1. Securities Analysis, Section IV Security Valuation & EIC Analysis (Part 2)

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

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

4. 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

5. 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

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

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

8. 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

9. 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

10. 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

11. 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?

12. 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)

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. Copyright © 2000 by Harcourt, Inc. All rights reserved Top-Down Approach, Step Three Company and Stock Analysis

20. Copyright © 2000 by Harcourt, Inc. All rights reserved Company Analysis and Stock Selection After analyzing the economy and stock markets for several countries you have decided to invest some portion of your portfolio in common stocks After analyzing various industries, you have identified those industries that appear to offer above-average risk-adjusted performance over your investment horizon Which are the best companies? Are they overpriced?

21. Copyright © 2000 by Harcourt, Inc. All rights reserved Company Analysis and Stock Selection Good companies are not necessarily good investments Compare the intrinsic value of a stock to its market value Stock of a great company may be overpriced Stock of a growth company may not be growth stock

22. Copyright © 2000 by Harcourt, Inc. All rights reserved Types of Companies and Stocks Growth Defensive Cyclical Speculative

23. Copyright © 2000 by Harcourt, Inc. All rights reserved Growth companies have historically been defined as companies that consistently experience above-average increases in sales and earnings Financial theorists define a growth company as one with management and opportunities that yield rates of return greater than the firm’s required rate of return Growth Companies

24. Copyright © 2000 by Harcourt, Inc. All rights reserved Growth Stocks Growth stocks are not necessarily shares in growth companies A growth stock has a higher rate of return than other stocks with similar risk Superior risk-adjusted rate of return occurs because of market undervaluation compared to other stocks

25. Copyright © 2000 by Harcourt, Inc. All rights reserved Value versus Growth Investing Growth stocks will have positive earnings surprises and above-average risk adjusted rates of return because the stocks are undervalued Value stocks appear to be undervalued for reasons besides earnings growth potential Value stocks usually have low P/E ratio or low ratios of price to book value

26. Copyright © 2000 by Harcourt, Inc. All rights reserved Value versus Growth Investing Buffett’s view: –Growth is a key determinant of value for any stock, so it is always a component of determining whether or not a stock is undervalued –Furthermore, so long as the market is under- valuing a stock, then he would categorize it as a “value” stock –Finally, he considers all investing to be “value” investing –Thus, he considers “value” vs. “growth” investing to be a false dichotomy

27. Copyright © 2000 by Harcourt, Inc. All rights reserved Defensive Companies and Stocks Defensive companies’ future earnings are more likely to withstand an economic downturn Low business risk Not excessive financial risk Stocks with low or negative systematic risk

28. Copyright © 2000 by Harcourt, Inc. All rights reserved Cyclical Companies and Stocks Sales and earnings heavily influenced by aggregate business activity Stocks with high betas

29. Copyright © 2000 by Harcourt, Inc. All rights reserved Speculative Companies and Stocks Assets involve great risk –e.g., biotechs, bankruptcies, etc. Can be viewed as a gamble –Possible great gain –Stock may be overpriced

30. Copyright © 2000 by Harcourt, Inc. All rights reserved Economic, Industry, and Structural Links to Company Analysis Company analysis is the final step in the top- down approach to investing Macroeconomic analysis identifies industries expected to offer attractive returns in the expected future environment Analysis of firms in selected industries concentrates on a stock’s intrinsic value based on growth and risk

31. Copyright © 2000 by Harcourt, Inc. All rights reserved Economic and Industry Influences If trends are favorable for an industry, the company analysis should focus on firms in that industry that are positioned to benefit from the economic trends Firms with sales or earnings particularly sensitive to macroeconomic variables should also be considered Research analysts need to be familiar with the cash flow and risk of the firms

32. Copyright © 2000 by Harcourt, Inc. All rights reserved Structural Influences Social trends, technology, political, and regulatory influences can have significant influence on firms Early stages in an industry’s life cycle see changes in technology that followers may imitate and benefit from Politics and regulatory events can create opportunities even when economic influences are weak

33. Copyright © 2000 by Harcourt, Inc. All rights reserved Company Analysis Industry competitive environment SWOT analysis Present value of cash flows Relative valuation ratio techniques

34. Copyright © 2000 by Harcourt, Inc. All rights reserved Firm Competitive Strategies Current rivalry Threat of new entrants Potential substitutes Bargaining power of suppliers Bargaining power of buyers

