues increased by 27 then by 19 0 Asset base increased 24 then by 25 0 Note lower sales growth higher asset growth Leverage o Leverage decreased 28 Percent of Sales Method library what financial statement items vary directly with sales 0 cost of goods sold 0 receivables what statement items vary somewhat with sales 0 general selling and administrative o inventory what items are fixed over the forecast period 0 fixed assets what s the capital budget after the forecast the balance sheet doesn t balance what are the external funding requirements 0 retention dividends debt retirement versus investment needs including working capital 0 total assets liabilities equity new external funding 29 Pro Forma Statements Library Over time financial results values change It is important to forecast change and the impact of change on the firm s ability to generate profits cash flows and growth The proforma statements are the first step in this process Income statement Forecast sales to grow at X CGS X SampGA 0 Excess capacity 0 New stores 0 Commissions Depreciation o Constant or constant replacement or increase or decrease in capacity Interest 0 Fixed or variable rate debt Reliance on short term debt Creditworthiness Relationship between debt and sales receivables Net Income 0 Dividends o Retention 30 Balance sheet C AR nv MS probably related to sales FA capital budget note depreciation CL probably related to sales Equity add in retention LTD constant What do you do when the balance sheet does not balance Cash Flow Operating investing and financing cash flows all come from the IS and BS The key is external financing needed or increase in cash 31 Growth Ultimately You are looking for insights into the future growth in FCFE andor dividends fg r dp or g ROE retention org Is expected 9 really achievable Under what circumstances How large is the market How much unmet demand exists now Used to exist It is more difficult for large firms to grow rapidly How competitive is the industry 0 Supplier power 0 Buyer power 0 Threat of entry 0 Threat of substitutes Profitable growth attracts competition what are the barriers to competition Over time growth rates trend toward the average for the economy 32 Estimating Free Cash Flow to Equity 351 358 Unlevered Firm Levered Firm at desired leverage Revenues Revenues operating expenses operating expenses EBITDA EBITDA depreciation and depreciation and amortization amortization EBIT EBIT interest expense EBT taxes taxes Net Income Net Income depreciation and amortization depreciation and amortization CF from operations CF from operations capital expenditures working capital needs capital expenditures working capital needs principal repayments proceeds from new debt FCF to equity FCF to equity 33 The Effect of Capital Structure Firms At Desired Leverage 8 debttotal capital FCF to equity Proceeds from new debt issue Net income Principal repayments 1 8 Capital expend 8 Capital expend Depreciation Depreciation working capital needs 1 8 Working capital needs Firms Below the Desired Leverage Proceeds from new debt issue gt Principal repayments 8 Capital expend Depreciation working capital needs Above Desired Leverage Proceeds from new debt issue lt Principal repayments 8 Capital expend Depreciation working capital needs 34 The Required Return Chap 4 7 8 The Discount Rate r is affected by Inflation expectations rf 1 real1 inf 1 where rf risk free rate more simply rf real inf prem and risk r rf risk premium rp where rp fbusiness financial liquidity exchange rate country risk or rp f market risk 2 Return real inf risk Note r may be viewed as o the weighted average cost of capital wacc in which case the cash flows to the firm or to the firm s providers of capital are the relevant cash flows or as the return to shareholders only re in which case the cash flows to equity are the appropriate cash flows 35 Estimation of Discount Rates r CAPM Investors choose risky assets and portfolios based on 0 expected returns 0 risk volatility variance or standard deviation Risk can be broken down into two components 0 systematic or market risk 0 unsystematic or nonmarket risk the comovement among asset returns is not perfectly positive as a result investors can reduce or eliminate diversify unsystematic risk risk sysematic risk of securities 36 Diversification results in a set of portfolios that is efficient in that each portfolio in the set offers 0 the highest possible return at a given level of risk or o the lowest possible risk at a given level of return Knowledgeable investors will choose portfolios from this set of portfolios according to their tolerance for risk and desire for return return risk 37 Estimating Discount Rates