2017-09-11 Outline • FUNDAMENTAL ANALYSIS • Macroeconomic and Industry Analysis Company Analysis: Equity Evaluation Models • Dividend discount models • Discounted cash flow models • Relative value models • P/E analysis • P/S analysis • P/CF analysis • Financial Statements and Ratio Analysis • Determinants of Firm Growth t 11 Fundamental analysis t Fundamental analysis • Definition: “…the process of using fundamental information about a company to arrive at an estimate of the share price.” • The underlying theme in fundamental analysis is that the true value of a stock is related to the financial characteristics of firms: growth prospects, risk profile, and cash flows. Any deviation from this true value indicates that the stock is undervalued or overvalued. “… Value for the fundamentalist is like an anchor to which a boat is moored by a long line. Like the boat, price moves respond to the prevailing market winds. Often it is blown far in one direction. Only after shortly thereafter to be tossed as far in the opposite. Knowing where the anchor lies allows the investor to profit from the various gusts.” Psychology and the stock market, David Dreman, 1977 • Before we go further, recall efficient market hypotheses • What is the basic intuition of efficient market hypothesis? What are the typical forms of efficient market hypotheses? • If an investor believes that fundamental analysis is actually working, i.e., one can use fundamental analysis to find mispriced asset, what form of efficient market hypothesis the investor must believe? t t Global economy Fundamental analysis • Typical procedure: Top down analysis • Global economy • Marco-economy • Industry analysis • Equity valuation models • Performance in countries and regions is highly variable • Political risk • Exchange rate risk • Developed markets or emerging markets? • Investment safety – e.g., legal system, corruption, nationalization, etc. • Bottom up analysis: opposite direction • Protect your profits • An example: • Economic forecast => Industry =>Corporations • You bought one share of facebook.com at US$30.59 on Jan 9th, 2013 with Canadian dollar. Exchange rate was US$1=CA$1.03 on that day. • Economic forecast helps to decide the asset allocation between equities, bonds and cash. Industry analysis helps to decide the weights of each industry sector within the equity portfolio. Company analysis helps to decide the company within industry sector. • Facebook.com was traded at US$58.23 on Jan 8th, 2014. Exchange rate was US$1=1.08 on that day. • What’s your annual rate of return in terms of USD and CAD respectively? Are they equal to each other? Explain. t 1 2017-09-11 Demand and supply shocks Macro-economy: key variables • • Gross domestic product (GDP) • Demand shock - an event that affects demand for goods and services in the economy • Tax rate cut • Increases in government spending Unemployment rates • Increase in money supply – think about the impacts of the QE on • For example, Fed Reserves mainly rely on unemployment rate to stock market after the 2008 financial crisis. make their decisions on interest rate change right now. • Interest rates & inflation • International measures • Consumer sentiment • Supply shock - an event that influences production capacity or production costs • Commodity price changes • Educational level of workforce • Change of weather on agriculture commodity supply – think about global warming and more frequent extreme weather conditions. • Change of production technology – think about the impacts of shale gas and shale oil. t t Government policy Business cycle • • Fiscal policy The recurring pattern of recession and recovery • Government spending • Tax rate change • Peak • Deficit & surplus • Trough • Recession and expansion • • Recent peak: Dec 2007. Recent trough: June 2009. Monetary Policy • What business cycle are we in right now? • manipulation of the money supply to influence economic activity • NBER is the final authority to determine a business cycle. • Tools of monetary policy • Reading on the side: http://www.nber.org/cycles.html • Open market operations • Discount rate • Reserve requirements t Cyclical indicators • t Industry analysis Leading indicators: tend to lead rest of economy • • Money supply, stock market, changes in raw materials prices, • For example: Dow Jones Industry Groups: basic materials, changes in consumer expectations, purchasing managers index consumer products, energy, financial, health care, industrial, technology, telecommunications and utilities. • Standard Industrial Classification (SIC) code (used by SEC) • Reading on the side: http://en.wikipedia.org/wiki/Purchasing_Managers_Index • Define an industry Coincident Indicators: indicators that tend to change directly with the