Valuing a Stock and a Bond

Stock Valuation is an Art not a Science Economic drivers of stock value Fundamental analysis based on accounting information Technical analysis based on price patterns 2

The Economics of Stock Value Ultimately, a stock’s value is a function of its dividends and earnings. We say the stock’s value today is the “present value of all future dividends, discounted at a rate appropriate for its risk”. This is called the “dividend discount model”, or DDM. So, where do we get the numbers, and what kind of numbers do we need? 3

What information is important? Current and expected dividends Expected long term growth rate in dividends or earnings b = % earnings retained (retention ratio) and r = “return on equity” Cash flow per share Book value per share 4

Let’s try this with ConocoPhillips The Data: Current price is $64. Last year’s dividend = $2.53, Expected dividend next year = $2.74 Dividend payout ratio = 28% Retention ratio = 72% Historic growth in earnings = 10% I’ve estimated a required return of 14% This data equates to a price of $ Morningstar shows: Fair value = $85 Consider buying at $68, and selling at $106 5

1. Price/Earnings Ratio 2. Price/Cash Flow Ratio 3. Price/Book Value 4. Price/Sales Other Ways to Estimate Price 6

Some Selected P/Es P/Es on trailing year earnings: ConocoPhillips: 8.1 Proctor & Gamble16.0 Intel10.2 Apple15.5 Johnson & Johnson15.3 United Technologies14.0 AEP/PSO12.9 What do these tell us about the stock? 7

Using the “P/E” (the price/earnings ratio) to Determine a Fair Price. Today’s price divided by 12 months of earnings. For COP the data is: Trailing P/E is 8.1 versus 13 for S&P 500 Forward P/E is 7.3 versus 12.5 for S&P 500 Five year average P/E is 8.0 So, if the normal P/E is 8.0X, and expected earnings are $7.94 then next year’s price is Price = normal P/E times expected earnings, which is = 8.0X $7.94 = $

Using the Price/Cash Flow Ratio P/CF is today’s price divided by yearly cash flow per share COP is 5.3X; S&P is 8.6X So, if the expected FCF per share in 2012 is $12.83, then today’s fair value price is: Price = FCF/share X expected cash flow = $12.83 X 5.3 = $68 9

Other Ratios Price/Book Tries to capture the amount of “premium” that exists in a stock’s price over its accounting value (book value). The benchmark number is 1.0 Price/Sales Like P/CF, it estimates the fair price by normal relationship between sales and price. 10

The P/E to Growth Measure: PEG The “PEG” ratio It’s the forward P/E ratio divided by the long term rate of growth in earnings: The benchmark value is 1.0. If a stock’s PEG > 1.0 its richly valued If a stock’s PEG < 1.0 its cheap However, you will find a majority of stocks with a PEG>1.0 For ConocoPhillips its: PEG = 7.3/10 =.73 11

So, let’s look at PEGs for some stocks P/Es and PEGs P/EPEG ConocoPhillips Proctor & Gamble Intel Apple Johnson & Johnson United Technologies AEP/PSO

How Wall Street Analysts Value Stocks. Technical Analysts or Fundamental Analysts 13

Strictly Financials14 Technical Analysis Technicians believe that all information about a security is reflected in its series of previous prices. They use past prices in an attempt to predict future price movements in a stock. Analysis relies on charts, filters, moving averages, etc.

8-15 Support and Resistance Levels A support level is a price or level below which a stock or the market as a whole is unlikely to go. A resistance level is a price or level above which a stock or the market as a whole is unlikely to rise. Support and resistance levels are “psychological barriers:” bargain hunters help “support” the lower level. profit takers “resist” the upper level. A “breakout” occurs when a stock (or the market) passes through either a support or a resistance level.

8-16 Charting: Open-High-Low- Close (OHLC)

8-17 Charting: Price Channels

8-18 Charting: Head and Shoulders

S&P 500 Pattern as of Friday* 19 *Source: Larry McMillan, “The Options Strategist”, Sept 30, 2011

8-20 Charting: Moving Averages Moving average charts are average daily prices or index levels, calculated using a fixed number of previous prices, updated daily. Because daily price fluctuations are “smoothed out,” these charts are used to identify trends. Example: Suppose the technical trader calculates a 15-day and a 50-day moving average of a stock price. If the 15-day crosses the 50-day from above, it is a bearish signal—time to sell. If the 15-day crosses the 50-day from below, it is a bullish signal— time to buy.

Strictly Financials21 Fundamental Analysts Believe they can find undervalued stocks by examining accounting data and economic factors to calculate a “true value” of a stock. Most brokerage research analysts are fundamental analysts. Believe the market is extremely rational and that value is derived from expected earnings, dividends and cash flow.