Single factor approach CAPM Consider a world as described in the preceding and o investors may lend or borrow at the risk free rate 0 investors have homogeneous expectations 0 there are no market frictions taxes trading costs etc Investors will be able to form portfolios which are 0 combinations of treasury bills and a risky market portfolio 0 superior to the efficient portfolios previously described Risky assets 0 yvill form the market portfolio which all investors will hold more or ess if mispriced will be forced back to their correct prices as all investors buy underpriced assets and sell overpriced assets Knowledgeable investors will choose portfolios from this set of portfolios according to their tolerance for risk and desire for return the Capital Market Line CML 38 CML return j risk o R RFRMRFoi G Beyond Portfolios The Pricing of Risky Assets The return on a risky asset is equal to o the risk free rate t bill fonvard or tbond plus 0 a risk premium equal to o the average risk premium offered for exposure to a normal level of systematic risk historically around 6 adjusted for o the risk of the risky asset relative to the market appropriate for individual assets and poorly diversified portfolios RxRFBRMRF 39 Consider RF 05 Risk premium 06 3X 7 RX 05 06 7 092 or 92 Project Consider By 10 Ry P 32 13 RZ Approaches to Estimating Beta do all 1 Analyst Reports at least 2 2 Correlation with the market betai coviMcs2 for at least 2 time penods JO Sharpe s Market Model for at least 2 time periods A Comparablesleverage 191197 7 different betas 7 different discount rates 40 Sharpe s Market Model Approach to Estimating Beta 0 market will not pay to avoid unsystematic risk 0 siysj due to p with market portfolio 0 RS Rm linearly related ri0LBirmsi where ri risk premium ra rf 0c is a constant the intercept or non market portion of return excess return above and beyond the risk premium 8 is the unsystematic component the difference between an actual observation and the regression line oi 3i2 om2 is Where GaiZ is unsystematic riskthat may be diversified away r f macro micro events 0 int rates new prod o systematic diversifiable 0 past relationships can predict future 41 EXAMPLE Historical risk premiums Ri Rf nonmarket systematic in Rf 3125 9375 Rmi Rf 8 gt if ERm 10 Rd 3125 9375 10 96875 8 Note If Rm explains RX high r2 r2 92 then OL 0 If portfolio is well diversified a O on average 42 ComparablesLeverage and Beta higher leverage higher beta 1 Operating DOL sales cost structure sales variable costs 2 Financial DFL debt vs equity EBIT EBT Total DOL x DFL o The more highly leveraged a firm the more volatile its earnings 0 The systematic portion of this volatility suggests higher betas 0 Operating leverage is typically firm or industry specific and thus in many cases may be considered diversifiable 0 Financial leverage is systematic and directly impacts a firm s beta Consider the following when comparing betas across firms Unlevered with respect to debt beta current beta lt levered beta 11tdebtequity allows evaluation of impact of debt Leveraged beta unleveraged beta x 1 1t DIE see page 1917 4056 Process find a comparable company unlever the company s beta then leverage the unleveraged beta using the target company s leverage as above 43 Estimation of Discount Rates r Dividend Discount Model reDPS1Po g stable firm constant 9 g lt r g 2 economy note the interaction between 9 and DPS or payout What is being assumed about risk when you use DDM Summary of Discount Rate Estimation Procedures 2 approaches 1 CAPM with several ways to estimate beta 2 DDM market price implies correct risk 3 Also APT other multifactor models 44 Valuation 13 14 17 18 19 20 35 Valuing Stocks With Discount Models Basic relation Vs P8 Value of the Firm s Eguitv Shares Intrinsic Value 00 vi 2 NCF1 rN t1 V0 VI of shares NCF may be dividends received cash flow to equity or cash flow to firm subtract out debt before calculating per share value The price received upon selling stock is the present value of all future dividends o r is the required rate of return for a specific stock or the WACC o valuing the growth in dividends or cash flow is critical to valuing stock 45 Where do dividendscash flow come from 0 sales costs interest taxes earnings 0 earnings allocated to investments debt retirement dividends o reinvestmentdisinvestment and operating decisions capital structure dividend policy Three Examples Let D dividend r required return to hold the stock g expected rate of growth in dividends Perpetuity eg preferred stock D1250 r16 g0 V0 D r Vo 25016 1563 Constant growth with g lt r D1 250 r 16 g 4 V0 D1 r v0 2516O4 2083 46 Variable growth a simple threestage DDM D0 2 r 16 