STOCK ANALYSIS AND INVESTMENT pptx

Several Kinds of “Value”• There are several types of value, of which we are concerned with four: – Book Value – The carrying value on the balance sheet of the firm’s equity Total Assets

CHAPTER EIGHT: STOCK ANALYSIS

AND INVESTMENT

INVESTMENT PROCESS

What is Value?

• In general, the value of an asset is the price

that a willing and able buyer pays to a willing and able seller

• Note that if either the buyer or seller is not

both willing and able, then an offer does not establish the value of the asset

Several Kinds of “Value”

• There are several types of value, of which we are concerned with four:

– Book Value – The carrying value on the balance sheet of the firm’s

equity (Total Assets less Total Liabilities)

– Tangible Book Value – Book value minus intangible assets (goodwill, patents, etc)

– Market Value - The price of an asset as determined in a competitive marketplace

– Intrinsic Value - The present value of the expected future cash flows discounted at the decision maker’s required rate of return

Determinants of Intrinsic Value

• There are two primary determinants of the intrinsic value of

an asset to an individual:

– The size and timing of the expected future cash flows.

– The individual’s required rate of return (this is determined by a

number of other factors such as risk/return preferences, returns on competing investments, expected inflation, etc.).

• Note that the intrinsic value of an asset can be, and often is, different for each individual (that’s what makes markets

work)

Common Stock

• A share of common stock represents an ownership position in the firm Typically, the owners are entitled to vote on

important matters regarding the firm, to vote on the

membership of the board of directors, and (often) to receive dividends

• In the event of liquidation of the firm, the common

shareholders will receive a pro-rata share of the assets

remaining after the creditors (including employees) and

preferred stockholders have been paid off If the liquidation is bankruptcy related, the common shareholders typically

receive nothing, though it is possible that they may receive some small amount

Common Stock Valuation

• As with any other security, the first step in valuing common stocks is to determine the expected future cash flows

• Finding the present values of these cash flows and adding

them together will give us the value:

• For a stock, there are two cash flows:

– Future dividend payments

– The future selling price

k CF V

Common Stock Valuation: An Example

• Assume that you are considering the purchase of a stock

which will pay dividends of $2 (D1) next year, and $2.16 (D2) the following year After receiving the second dividend, you plan on selling the stock for $33.33 What is the intrinsic

value of this stock if your required return is 15%?

V  2 00.  2 16.  33 33.  28 57

2.00 33.332.16

?

Some Notes About Common Stock

• In valuing the common stock, we have made two assumptions:

– We know the dividends that will be paid in the future – We know how much you will be able to sell the stock for in the future.

• Both of these assumptions are unrealistic,

especially knowledge of the future selling price.

• Furthermore, suppose that you intend on holding

on to the stock for twenty years, the calculations would be very tedious!

Common Stock: Some Assumptions

• We cannot value common stock without making some

simplifying assumptions These assumptions will define the path of the future cash flows so that we can derive a present value formula to value the cash flows

• If we make the following assumptions, we can derive a simple model for common stock valuation:

– Your holding period is infinite (i.e., you will never sell the stock so you don’t have to worry about forecasting a future selling price).

– The dividends will grow at a constant rate forever.

• Note that the second assumption allows us to predict every future dividend, as long as we know the most recent dividend and the growth rate

The Dividend Discount Model (DDM)

• With these assumptions, we can derive a

model that is variously known as the Dividend Discount Model, the Constant Growth Model,

or the Gordon Model:

• This model gives us the present value of an

infinite stream of dividends that are growing

Estimating the DDM Inputs

• The DDM requires us to estimate the dividend growth rate

and the required rate of return

• The dividend growth rate can be estimated in three ways:

– Use the historical growth rate and assume it will continue

– Use the equation: g = br

– Generate your own forecast with whatever method seems appropriate

krf + bi(km – krf) or some other asset pricing model

The DDM: An Example

• Recall our previous example in which the

dividends were growing at 8% per year, and

your required return was 15%.

• Note that this is exactly the same value that

we got earlier, but we didn’t have to use an

assumed future selling price.

The DDM Extended

• There is no reason that we can’t use the DDM

at any point in time.

• For example, we might want to calculate the price that a stock should sell for in two years.

