Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Chapter 14

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Chapter Summary  Objective: Introduction to fundamental stock analysis. This chapter introduces different types of valuation models and shows how economic conditions affect the results. Dividend discount models Price-Earnings ratios Other methods and issues Macroeconomic analysis

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition  Basic Types of Models Balance Sheet Models Dividend Discount Models Price/Earning Ratios  Estimating Growth Rates and Opportunities Fundamental Analysis: Models of Equity Valuation

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition  Intrinsic Value Self assigned Value Variety of models are used for estimation  Market Price Consensus value of all potential traders  Trading Signal IV > MP Buy IV < MP Sell or Short Sell IV = MP Hold or Fairly Priced Intrinsic Value and Market Price

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Summary Reminder  Objective: Introduction to fundamental stock analysis. This chapter introduces different types of valuation models and shows how economic conditions affect the results. Dividend discount models Price-Earnings ratios Other methods and issues Macroeconomic analysis

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition V 0 = Value of Stock D t = Dividend k = required return Dividend Discount Models: General Model

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition  Stocks that have earnings and dividends that are expected to remain constant  Preferred Stock No Growth Model

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition E 1 = D 1 = $5.00 k =.15 V 0 = $5.00 /.15 = $33.33 No Growth Model: Example

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition g = constant perpetual growth rate Constant Growth Model

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition E 1 = $5.00b = 40% k = 15% (1-b) = 60%D 1 = $3.00 g = 8% V 0 = 3.00 / ( ) = $42.86 Constant Growth Model: Example

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition g = growth rate in dividends ROE = Return on Equity for the firm b = plowback or retention percentage rate = (1- dividend payout percentage rate) Estimating Dividend Growth Rates

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition 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 Specified Holding Period Model

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition PVGO = Present Value of Growth Opportunities E 1 = Earnings per share for period 1 Partitioning Value: Growth and No Growth Components

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition ROE = 20% d = 60% b = 40% E 1 = $5.00 D 1 = $3.00 k = 15% Partitioning Value: Example g =.20 x.40 =.08 or 8%

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Vo = value with growth NGVo = no growth component value PVGO = Present Value of Growth Opportunities Partitioning Value: Example (cont’d)

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Summary Reminder  Objective: Introduction to fundamental stock analysis. This chapter introduces different types of valuation models and shows how economic conditions affect the results. Dividend discount models Price-Earnings ratios Other methods and issues Macroeconomic analysis

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition  P/E Ratios are a function of two factors Required Rates of Return (k) Expected growth in Dividends  Uses Relative valuation Extensive Use in industry Earnings, Growth and Price-Earnings Ratios

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition  E 1 - expected earnings for next year E 1 is equal to D 1 under no growth  k - required rate of return P/E Ratio: No Expected Growth

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition b = retention ratio ROE = Return on Equity P/E Ratio with Constant Growth

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition E 0 = $2.50 g = 0 k = 12.5% P 0 = D/k = $2.50/.125 = $20.00 PE = 1/k = 1/.125 = 8 Numerical Example: No Growth

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition E 1 = $2.50 (1 + (.6)(.15)) = $2.73 D 1 = $2.73 (1-.6) = $1.09 P 0 = 1.09/( ) = $31.14 PE = 31.14/2.73 = 11.4 PE = (1 -.60) / ( ) = 11.4 Numerical Example with Growth b = 60% ROE = 15% (1-b) = 40% k = 12.5% g = 9%

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Pitfalls in P/E Analysis  Use of accounting earnings Historical costs May not reflect economic earnings  Reported earnings fluctuate around the business cycle

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Summary Reminder  Objective: Introduction to fundamental stock analysis. This chapter introduces different types of valuation models and shows how economic conditions affect the results. Dividend discount models Price-Earnings ratios Other methods and issues Macroeconomic analysis

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Other Valuation Ratios  Price-to-Book  Price-to-Cash-Flow  Price-to-Sales

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition The Free Cash-Flow Approach  Fundamental idea: the intrinsic value of a firm is the present value of all its net cash-flows to shareholders  Estimate the value of the firm as a whole It equals the present value of cash-flows, assuming all-equity financing plus the net present value of tax shields created by using debt;  Derive the value of equity by subtracting the market value of all non-equity claims

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Inflation and Equity Valuation  Inflation has an impact on equity valuations  Historical costs underestimate economic costs  Empirical research shows that inflation has an adverse effect on equity values Research shows that real rates of return are lower with high rates of inflation

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Potential Causes of Lower Equity Values with Inflation  Shocks cause expectation of lower earnings by market participants  Returns are viewed as being riskier with higher rates of inflation  Real dividends are lower because of taxes

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Growth or Value Investing  Growth Investing – picking companies that are considered to have superior growth prospects  Value Investing – choosing companies for which fundamental analysis reveals unrecognized value  The Graham technique

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition Summary Reminder  Objective: Introduction to fundamental stock analysis. This chapter introduces different types of valuation models and shows how economic conditions affect the results. Dividend discount models Price-Earnings ratios Other methods and issues Macroeconomic analysis

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition  Performance in countries and regions is highly variable  Political risk  Exchange rate risk Sales Profits Stock returns Global Economic Considerations

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition  Gross domestic product (GDP)  Unemployment rates  Interest rates & inflation  International measures  Consumer sentiment Key Economic Variables

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition  Fiscal Policy - Government spending and taxing actions  Monetary Policy - manipulation of the money supply to influence economic activity  Tools of monetary policy Open market operations Discount rate Reserve requirements Government Policy

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition  Demand shock - an event that affects demand for goods and services in the economy Tax rate cut Increases in government spending  Supply shock - an event that influences production capacity or production costs Commodity price changes Educational level of economic participants Demand and Supply Shocks

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition  Business Cycle Peak Trough  Industry relationship to business cycles Cyclical Defensive Business Cycles

Bodie Kane Marcus Perrakis RyanINVESTMENTS, Fourth Canadian Edition  Leading Indicators - tend to rise and fall in advance of the economy. Examples: Average work week New orders - durables Residential construction Stock Prices  Lagging Indicators - indicators that tend to follow the lag economic performance Cyclical Indicators