gm 25 stage l 9314 20 stage2 9500 5 stage 3 D 2 3 3E 4 4 I I I I I Q 25 25 20 20 5 5 gt PV of D1 2155 D2 232 D3 240 D4 249 P4 P4 4 16 05 4295 V0 3308 P4 Terminal Price 47 Terminal Price Pn Dn1rg Sustainable growth 9 ROE 1payout Valuing Growth g what is g ngi how many periods will it last time 48 DDM S Vn D1lrg Constant growth Gordon growth 0 Works best when g foreverltg economy 0 Established dividend policy Extremely sensitive to small changes in growth estimates 49 The 2Stage DDM p 328 extraordinary unstable phase and a stable phase lasting forever Works well for o expect current high growth to abruptly disappear patent o where the initial growth rate is fairly modest hence no transition phase is needed 0 firms payout residual cash flow as dividends Potential problems 0 defining n o sudden transformation in growth 0 focus on dividends for firms that do not pay out free cash flow high nh v0 Z DPSt 1rht t1 stable Pn1r Where Pn DPSn 1 gn r39gn time 50 The H Model a two stage approach with declining extraordinary growth p 339 assumes constant payout ratio linear decline in extraordinary growth rate g over a period that lasts 2H penods value of high growth h Vh 29i3Cgh nD r 39 gn value of stable growth n vs Qg gnn r 39 gn V0 Vs Vh g ZH tIme 51 Three Stage DDM p 341 most general approach allows consideration of changes in risk and payout high n1 V0 2 EPSO 1 ght payouth 1rhight transition tn2 Z DPSt 1rtransmont tn11 stable EPS 2 1 gn paVOUtn rstable39gn1rt payout 52 Free Cash Flow to Equity Discount Models Differences in dividends and FCF dividends o are relatively stable 0 permit CF to be held back for future investment needs 0 are taxable and 0 may be effective signals FCF Valuation Models 0 constant growth two stage and E model 0 use FCF in place ofdividends Constant Growth v0 FCFE1Irg 53 Two Stage p 363 n v0 2 FCFEt I rhgf Pn1 rhgn t1 where Pn FCFEn1l rsggn time 54 E Model 3 stage p 367 high n1 v0 Z FCFEt 1rhgt t1 transition tn2 Z FCFEt 1rgvt tnh1 stable Pn2 1 r59 9 time stable growth CS dep 55 time V V On the use of FCFE and the firm s dividend policy The Impact of Reinvestment and Growth on Stock Value Consider A company with Earnings 1000 re 15 ROE 10 Dividend Payout 60 Do 600 reinvestment 1 6 40 g 104 4yr P 61041504 5673 When growth destroys value an example Change Payout to 40 Do 400 reinvestment 1 4 60 g 10 6 6yr an increase in growth P 41061506 4711 higher growth but lower price Change Payout to 80 Do 800 reinvestment 1 8 20 g 102 2yr P 81021502 6277 lower growth but higher price Note ROE lt re 56 When growth increases value an example if ROE 20 payout 60 Do 600 reinvestment 1 6 40 then 9 20 4 8 P 6 108l15 08 9257 compare this to 5673 Change payout to 40 Do 400 reinvestment 1 4 60 then 9 20 6 12 P 4 112l15 12 14933 The bottom line If ROE gt re growth will lead to higher value Some other issues in growth 0 Growth and profits are attractive to other firms 0 Firms that discover attractive growth opportunities attract competitors In the absence of regulation or patent protection rms may be able to protect growth pro ts and market share by 0 Being the low cost producer ability to compete on price 0 Being the high quality provider ability to compete on product 57 Comparing FCFE and DDM Results VFCFE VDDM When 1 D FCFE 2 FCFE gt D and excess CF invested in NPV 0 projects When VFCFE 9E VDDM which value should you use 1 FCFE gt D VFCFE gt VDDM ls excess CF invested in negative or positive NPV projects If in Negative NPV projects a takeover may result in a change in dividend policy 0 How efficient is the market for control size and legal 2 lt D VFCFE lt VDDM 0 requires new capital flotation costs possible excess leverage and possible capital rationing o sustaining the dividend may be a problem 58 SensitivityScenario Analysis Sensitivity analysis 1 Identify key assumptions in the base case analysis 0 Macroeconomic factors such as taxes interest rates economic growth etc o Firm specific factors such as revenues margins 2 Change each assumption one at a time leaving all others the same 3 Estimate profit cash flow growth and the stock s value for each change in a key assumption 0 What if sales do not grow as fast as projected or grow faster 0 What if CGS increases faster than sales or grow slower 4 Summarize by graphs or tables Advantages 0 not a single point estimate 0 more consistent with the concept of uncertainty 0 inexpensive 0 gives managers an appreciation of intricacies and relationships needed to exploit opportunities and manage risk Concerns 1 A range of values does not say anything about the likelihood of the alternatives 2 Variables may be interdependent eg competition may force a lower price that lowers total revenues