economy. • Reading on the side: http://en.wikipedia.org/wiki/Standard_Industrial_Classification • industrial production, manufacturing, and trade sales • Lagging Indicators: indicators that tend to follow the lag economic performance. • ratio of trading inventories to sales, ratio of consumer installment credit outstanding to personal income • Business indicators are published by Conference Board: • www.conference-board.org/data/bci.cfm t • Industry life cycles • Sensitivity to business cycles • Sector rotation t 2 2017-09-11 Sensitivity to business cycles Industry life cycles • Pioneer development • Growth • Industry relative performance to business cycles • Cyclical: sensitive to the state of economy and business cycle change • For example: durable goods, capital equipment • Can you think of some other industries? • No payout. Why? • • Stock dividends • For example: food and pharmaceutical • Other examples? • Expansion • Stock dividends or splits • • Three factors that determine sensitivity to business cycles • Sensitivity of sales Maturity and stabilization • High vs. low • Operating leverage • Variable cost vs. fixed cost – higher the fixed cost, higher the operation leverage • High fixed cost – more sensitive; High variable cost – less sensitive • Degree of operating leverage (DOL) = % change in profits / % change in sales • High payout ratio, cash dividends • Defensive: less sensitive to business cycle change Declining market • High payout ratio despite falling earnings. Why? • Eventually dividend cuts or elimination. • Financial leverage • The use of debt t t Operating leverage Sensitivity of sales • What are the DOLs for firm A and B when state of economy changes from normal to expansion? • Which firm should you choose during recession? Expansion? t t Company analysis: models of equity valuation Sector rotation • Shift portfolio into industries that are expected to outperform based on investor’s assessment of the state of economy. • Dividend discount models • Discounted cash flow models • Peak – natural resource extraction firms • Relative value models with financial multipliers • P/E analysis • Recession – defensive industries such as pharmaceuticals and food • P/S analysis • P/CF analysis • Trough – capital goods industries • Expansion – cyclical industries such as consumer durables n t 3 2017-09-11 Dividend discount model DDM (continued) • Recall: the value of a stock is the present value of future dividend • Generic model of DDM: Recall: • No dividend growth  Dt Po   ( 1  k)t t 1 • For correctly priced stock, required rate of return k is equal to its expected return, therefore • Po  Constant dividend growth D k Po  D1 kg k  rf    E (rM )  rf  t Multistage growth models Estimating dividend growth rates Recall: t • g  ROE  b Initial stage of high growth, transitional stage of slowing down and a final stage of stable growth n1 P0   PV [ h E 0 (1  g h ) t ]  g = dividend growth rate t 1 ROE = Return on Equity n2   s E n 2 (1  g s )    (k s  g s )   PV ( D )   t  n1 1 t where Et = Dt = gh = gs = h = s = kh = ks = b = retention rate = (1- dividend payout rate) Alternatively: find out average dividend growth rates through historical dividend data earning per share in year t dividend per share in year t growth rate in high-growth period growth rate in stable-growth period payout ratio in high-growth period payout ratio in stable-growth period cost of equity in high-growth period cost of equity in stable-growth period t Example: Home Depot Home Depot: inputs • Home Depot is one of the great retailing success • • Dividend per share in 1994 = $0.16 • • The rationale for using multistage DDM: • At the beginning of 1995, the Home Depot is still in very high growth stage. Analysts project that its earnings per share will grow at 36% for the next five years. • The firm has had a record of paying out dividends that roughly approximate free cash flow to equity. t Initial earnings/dividends • Earnings per share in 1994 = $1.33 stories of the 1980s and early 1990s. It posted extraordinary growth both in revenues and profits and rewarded its stockholders with great returns Inputs for the high growth period (from 1995) • Length of the high growth period = 5 years • Expected growth rate = 36.00% (Based upon analyst projections) • Beta during high growth period = 1.60, Risk free rate 7.5%, S&P500 annual return 13% • Cost of equity during high growth period? • Dividend payout ratio = 12.03% (based on existing payout ratio) t 4 2017-09-11 Summary of Inputs Home Depot: inputs • gh =36% Betah =1.6 Kh =16.3% Inputs for the transition period gd =? Betad =? Kd =? gs =6% Betas =1.0 Ks=13% • Length of the transitional period = 5 years • Growth rate in earning will decline from 36% in year 5 to 6% in year 10 in linear increments • Beta will drop from 1.60 to 1.00 over the same period in linear increments • 5 yrs Inputs for the stable growth (after 10 years of high growth and transitional periods) • Expected Growth Rate = 6% • Beta during stable growth rate =1 High Stable Growth In 1994 EPS0 =1.33 DPS0 =0.16 Earning Growth Rates 5 yrs Declining Growth h=? Infinite Stable Growth h=60% h=12.03% • Cost of equity = ? Assuming the same risk free rate and S&P500 return Dividend Payout ratio • Payout Ratio = 60% Low payout ratio Increasing payout ratio High payout ratio t Home Depot: estimation Home Depot: some calculations • Using the estimated input, the present value of high growth and transitional • Assume the change of growth, beta and dividend payout period of Home Depot is ratio is linear in the declining growth period. • The annual change of growth ratio is = (6% -36%)/5=-6% g6 = g5-6%=36%-6%=30%; g7 = g6-6%=30%-6%=24%; g8 = g7-6%=24%-6%=18%; g9 = g8-6%=18%-6%=12% g10 = g9-6%=12%-6%=6% • The annual change of beta is = (1.0 -1.6)/5=-0.12 beta6 =beta5-0.12=1.6-0.12=1.48; beta7 =beta6-0.12=1.48-0.12=1.36; beta8 =beta7-0.12=1.36-0.12=1.24; beta9 =beta8-0.12=1.24-0.12=1.12; beta10 =beta9-0.12=1.12-0.12=1; • The annual change of dividend payout is = (60% -12%)/5=9.6% π6= π5 + 9.6% = 12.0%+9.6%=21.6%; π7= π6 + 9.6% = 21.6%+9.6%=31.2% π8= π7 + 9.6% = 31.2%+9.6%=40.8%; π9= π8 + 9.6% = 40.8%+9.6%=50.4% π10= π9 + 9.6% = 50.4% + 9.6%=60% g=0.36 g6=0.3 Period EPS Pay out Ratio (%) Divd. Cost of Present Equity (%) Value 1 $1.81 12.03 $0.22 16.30 $0.19 2 $2.46 12.03 $0.30 16.30 $0.22 3 $3.35 12.03 $0.40 16.30 $0.25 4 $4.55 12.03 $0.55 16.30 $0.30 5 $6.19 12.03 $0.74 16.30 $0.35 6 $8.04 21.62 $1.74 15.64 $0.71 7 $9.97 31.22 $3.11 14.98 $1.10 8 $11.77 40.81 $4.80 14.32 $1.49 9 $13.18 50.41 $6.64 13.66 $1.81 10 $13.97 60.00 $8.38 13.00 $2.02 Sum =1.31 Sum =7.12 t Home Depot: estimation Practical difficulties with DDM • The terminal price at the end of year 10 can be calculated based on the earning per shares in year 11, the stable growth rate of 6%, the cost of equity of 13% (based upon the beta of 1), and the payout ratio of 60%. • Terminal price at end of transition (i.e., the end of year 10) = $13.97*0.60*(1+0.06)/(0.13-0.06)=$ 126.93 • The components of value are as follows: • The model is very sensitive to the value of inputs Can you forecast future dividends? • What about the discount rate k? • Some companies do not pay dividends, or the dividends are unpredictable. In these cases we have to use alternative valuation models such as discounted free cash flow model • • Present value of dividends in high growth phase: $1.31 • Present value of dividends in transitional phase: $7.12 • Present value of terminal price at end of transition: $30.56 • Value of Home Depot Stock: $38.99 • Home Depot was trading at $45, in February 1995. t t 5 2017-09-11 Discounted cash flow model Discounted cash flow model • The basic idea of DCFM is that the true value of a firm is the present value of its all free cash flows available to shareholders. T Value of Firm   t 1 • where: • Recall: ki ke B E PT  FCFt 1  WACC t  • Free cash flow = after tax EBIT + depreciation - capital PT (1  WACC ) T expenditure – increase in net working capital • Value of equity = Value of Firm – Value of Debt FCFT 1 WACC  g WACC  ki • Price of stock = Value of equity / # outstanding shares B E  ke BE BE = After tax cost of debt = before tax cost of debt ×(1-tax rate)= Kb×(1-t) = Cost of equity = Value of debt = Value of equity t Example: Nike Example: Nike • Estimating WACC: WACC  ki • B E  ke BE BE Collecting information on T-bill, cost of debt and stock price assume WACC=12% for now • Rf = 5.74% Kb = TYM = 7.16% • Beta = 0.69 • Ke = 10.92% • t t Example: Nike • D: Market value of debt: assume it is close to book value of debt=$1,296.6m • E: Market value of equity =market price *#share=$42.09*271.5m=$11,427.4m WACC  kb (1  T ) B  ke E BE BE =7.16%(1-38%)*0.102+10.92%*0.898=10.26% • Apparently, this WACC is lower than the WACC used in projection. We can recalculate firm value and stock price with new WACC. • Nike’s stock price is $51.24 with the new WACC, which is 22% higher than its current share price of $42.09. • Calculate the stock price $51.24 with the new WACC as a practice after class. 