35. Copyright © 2000 by Harcourt, Inc. All rights reserved Firm Competitive Strategies Defensive or offensive Defensive strategy deflects competitive forces in the industry Offensive competitive strategy affects competitive force in the industry to improve the firm’s relative position Porter suggests two major strategies: low- cost leadership and differentiation

36. Copyright © 2000 by Harcourt, Inc. All rights reserved Low-Cost Strategy Seeks to be the low cost leader in its industry –Through economies of scale (in production or marketing), better logistics, etc. Must still command prices near industry average, so still must differentiate Discounting too much erodes superior rates of return

37. Copyright © 2000 by Harcourt, Inc. All rights reserved Differentiation Strategy Identify as unique in its industry in an area that is important to buyers Above average rate of return only comes if the price premium exceeds the extra cost of being unique

38. Copyright © 2000 by Harcourt, Inc. All rights reserved Focusing a Strategy Select segments in the industry Tailor strategy to serve those specific groups Determine which strategy a firm is pursuing and its success Evaluate the firm’s competitive strategy over time

39. Copyright © 2000 by Harcourt, Inc. All rights reserved SWOT Analysis Examination of a firm’s: –S trengths –W eaknesses –O pportunities –T hreats

40. Copyright © 2000 by Harcourt, Inc. All rights reserved SWOT Analysis Examination of a firm’s: –S trengths –W eaknesses –O pportunities –T hreats INTERNAL ANALYSIS

41. Copyright © 2000 by Harcourt, Inc. All rights reserved SWOT Analysis Examination of a firm’s: –S trengths –W eaknesses –O pportunities –T hreats EXTERNAL ANALYSIS

42. Copyright © 2000 by Harcourt, Inc. All rights reserved Lynch’s Favorable Attributes 1. Firm’s product is not faddish 2. Company has competitive advantage over rivals 3. Industry or product has potential for market stability 4. Firm can benefit from cost reductions 5. Firm is buying back its own shares or managers (insiders) are buying

43. Copyright © 2000 by Harcourt, Inc. All rights reserved Lynch’s Categories of Companies 1. Slow growers 2. Stalwart 3. Fast growers 4. Cyclicals 5. Turnarounds 6. Asset plays

44. Copyright © 2000 by Harcourt, Inc. All rights reserved Company and Common Stock Valuation General models for valuation discussed in previous set of lecture notes. But, where do you get the inputs for these models? Sources for inputs, checking your figures, and some specific-purpose extensions of the models discussed next.

45. Copyright © 2000 by Harcourt, Inc. All rights reserved Estimating the Inputs: The Required Rate of Return and The Expected Growth Rate of Valuation Variables Valuation procedure is the same for securities around the world, but the required rate of return (k) and expected growth rate of earnings and other valuation variables (g) such as book value, cash flow, and dividends differ among countries

46. Copyright © 2000 by Harcourt, Inc. All rights reserved Required Rate of Return (k) Required rate of return on equity (k e ) affects valuation, regardless of approach: –k  V , and vice versa This required rate of return will be used as the discount rate and also affects relative-valuation Although k e is not directly used in the present value of operating cash flow approach, it is nonetheless a component of WACC

47. Copyright © 2000 by Harcourt, Inc. All rights reserved Required Rate of Return (k) But, what is the proper approach for deriving k e ? –CAPM? –APT? –Haugen’s ad hoc expected return factor model? Still an open question –CAPM most widely used in practice –Even then, questions can remain in terms of how to apply the model

48. Copyright © 2000 by Harcourt, Inc. All rights reserved Estimating Growth Rates Three general approaches: 1.Reinvestment-rate approaches –Sustainable Growth Rate = RR X ROE 2.Historical estimates –Point estimates of growth rates –Regression-based estimates of growth rates 3.Back out growth rates from estimated size of future market –Compare company to industry (Ch. 20) and industry to economy as a whole (Ch. 19)

49. Copyright © 2000 by Harcourt, Inc. All rights reserved Expected Growth Rate of Dividends Determined by –the growth of earnings –the proportion of earnings paid in dividends In the short run, dividends can grow at a different rate than earnings due to changes in the payout ratio Earnings growth is also affected by compounding of earnings retention g = (Retention Rate) x (Return on Equity) = RR x ROE

50. Copyright © 2000 by Harcourt, Inc. All rights reserved DuPont Breakdown of ROE Profit Total Asset Financial Margin Turnover Leverage = xx

51. Copyright © 2000 by Harcourt, Inc. All rights reserved Estimating Growth Based on History Alternative to reinvestment rate approach Historical growth rates of sales, earnings, cash flow, and dividends Two general techniques 1.arithmetic or geometric average of annual percentage changes (point estimates) 2.linear or log-linear regression models Both use time-series plot of data