and profit margins 3 Extreme outcomes may bias decisionmakers 4 The process is essentially subjective Different decisionmakers can look at the same outcomes summary and reach different conclusions depending on their tolerance for risk 59 Scenario Analysis 1 Think about a combination of variables as a scenario 2 Construct independent scenarios that reflect possible interactions 3 Evaluate outcomes for each scenario 4 Assign probabilities to each scenario 5 Calculate a weighted average ofthe outcomes Advantages 1 Explicitly considers the likelihood and interdependence problems 2 Reduces the impact of extreme outcomes Concerns 1 Development of scenarios implies that only a few alternatives are possible when many alternatives are possible 2 In constructing scenarios there is the possibility of losing information that is valuable 3 Decisionmakers may be biased in identifying possible changes in variables eg sales will not fall below x or in constructing scenarios 4 The process is essentially subjective Different decisionmakers can look at the same outcomes summary and reach different conclusions depending on their tolerance for risk gtRun all valuation models with different assumptions Probabilistic Scenario Analysis Assess the likelihood of each scenario gtCalculate an expected value Note A complete scenario will have growth time and cashflow as outputs the variables that are needed in valuation models 60 THE USE OF MULTIPLES chapters 1720 Two basic approaches 1 using fundamentals stable growth or high growth or 2 comparing across time or among firms Ratios used 0 PE PFCFE PFCF PD DP o PBV o PS PIE for Stable Firm PE payoutrg o as r increases PE decreases what increases r o as g increases PE increases what increases g o as payout increases PE increases what increases payout o as payout increases what happens to g 61 PIE for High Growth Firm P0E0 high stable high payouth 1 91ht 1 1ghn 1rhn rh 91ht stable paYOUtn 1 91hn 1 9n rn39gn1rht Franchise Value and PIE Ratios ROFF return on future franchise investments potential projects with above market returns PE Base PE Franchise factor X Growth equivalent 1r ROFF rROE X r X PV of franchise investmentsBV of equity 62 Comparisons of PIE Ratios Accounting Differences 1 across countries 0 financial fundamentals eg interest rates economic growth 2 across time 0 financial fundamentals eg interest rates growth risk 3 across firms 0 what is comparable o differences in fundamentals 2 actual PE s vs expected PE s based on prevailing fundamentals The Regression Approach example PE or 31 earnings growth 32 payout 33 5333 see page 4845 1 or let factor 3 beta 2 or regress EP against growth issues 1 assumes linear relation 2 multicollinearity 3 stability of historical relationship 63 PriceEarnings Ratios some other approaches Five year high average low 0 Calculate the historical ve 3 or 7 year high average low PE s 0 Multiply the historical ve year high average low PE s times an earnings estimate Relative PEs take the average PE over a year and divide it by the SampP 500 or other index PE for the same year PEM then multiply the PE relative times the current market PE times an earnings estimate Why are the historical PE ratios different N Why would a stock be moreless likely to trade near its highlowaverage PE ratio 00 How do interest rates growth rates and payout rates affect PE ratios How do these factors interact 64 Comparing PIE to Growth the PEG Ratio is a firm undenalued when PE lt 9 or if gPE gt 20 or if PEG lt 5 0 higher interest rates lead to lower PE s 0 higher betas lead to lower PE s Problems with PIE Valuation negative earnings volatility effects on level of PE 65 PriceBook Value Ratios BV assets BV liabilities BV equity BV assets purchase price depreciation at issue BV is stable simpler may be comparable and of use with negative earnings 0 EV is affected by accounting is hard to use for senice firms and may be negative Stable Firm PBV ROE gn r gn note 0 PBVgt1ifROEgtr o ROE r return differential 0 higher return differential higher PBV 66 High Growth POIBVO high stable high ROE payouth 1 gh11gh 1rh rh 91ht stable ROE payoutn 1 9h 1 9n rngn1rh PBV is higher for 0 higher ROE 0 higher payout 0 lower risk 0 higher growth in earnings in either or both periods 67 PBV as a Screen Undenalued Securities high ROE low PBV Fairly valued Iowlow or highhigh OveNalued Iow ROE high PBV Comparables and Regressions same story as for PE ratio PBV Variations Tobin s Q MVReplacement cost 0 low is suggestive of undenaluation 68 PriceSales Ratio Will not be negative not excessively influenced by accounting decisions not as volatile as PE ratios Fails to show cost control problems and profit margins Stable