6 2018-01-17 Relative value models • Relative valuation: Compare multiples (Price/Earnings, Price/Book-Value, Price/Sales etc.) across “comparable” firms. • For example, an analyst might say that XYZ is undervalued relative to ABC (which is in the same industry) because it has a lower P/E ratio, but a higher earnings growth rate. P/E approach • As a rule of thumb, or simplified model, analysts often assume that a stock is worth some “justified” P/E ratio times the firm’s expected earnings. • Inputs: • A justified P/E ratio: • Earning • The logic of Market Multiple Models • Sales, earnings and cash flow drive profits, growth and value. • P/S, P/E & P/CF ratios show the relationship between price and these value drivers. • Firms within an industry have similar sales, profit and cash flow patterns as well as similar required returns. • Therefore, a reasonable value for a firm is its sales, earnings or cash flows times the respective industry ratio. Estimate “justified” P/E ratio To calculate the value of the stock, we merely multiply its next year’s earnings by this justified P/E: P0  P E  EPS 0 Example: Estimate P/E ratio • Method 1: based on the industry average P/E; • A utility company follows constant growth dividend • Method 2 : company’s own historical P/E; • Method 3: some other P/E that the analyst feels is justified. model. payout ratio is 0.3, g=0.05, beta=1.2, risk free rate is 4% and market risk premium is 5%. Industry average P/E=5. Is the company under-evaluated or over-evaluated? • For example, with constant growth DDM: P0  D0 (1  g ) P D (1  g )  0  0 kg E0 E0 ( k  g ) P/S approach In some cases, companies aren’t currently earning any money and this makes the P/E approach impossible to use. Although they have high revenues, accounting measure of earnings is poor because of factors such as expenses on R&D or new market/products development. • In these cases, analysts often estimate the value of the stock as some multiple of sales (Price/Sales ratio). • The justified P/S ratio may be based on historical P/S for the company, P/S for the industry, or some other estimate: • P0  P  Sales 0 S Example: Amazon.com • For 2012 fiscal year • Sales = 61,093 million (income statement) • # Shares = 458 million (balance sheet) Sales/Share = 61093/458 = 133.39 • Industry average P/S = 3.46 • So, using industry P/S Amazon should be priced at: 3.46 x 133.39 = $461.53 • Amazon.com was traded at $250.87 on Dec 31 st, 2012, and $398.79 on Dec 31st, 2013. • Reading on the side: • How to create value without earnings: the case of Amazon, Journal of Applied Corporate Finance (2013) Vol.25: 39-43 n 1 2018-01-17 P/CF approach • Example: Walmart In some cases, analysts estimate the value of the stock as some multiple of P/CF (Price/Cash Flow). Especially when cash flow is an important indicator of an industry. • For the fiscal year 2012 • CF = 25,591 million • # Shares = 3,242 million • CF/Share = 25591/3242 = 7.89 • • It is suggested that P/CF should be used in conjunction with the P/E ratio because earnings (E) is easily to be manipulated. Cash flows are typically more stable. The justified P/CF ratio may be based on historical P/CF for the company, P/CF for the industry, or some other estimates: P P 0 CF  CF • Industry average P/CF = 11 • Using industry P/CF Walmart should be priced at: 11x7.89 = $86.79 • Walmart was traded at $68.23 on Dec 31 st, 2012 and $78.69 on Dec 31st, 2013. 0 t Disadvantages of relative value models • Financial statements • Three major financial statements: • Income statement: profitability over a period of time, including items These models are popular and easy to use, but they do have problems: such as revenue, expense, net income, etc. • Sales growth; profit margin; R&D; expenses; ROE • Even within an industry, companies are rarely perfectly comparable. • There is no way of knowing for sure what the “correct” price multiple • Balance sheet: list of assets, liabilities and equity at a particular point of time. It indicates a firm’s financial health at a given point of time. is. • A company’s (or industry’s) historical multiples may not be relevant today due to changes in sales or earnings growth over the time. Adjusted with an estimated future growth rate can help mitigate this problem, e.g. PEG (p/e to growth ratio) • • Cash reserves; liquidity level; current ratio; financial leverage; • Cash flow statement: report of actual cash flow generated by operations, investments and financial activities. First two statements are subject to accounting accrual methods manipulation, cannot be used alone without cash flow statement. • Indicating the source and application of cash flows, e.g., payout, capital Normally, relative value models should not be used on their own, and rather be complemented with discounted cash flow model or discounted dividend model expenditures, acquisition, etc. • http://freeedgar.com/ for free financial statement info of public firms t Profitability measures • ROE: measures the profitability for contributors of equity capital ROE  • ROE and ROA • One factor to link ROE with ROA is debt, i.e., financial leverage. Debt ROE  (1  T )  [ ROA  ( ROA  r ) ] Equity • When debt is zero or ROA=r, then ROE  (1  T )  ROA • If ROA>r, then ROE  (1  T )  ROA • If ROA