52. Copyright © 2000 by Harcourt, Inc. All rights reserved Checking Your Figures: Three Alternative Measures of Value (cf., Value Investing) 1.Value of Company’s Assets –Graham & Dodd net-net approach –Book Value of Assets – P/BV for valuation –Market value / replacement value of assets 2.Earnings Power Value –Value company’s current earnings, adjusted for seasonality / cyclicality – DCF value assuming growth = 0 or = long-run growth in economy –Greater than value of company’s underlying assets iff company holds competitive advantage or benefits from barriers to entry –Understanding value requires knowledge of industry

53. Copyright © 2000 by Harcourt, Inc. All rights reserved Checking Your Figures: Three Alternative Measures of Value (cf., Value Investing) 3.What is Growth Worth? –Adds value only if growth occurs “within the franchise” Potential problem - firm retains earnings, but reinvestment returns are below the firm’s cost of capital (i.e., project NPV is negative) Taking on more projects means that sales and earnings will grow, but not by enough to cover additional costs of capital, so growth will actually destroy value held by current shareholders Key lesson = not all growth is “value-adding” Only projects with positive NPV’s will create value, and projects will only have positive NPV if they exploit or occur within the firm’s realm of competitive advantage, i.e., within the firm’s franchise

54. Copyright © 2000 by Harcourt, Inc. All rights reserved Analysis of Growth Companies Generating rates of return greater than the firm’s cost of capital is considered to be temporary Earnings higher than the required rate of return are pure profits canHow long can they earn these excess profits? are they likely toHow long are they likely to earn these excess profits? does the market expect them toHow long does the market expect them to earn these excess profits? Is the stock properly valued?

55. Copyright © 2000 by Harcourt, Inc. All rights reserved Measures of Value-Added The Franchise Factor –Breaks P/E into two components P/E based on ongoing business (base P/E) Franchise P/E the market assigns to the expected value of new and profitable business opportunities Franchise P/E = Observed P/E - Base P/E Incremental Franchise P/E = Franchise Factor X Growth Factor

56. Copyright © 2000 by Harcourt, Inc. All rights reserved Growth Duration Evaluate the high P/E ratio by relating P/E ratio to the firm’s rate and duration of growth P/E is function of –expected rate of growth of earnings per share –stock’s required rate of return –firm’s dividend-payout ratio Use the ratio of P/E’s, related to growth and dividend rates, to infer the market’s implied growth duration:

57. Copyright © 2000 by Harcourt, Inc. All rights reserved Intra-Industry Analysis Directly compare two firms in the same industry An alternative use of T to determine a reasonable P/E ratio Factors to consider –A major difference in the risk involved –Inaccurate growth estimates –Stock with a low P/E relative to its growth rate is undervalued –Stock with high P/E and a low growth rate is overvalued

58. Copyright © 2000 by Harcourt, Inc. All rights reserved Growth Duration

59. Copyright © 2000 by Harcourt, Inc. All rights reserved Growth Duration Alternatively, the equation can be rearranged to determine a justified P/E ratio for a firm, given its expected dividend yield and growth rate and the expected length of time over which the firm will continue to experience above-average growth, relative to its benchmark (B).

60. Copyright © 2000 by Harcourt, Inc. All rights reserved Extensions on Growth Duration For more information and additional extensions and applications in using market- based information to infer the market’s assumptions about the various factors that drive a stock’s valuation, see: –www.expectationsinvesting.comwww.expectationsinvesting.com

61. Copyright © 2000 by Harcourt, Inc. All rights reserved When to Sell Knowing when to sell is an even harder decision than knowing when to buy –Holding a stock too long may lead to lower returns than expected –If stocks decline right after purchase, is that a further buying opportunity or an indication of incorrect analysis? –Continuously monitor key assumptions –Evaluate closely when market value approaches estimated intrinsic value –Know why you bought it and watch for that to change –Always need a “sell discipline”

62. Copyright © 2000 by Harcourt, Inc. All rights reserved Efficient Markets Opportunities are mostly among less well-known companies To outperform the market you must find disparities between stock values and market prices - and you must be correct Concentrate on identifying what is wrong with the market consensus and what earning surprises may exist –Again, useful to examine the expectations that underlie the current market price –Are these realistic/optimistic/pessimistic?

63. Copyright © 2000 by Harcourt, Inc. All rights reserved Next Up: Final Topic Are the Markets Rational?

64. Copyright © 2000 by Harcourt, Inc. All rights reserved