Securities Analysis, Section IV Security Valuation & EIC Analysis (Part 1)

Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Sixth Edition by Frank K. Reilly & Keith C. Brown Chapters 11,14,15, & 18

Copyright © 2000 by Harcourt, Inc. All rights reserved The Investment Decision Process Determine the required rate of return Evaluate the investment to determine if its market price is consistent with your required rate of return –Estimate the value of the security based on its expected cash flows and your required rate of return –Compare this intrinsic value to the market price to decide if you want to buy it But how do you narrow down the list of potential investments to a reasonable level?

Copyright © 2000 by Harcourt, Inc. All rights reserved Valuation Process Two general approaches: 1.Top-down, three-step approach 2.Bottom-up, stock valuation, stock picking (stock screening) approach The difference between the two approaches is the perceived importance of economic and industry influence on individual firms and stocks

Copyright © 2000 by Harcourt, Inc. All rights reserved Top-Down, Three-Step Approach 1. General economic influences –Decide how to allocate investment funds among countries, and within countries to bonds, stocks, and cash 2. Industry influences –Determine which industries will prosper and which industries will suffer on a global basis and within countries 3. Company analysis –Determine which companies in the selected industries will prosper and which stocks are undervalued

Copyright © 2000 by Harcourt, Inc. All rights reserved Does the Three-Step Process Work? Studies indicate that most changes in an individual firm’s earnings can be attributed to changes in aggregate corporate earnings and changes in the firm’s industry If you are trying to stay ahead of the market quarter by quarter, then this is your best bet

Copyright © 2000 by Harcourt, Inc. All rights reserved Does the Three-Step Process Work? Studies have found a relationship between aggregate stock prices and various economic series such as employment, income, or production An analysis of the relationship between rates of return for the aggregate stock market, alternative industries, and individual stocks showed that most of the changes in rates of return for individual stock could be explained by changes in the rates of return for the aggregate stock market and the stock’s industry

Copyright © 2000 by Harcourt, Inc. All rights reserved Theory of Valuation The value of an asset is the present value of its expected returns You expect an asset to provide a stream of returns while you own it To convert this stream of returns to a value for the security, you must discount this stream at your required rate of return This requires estimates of: –The stream of expected returns, and –The required rate of return on the investment

Copyright © 2000 by Harcourt, Inc. All rights reserved Stream of Expected Returns First item to estimate Two considerations: Form of returns –Earnings –Cash flows –Dividends –Interest payments –Capital gains (increases in value) Time pattern and growth rate of returns

Copyright © 2000 by Harcourt, Inc. All rights reserved Required Rate of Return Second item to estimate Determined by –1. Economy’s risk-free real rate of return, plus –2. Expected rate of inflation during the holding period, plus –3. Risk premium determined by the uncertainty of returns

Copyright © 2000 by Harcourt, Inc. All rights reserved Uncertainty of Returns There are many different sources of uncertainty: Internal characteristics of assets –Business risk (BR) –Financial risk (FR) –Liquidity risk (LR) –Exchange rate risk (ERR) –Country risk (CR) Market determined factors –Systematic risk (beta) or –Multiple APT factors

Copyright © 2000 by Harcourt, Inc. All rights reserved Investment Decision Process: A Comparison of Estimated Values and Market Prices If Estimated Value > Market Price, Buy If Estimated Value < Market Price, Don’t Buy

Copyright © 2000 by Harcourt, Inc. All rights reserved Top-Down Approach, Step One Two Components: Geographic (International) Allocation –Which region / country? Asset Allocation –Bonds? –Preferred Stocks? –Common Stocks?

Copyright © 2000 by Harcourt, Inc. All rights reserved Valuation of Bonds Valuation of Bonds is relatively easy because the size and time pattern of cash flows from the bond over its life are known 1.Interest payments usually every six months (semiannually) equal to one-half the coupon rate times the face value of the bond 2.Payment of principal on the bond’s maturity date

Copyright © 2000 by Harcourt, Inc. All rights reserved Valuation of Bonds Example: in 2000, a $10,000 bond due in 2015 with 10% coupon Discount these payments at the investor’s required rate of return (if the risk-free rate is 9% and the investor requires a risk premium of 1%, then the required rate of return would be 10%)

Copyright © 2000 by Harcourt, Inc. All rights reserved Valuation of Bonds Present value of the interest payments is an annuity for thirty periods at one-half the required rate of return: $500 x = $7,686 The present value of the principal is similarly discounted: $10,000 x.2314 = $2,314 Total value of bond at 10 percent = $10,000