Firm PS net profit margin payout ratio 1gn r g High Growth POISO high stable high net prom margin paVOU Eh 1 9h 1 1ghn 1rhn rh 91ht stable net profit margin payoutn 1 gh 1 gn rngn1rh PS is higher for 0 higher profit margin 0 higher payout 0 lower risk 0 higher growth in earnings in either or both periods Note may use FCFE instead of EPSO payout see pages 547 69 Growth Sales and Margin o if margin falls sales must increase proportionater or growth falls 0 high margin or low margin What is the Value of Market Share economies of scale profit margins cost drive out competitors profit margins price Brand Value Screening and Mismatches look for high margin low PIS firms 7O Companies with No Earnings Valuing New Wave Stocks from the AAquot Seminar Stock Investment Strategies 2001 see also httpwwwsternnyueduadamodar Valuing a stock issued by a company that sells familiar products produces steady earnings and has a long record of paying dividends is not easy but it is a fairly straightforward process Even valuing a company that does not pay dividends or pays only a small dividend can be accomplished by a number of reasonable procedures if the company has an operating history and is in a familiar business When it comes to new wave stocks with little history and frequently even less profitability however stock valuation presents a special challenge to investors The internet stocks of recent years like the biotechnology stocks of the 1980 s the copiers and mainframes ofthe 1960 s and 1970 s even the automobile stocks of the 1920 s and after all share the common attribute of representing ownership shares in a new technology andor uses of a new technology These stocks frequently have no earnings pay no dividends and pose futures that are obscure For an investor what is a sensible way to think about these stocks and to estimate their fairvalues There are three things investors must do 1 Recognize that all stocks must ultimately be valued on their fundamentals profits dividends growth sales and so forth This is easy to lose sight of when looking at companies with no or only minimal earnings competing in markets where the business models the nature of future competition and even the nature of and markets for the products sold are only partially understood 2 Recognize that a fair price for any stock is the present value of the future cash flows that ownership ofthe stock brings These cash flows are either dividends including those that come under the guise of stock repurchases andor the future price at which a stock is sold 71 It is important to remember that you cannot always count on selling a stock for more than you paid for it even though there are times when some stocks seem to trade at higher and higher prices for little if any reason When you go to sell a stock you must have a willing buyer the price they are willing to pay must be the present value ofthe future cash flows they expect from owning the stock At some point in time even new wave high growth companies will see their growth slow and the demand by investors for profits and ultimately dividends increase In other words somewhere along the line of stock purchases and sells and purchases and sells someone will insist on paying no more than isjustified by expectations of cash flows built on profits and ultimately dividends 3 Take a careful look at what the current valuation for a company implies about the future of that company For example at its current market valuation share price times number of shares outstanding how does the company rank against other firms At its current PE ratio or PB ratio or PS ratio if the company does not have earnings or much in the way of tangible assets what is implied about future growth sales profitability and dividends After filtering out all the hype and media analysis what is the real story behind the company For example is Amazon a bookstore a search service andor a distributor What kind of profits do bookstoressearch senicesdistributors generate What does this imply for Amazon In an interesting article in the Wall Street Journal April 19 1999 Professor Jeremy Siegel author of Stocks for the Long Run discusses some ofthe issues addressed in the preceding points using America Online AOL as an example His analysis begins by looking at the numbers 72 0 At the time ofthe article AOL s market value approached 200 billion selling for 7080share placing it close to the size ofthe largest 10 US companies Even though high PE ratios may bejustifiable for smaller high growth firms when firms become large their growth rates decline and their PE ratios fall to more normal levels So assuming AOL one day will warrant a somewhat normal PE of 30 it will