Other terms you might hear analysts’ say* 1. “Beta” 2. “Alpha” 22 *They come from using statistics to analyze stock price behavior

Beta – It’s a risk measure of the stock’s volatility relative to the market. The benchmark: If beta = 1.0 the stock varies like the market. If beta < 1.0 the stock is less volatile than the market. If beta > 1.0 the stock is more volatile than the market. “Beta” return, means the return you get in a stock that’s provided by being exposed to the market in general. An index fund of the S&P 500 is all beta risk and beta return. 23

Alpha – a measure of the excess risk adjusted return The benchmark Most stocks will have an “alpha” near 0.0 Alpha for an S&P 500 index fund should equal 0 If an investment manager is adding value they should generate a “positive alpha”. This is return greater than expected based on the risk of the investment. Managers that consistently produce “positive alpha” are hard to find. 24

What does all this mean? Stock Valuation is an art not a science. Consistently identifying “under” or “over” valued stocks is very difficult. By understanding the factors that drive stock value, you can better understand when the market in general may be excessively high or low. You can now better judge the quality of the services an investment advisor might be offering you. 25

What Determines Bond Prices? The Bond’s properties is included in a contract, the bond indenture, that specifies the par value, coupon rate and maturity date. We need the “market interest rate” to find the bond’s current value. This is the bond’s “yield to maturity” (YTM). 26

Treasury Yield Curve 9/30/2011* 27 *Source: WSJ, Oct 1, 2011

Bond Yields and Prices A bond’s price is a function of the future cash flows it will produce and a discount rate. For a bond, there’s two cash flows: The semiannual interest payments (if any) The par value that will be returned at bond maturity. The discount rate to use can be determined by looking at the market, but it’s a function of: The risk-free interest rate, + expected inflation rate, + liquidity (or maturity) premium + default premium. Adding these together we get the “nominal” interest rate, which is the one you observe in the market (our YTM value). 28

The Bond Pricing Process When a bond is sold, the issuer will set the coupon rate at the current market rate of interest, today about 2% for a 10 year U.S. Treasury Bond. The rate of interest lenders are willing to take (yield to maturity) fluctuates continuously as new information about inflation, economic growth, credit demand, etc. flow to the market. Since par, coupon and maturity for any bond are set by contract, the only thing that can vary to clear the market is the current price of the bond. Thus, bond prices vary continuously. 29

How Bonds are quoted and traded Bond prices are typically quoted as a “% of par” basis, eg A par bond is quoted at 100 Thus the coupon rate = market interest rate. A premium bond is above 100 Thus the coupon rate > market interest rate A discount bond is below 100 Thus the coupon rate < market interest rate Bonds that pay no annual interest are called “zero coupon bonds” (or zeros). 30

What do we know about how bond prices behave?* Bond prices move inversely with interest rates. High coupon bonds are less volatile in price than low coupon bonds. Long maturity bonds vary more in price than short maturity bonds. But higher coupon bonds tend to cushion this effect. 31 *There’s no magic, its all in the mathematics of bond prices.

What are the risks in holding bonds? Interest rate risk – a bond’s price changes with interest rates (but differently, see prior slide). It has two offsetting components: Price Risk – the bond’s price will change inversely to interest rate changes. Reinvestment rate risk – because you are assuming reinvestment of coupon payments at the market rate of interest, changing interest rates will affect what you really make from the bond. Default risk – The chance that the issuer will go bankrupt and not return the par value. 32

Duration – The General Risk Measure for a Bond Duration is the “time weighted” years to maturity of a bond or a portfolio of bonds. 1 For example, a 5 year, 6% coupon bond, selling with a YTM of 9%, has a duration of 4.2 years. A 25 year, 6% coupon bond, selling at a YTM of 9% has a duration of 10.6 years. A 25 year, zero coupon bond, selling at a YTM of 9% has a duration of 25 years. (There’s a pattern here.) Think of duration as the measure that best describes the risk of any particular bond (not including default risk.) 33 1 Mathematically, it’s a derivative, ΔPrice/Δinterest rate

Considerations about Bonds in Today’s Markets U.S. Treasuries – The ultimate “non-correlated” asset. They are not callable, Have “no” default risk Are the asset of choice in times of turmoil Zero treasuries, “strips” have no reinvestment rate risk High-Yield corporate bonds - For those willing to take more risk in search of higher returns Municipal bonds – For those seeking tax shelters from U.S. (and often) state taxes. But remember – all bonds will decline in value if inflation expectations cause rising interest rates (except TIPS). 34