Security Valuation and Selection Chapter 17

Fundamental Analysis versus Technical Analysis uFundamental analysis F the practice of evaluating the information contained in financial statements, industry reports, and economic factors to determine the intrinsic value of a firm

Fundamental Analysis versus Technical Analysis uIntrinsic value F the “true” or economic, value of a firm

Fundamental Analysis versus Technical Analysis uFundamentalist F analysts who utilize analysis in an attempt to forecast future stock price movements

Fundamental Analysis versus Technical Analysis uTechnical analysis F examination of supply and demand for securities to determine trends in price movements of stocks or financial instruments

Fundamental Analysis versus Technical Analysis uTechnicians F the term given to analysts who examine stocks and financial markets using technical analysis

Economic Analysis uForecasting business cycles F to determine when to expect changes in the business cycle, or the direction in which aggregate economic activity is moving

Economic Analysis uBusiness cycle F the movement in aggregate economic activity as measured by the gross domestic product (GDP)

Economic Analysis uExpansion F increasing economic activity

Economic Analysis uContraction F decreasing economic activity

Economic Analysis uGross Domestic Product (GDP) F a measure of all of the goods and services produced in the economy during a specified time period

Economic Analysis uRecession F two consecutive quarters of economic contraction, or decline, in the GDP

Economic Analysis

uEconomic indicators F Leading economic indicators v economic measures that tend to move prior to, or precede, movements in the business cycle

Economic Analysis uEconomic indicators F Lagging economic indicators v economic measures that tend to move after, or follow, movements in the general economy (business cycles)

Economic Analysis uEconomic indicators F Coincident indicators v economic measures that tend to mirror, or move at the same time as, business cycles

Business Cycles

Business Cycles - Monetary Policy and Fiscal Policy uMonetary Policy F the means by which the Federal Reserve influences economic conditions by managing the nation’s money supply

Business Cycles - Monetary Policy and Fiscal Policy uFiscal Policy F Government spending, which is primarily supported by the government’s ability to tax individuals and businesses

Business Cycles - Monetary Policy and Fiscal Policy uDeficit spending F situation that occurs when the government spends more than it collects in taxes

Industry Analysis uCyclical industries F industries that tend to be directly related to business cycles such that they perform best during expansions and worst during contractions

Industry Analysis uDefensive, or countercyclical, industries F industries that tend to perform best when the economy is in a contraction or recession, but are generally the poorest performers in expanding economies

Industry Analysis uIndustry life cycle F the various phases of an industry with respect to its growth in sales and its competitive conditions

Industry Sales Life-Cycle Stages Introductory Expansion (Growth) Mature Industry Life Cycle

Evaluating the Firm’s Financial Position uFinancial statement analysis F comparison to other similar firms F forecast direction for future F predict earnings and dividends F risk evaluation

Stock Valuation Techniques uDividend discount models (DDM) F a model that utilizes the discounted cash flow principle to value common stock F value is represented by the present value of the dividends expected to be received from investing in the stock

uDividend discount models (DDM) Stock Valuation Techniques

uValuation using P/E ratios F ratio computed by dividing the current market price per share, P0, by the earnings per share, EPS0

Stock Valuation Techniques uEvaluation using the economic value added (EVA) approach F method used to evaluate if the earnings generated by a firm are sufficient to compensate the suppliers of funds - both the bondholders and the stockholders

uEvaluation using the economic value added (EVA) approach Stock Valuation Techniques

Economic Value Added (EVA) uChanging the capital structure can change value because the WACC is affected uIncreasing the efficiency of the firm through reductions in operating expenses or increases in revenue will increase operating income and thus increase value

Technical Analysis uCharting - using charts and graphs F Bar chart v a graph that indicates the high, low, and closing price movements for a stock during a specified period

Technical Analysis uCharting - using charts and graphs F Trend line v a line that indicates the direction of the stock price movements v it is drawn so that it touches either the high prices or the low prices for some of the trading days

Technical Analysis uCharting - using charts and graphs F Trend line penetration v the point at which the trading line crosses the trend line

Technical Analysis

uMeasures and indicators used by technical analysts F The Dow Theory v a technique used to predict reversals in market patterns by examining the movements of the Dow Jones Industrial Average and the Dow Jones Transportation Average

Technical Analysis uMeasures and indicators used by technical analysts F Moving averages v stock price averages for a fixed time frame, say 100 days, computed for a particular period of time

Technical Analysis uMeasures and indicators used by technical analysts F Technical indicators v measures used by technical analysts to forecast future movements in stock prices

Technical Analysis uMeasures and indicators used by technical analysts F Market breadth indicators v measure the trading volume and the range of trading that takes place in the market

Technical Analysis uMeasures and indicators used by technical analysts F Advance/decline line v a graph that depicts the results computing the difference between the number of advancing stocks and the number of declining stocks over some time period

Technical Analysis uMeasures and indicators used by technical analysts F Sentiment indicators v technical indicators that are used to monitor the “mood” or psychology of the market

Stock Selection Criteria uGrowth stocks F stocks of firms that have many positive net present value opportunities F in general, these firms exhibit sales and earnings growth that significantly exceed the industry averages

uValue stocks F stocks of firms that are mispriced, especially those that are undervalued $1.99 Stock Selection Criteria

Investment Selection in Efficient Markets uAbnormal returns F returns that exceed the returns earned by investments with similar risks uWeak form efficiency F current market prices reflect all historical information, including any information that might be provided by examining past price movements and trading volume data

Investment Selection in Efficient Markets uSemistrong form efficiency F current market prices reflect all publicly available information, including information contained in historical data and information contained in current financial statements uStrong form efficiency F current market prices reflect all information, whether it is public or private

Investment Selection in Efficient Markets uEven if we accept that abnormal returns cannot be earned on a consistent basis, we still need to evaluate the investments we select to ensure the risk position is appropriate and that our investment goals are being met

End of Chapter 17 Security Valuation and Selection