Copyright © 2000 by Harcourt, Inc. All rights reserved Valuation of Bonds The $10,000 valuation is the amount that an investor should be willing to pay for this bond, assuming that the required rate of return on a bond of this risk class is 10 percent

Copyright © 2000 by Harcourt, Inc. All rights reserved Valuation of Bonds If the market price of the bond is above this value, the investor should not buy it because the promised yield to maturity will be less than the investor’s required rate of return But typically there is little mispricing in bonds “Home Run” in bond investing is: 1.Investing in bond just before unanticipated upgrade 2.Lengthening duration just before interest rate decrease

Copyright © 2000 by Harcourt, Inc. All rights reserved Valuation of Bonds Alternatively, assuming an investor requires a 12 percent return on this bond, its value would be: $500 x = $6,882 $10,000 x.1741 = 1,741 Total value of bond at 12 percent = $8,623 Higher rates of return lower the value! (and vice versa) Compare the computed value to the market price of the bond to determine whether you should buy it.

Copyright © 2000 by Harcourt, Inc. All rights reserved What Determines the Price Volatility for Bonds The maturity effect The coupon effect The yield level effect Some trading strategies

Copyright © 2000 by Harcourt, Inc. All rights reserved The Duration Measure Since price volatility of a bond varies inversely with its coupon and directly with its term to maturity, it is necessary to determine the best combination of these two variables to achieve your objective A composite measure considering both coupon and maturity would be beneficial

Copyright © 2000 by Harcourt, Inc. All rights reserved The Duration Measure Developed by Frederick R. Macaulay, 1938 Where: t = time period in which the coupon or principal payment occurs C t = interest or principal payment that occurs in period t i = yield to maturity on the bond

Copyright © 2000 by Harcourt, Inc. All rights reserved Characteristics of Duration Duration of a bond with coupons is always less than its term to maturity because duration gives weight to these interim payments –A zero-coupon bond’s duration equals its maturity An inverse relation between duration and coupon A positive relation between term to maturity and duration, but duration increases at a decreasing rate with maturity An inverse relation between YTM and duration Sinking funds and call provisions can have a dramatic effect on a bond’s duration

Copyright © 2000 by Harcourt, Inc. All rights reserved Duration and Bond Price Volatility An adjusted measure of duration can be used to approximate the price volatility of a bond Where: m = number of payments a year YTM = nominal YTM

Copyright © 2000 by Harcourt, Inc. All rights reserved Duration and Bond Price Volatility Bond price movements will vary proportionally with modified duration for small changes in yields An estimate of the percentage change in bond prices equals the change in yield time modified duration Where:  P = change in price for the bond P = beginning price for the bond D mod = the modified duration of the bond  i = yield change in basis points divided by 100

Copyright © 2000 by Harcourt, Inc. All rights reserved Trading Strategies Using Duration Longest-duration security provides the maximum price variation If you expect a decline in interest rates, increase the average duration of your bond portfolio to experience maximum price volatility If you expect an increase in interest rates, reduce the average duration to minimize your price decline Note that the duration of your portfolio is the market-value- weighted average of the duration of the individual bonds in the portfolio

Copyright © 2000 by Harcourt, Inc. All rights reserved Valuation of Preferred Stock Owner of preferred stock receives a promise to pay a stated dividend, usually quarterly, for perpetuity Since payments are only made after the firm meets its bond interest payments, there is more uncertainty of returns Tax treatment of dividends paid to corporations (80% tax-exempt) offsets the risk premium

Copyright © 2000 by Harcourt, Inc. All rights reserved Valuation of Preferred Stock The value is simply the stated annual dividend divided by the required rate of return on preferred stock (k p )

Copyright © 2000 by Harcourt, Inc. All rights reserved Valuation of Preferred Stock The value is simply the stated annual dividend divided by the required rate of return on preferred stock (k p ) Assume a preferred stock has a $100 par value and a dividend of $8 a year and a required rate of return of 9 percent

Copyright © 2000 by Harcourt, Inc. All rights reserved Valuation of Preferred Stock The value is simply the stated annual dividend divided by the required rate of return on preferred stock (k p ) Assume a preferred stock has a $100 par value and a dividend of $8 a year and a required rate of return of 9 percent

Copyright © 2000 by Harcourt, Inc. All rights reserved Valuation of Preferred Stock The value is simply the stated annual dividend divided by the required rate of return on preferred stock (k p ) Assume a preferred stock has a $100 par value and a dividend of $8 a year and a required rate of return of 9 percent