have to produce PE X Earnings market value 30 X Earnings 200 billion 67 billion in earnings tojustify its market value In 1998 only General Electric produced this much profit Assuming AOL can achieve a 10 profit margin the average margin for the 50 largest firms in the US in 1998 was 66 it will need sales of 67 billion annually exceeded by only seven US firms in 1998 firms having an average margin of 57 to generate 67 billion in earnings 0 AOL s market value per subscriber is about 50 times the annual subscription fee 0 AOL was selling at 450 times expected 1999 earnings when this article was written As a point of comparison while the Nifty 50 stocks of the early 1970 s were not overpriced as a group those with PE s over 60 failed to outperform the market in the 25 years following Furthermore none of the technology stocks of the Nifty 50 outperformed the market even though the technologies they represented eg IBM Digital equipment Xerox Polaroid became the technology ofthe present as time passed 73 Professor Siegel then examines some of the qualitative or story issues that investors should consider in analyzing a company like AOL Of special interest are two observations 0 Value depends on scarcity not usefulness The internet is useful without doubt It is also easy for competitors to enter the internet is not scarce and it does not require much capital to play so it is likely that the services provided via the internet will have to be provided at cost Hence it is going to be difficult to translate sales into profits 0 That the internet is good for consumers does not mean the money consumers save will go to internet companies Although Professor Siegel does not say what a fair value is for AOL the implication of the analysis is that it will be difficult for AOL to produce returns thatjustify its market value Perhaps more importantly he demonstrates how an investor can translate the market value of a company at a given time into future profits and sales and then analyze what the implications of the current valuation are All in all the new wave companies of any age should be analyzed within the context of their fundamentals The difficulty comes in dealing with the great uncertainty that comes with emerging technologies industries and products In spite of the uncertainty however the fundamentals should drive your analysis To return to AOL 0 Do you believe AOL will be able to earn 67 billion and to produce 67 billion in sales or more if there is pressure on profit margins in the not too distant future When will AOL start paying dividends How large will these dividends be How fast will the dividends grow Will the dividends start soon enough be large enough and grow fast enough to justify the price of AOL today 74 Technical Analysis adapted from the AAquot seminar Stock Investing Strategies 2002 Technical analysis is the study of price or volume patterns over time in an attempt to identify stocks or even markets that may be beginning to trend up or down Investors who follow a technical analysis discipline believe that patterns in price and related dated eg volume can be interpreted as signals about future price movements The essence of technical analysis is to identify and then exploit recurring trends Some technical analysts believe that there are investors who possess information about certain stocks that is better than the information held by most people Theses astute investors will try to quietly accumulate the shares of undervalued stocks or sell the shares of overvalued stocks before other investors come to the same conclusion 0 Other technical analysts believe the trends are driven by behavioral factors a tendency of investors to overreact or whatever Regardless although something must happen to generate a trend it does not really matter what all that matters is that the trend is predictable recurring and can be identified early enough to be profitable If by examining the price or volume movements of stocks trends can be identified early enough investors may be able to ride the trend or play turning points Moving Averages The Dow Theory uses the Dow Jones Industrial Average DJIA and the Dow Jones Transportation Average DJTA to identify long term trends in stock prices The DJIA is typically used to establish the existence of a trend the DJTA is used to confirm or reject what the DJIA suggests 0 These long term trends may from time to time be interrupted by intermediate trends that are eliminated by corrections or reversions to the underlying long term trend 0 Upward trends are confirmed by progressively higher and higher peaks upwardly moving tops while downward trends are indicated by progressively lower and lower bottoms 75