Copyright © 2000 by Harcourt, Inc. All rights reserved Valuation of Preferred Stock Conversely, given a market price, you can derive its promised yield:

Copyright © 2000 by Harcourt, Inc. All rights reserved Valuation of Preferred Stock Given a market price, you can derive its promised yield

Copyright © 2000 by Harcourt, Inc. All rights reserved Valuation of Preferred Stock Given a market price, you can derive its promised yield At a market price of $85, this preferred stock yield would be

Copyright © 2000 by Harcourt, Inc. All rights reserved Top-Down Approach, Step Two Industry Analysis

Copyright © 2000 by Harcourt, Inc. All rights reserved Industry Performance Wide dispersion in rates of return in different industries Performance varies from year to year Company performance varies within industries Risks vary widely across industries but are fairly stable over time within industries

Copyright © 2000 by Harcourt, Inc. All rights reserved Links Between the Economy and Industry Sectors Economic trends are either –Cyclical - up and down with business cycle –Structural - major change Combined changes have implications for the industry being analyzed Switching from one industry group to another over the course of a business cycle is known as a rotation strategy –Identify and monitor key assumptions and variables

Copyright © 2000 by Harcourt, Inc. All rights reserved The Stock Market and the Business Cycle Figure 19.2

Copyright © 2000 by Harcourt, Inc. All rights reserved The Stock Market and the Business Cycle Figure 19.2 trough peak

Copyright © 2000 by Harcourt, Inc. All rights reserved The Stock Market and the Business Cycle Figure 19.2 Financial Stocks Excel trough peak Consumer Durables Excel Capital Goods Excel Basic Industries Excel Consumer Staples Excel

Copyright © 2000 by Harcourt, Inc. All rights reserved Cyclical Economic Factors Inflation Interest rates International economics Consumer sentiment –All give clues about when to rotate portfolio

Copyright © 2000 by Harcourt, Inc. All rights reserved Structural Economic Changes and Alternative Industries Social Influences –Demographics –Lifestyles Technology Politics and regulations –Economic reasoning –Fairness –Regulatory changes affect numerous industries –Regulations affect international commerce

Copyright © 2000 by Harcourt, Inc. All rights reserved Theme Investing Based on identifying emerging trends, such as: –Technology –Aging population –Freer trade and developing-country growth Identification of themes provides insight into industry analysis Find a story to describe your vision of the future, then invest in companies whose businesses are consistent with that story –Peter Lynch question – what is the story for your stock?

Copyright © 2000 by Harcourt, Inc. All rights reserved Earnings and Valuation Valuation of company will depend upon its earnings Earnings of company are dependent upon (and a subset of) the earnings of the industry Level of earnings for the industry are a function of: –Industry sales –Degree of competition within industry (impacts profit margins – ability of company to realize profits from sales)

Copyright © 2000 by Harcourt, Inc. All rights reserved Earnings and Industry Analysis Estimating earnings per share –start with forecasting sales per share Industrial life cycle Input-output analysis Industry-aggregate economy relationship –earnings forecasting and analysis of industry competition competitive strategy competitive environment industry operating profit margin industry earnings estimate industry earnings multiplier

Copyright © 2000 by Harcourt, Inc. All rights reserved Sales Forecasting and Industry Life Cycle Pioneering development Rapidly accelerating industry growth Mature industry growth Stabilization and market maturity Deceleration of growth and decline

Copyright © 2000 by Harcourt, Inc. All rights reserved Sales Forecasting and Input-Output Analysis Identify suppliers and customers Future demand from customers Ability of suppliers to provide goods and services required Extended to global industries, include worldwide suppliers and customers

Copyright © 2000 by Harcourt, Inc. All rights reserved Sales Forecasting and the Industry-Economy Relationship Compare industry sales to aggregate economic series related to the goods and services provided by the industry

Copyright © 2000 by Harcourt, Inc. All rights reserved Forecasting Earnings Per Share Analysis of industry competition Analysis of competitive structure Porter’s concept of competitive strategy

Copyright © 2000 by Harcourt, Inc. All rights reserved Competitive Structure of an Industry Porter’s Competitive Forces –Rivalry among existing competitors –Threat of new entrants –Threat of substitute products –Bargaining power of buyers –Bargaining power of suppliers

Copyright © 2000 by Harcourt, Inc. All rights reserved