• To do this, we can simply generalize the DDM:

• For example, to value a stock at year 2, we

N CS



The DDM Example (cont.)

• In the earlier example, how did we know that the stock would be selling for $33.33 in two years?

• Note that the period 3 dividend must be 8% larger than the period 2 dividend, so:

• Remember, the value at period 2 is simply the present value of D3, D4, D5, …, D∞

What if Growth Isn’t Constant?

• The DDM assumes that dividends will grow at a constant rate forever, but what if they don’t?

• If we assume that growth will eventually be constant, then we can modify the DDM

• Recall that the intrinsic value of the stock is the present value

of its future cash flows Further, we can use the DDM to

determine the value of the stock at some future period when growth is constant If we calculate the present value of that price and the present value of the dividends up to that point,

we will have the present value of all of the future cash flows

What if Growth Isn’t Constant? (cont.)

• Let’s take our previous example, but assume that the dividend will grow at a rate of 15%

per year for the next three years before

settling down to a constant 8% per year

What’s the value of the stock now? (Recall

2.1275 2.4466 2.8136 3.0387 …

g = 15% g = 8%

What if Growth Isn’t Constant? (cont.)

• First, note that we can calculate the value of the stock at the end of period 3 (using D4):

43 08

15

0387

34 15

1

41 43 8136

2 15

1

4466

2 15

1

1275

2

3 2

V

Two-Stage DDM Valuation Model

• The previous example showed one way to

value a stock with two (or more) growth rates Typically, such a company can be expected to have a period of supra-normal growth

followed by a slower growth rate that we can expect to last for a long time.

• In these cases we can use the two-stage DDM:

CS CS

n n

CS CS

CS

k

g k

g g

D k

g g

k

g D

1

1 1

2 1

0 1

1 1 0

Two-Stage DDM Valuation Model (cont.)

• The two-stage growth model is not a complex as it seems:

– The first term is simply the present value of the first N dividends (those before the constant growth period)

– The second term is the present value of the future stock price.

– So, the model is just a mathematical formulation of the methodology that was presented earlier It is nothing more than an equation to calculate the present value of a set of cash flows that are expected to follow a particular growth pattern in the future.

CS CS

CS

k

g k

g g

D k

g g

k

g D

1

1 1

2 1

0

1

1

1 0

PV of the first N dividends + PV of stock price at period N

Three-Stage DDM Valuation Model

• One improvement that we can make to the

two-stage DDM is to allow the growth rate to change slowly rather than instantaneously.

• The three-stage DDM is given by:

0

2

g k

D V

CS CS

Other Valuation Methods

• Some companies do not pay dividends, or the dividends are unpredictable.

• In these cases we have several other possible valuation models:

– Earnings Model

– Free Cash Flow Model

– P/E approach

– Price to Sales (P/S)

The Earnings Model

• The earnings model separates a company’s

earnings (EPS) into two components:

– Current earnings, which are assumed to be

repeated forever with no growth and 100%

The Earnings Model (cont.)

so this represents the minimum value (assuming profitable growth)

• If the company grows beyond their current EPS by reinvesting

a portion of their earnings, then the value of these growth

opportunities is the present value of the additional earnings

in future years

• The growth in earnings will be equal to the ROE times the

retention ratio (1 – payout ratio):

• Where b = retention ratio and r = ROE (return on equity)

br

g 

The Earnings Model (cont.)

• If the company can maintain this growth rate forever, then the present value of their growth opportunities is:

• Which, since NPV is growing at a constant rate can be rewritten as:

g k k

r RE g

k

RE k

r RE

g k

NPV PVGO

1 1

1

The Earnings Model (cont.)

• The value of the company today must be the sum of the value of the company if it doesn’t grow and the value of the future growth:

1, r is the return on equity, k is the required

g k

k

r RE k

EPS g

k

NPV k

1 1

The Free Cash Flow Model

• Free cash flow is the cash flow that’s left over after making all required investments in

operating assets:

• Where NOPAT is net operating profit after tax

• Note that the total value of the firm equals

the value of its debt plus preferred plus

common:

Cap Op

NOPAT

CS P

V

V   

The Free Cash Flow Model (cont.)

• We can find the total value of the firm’s

operations (not including non-operating

assets), by calculating the present value of its future free cash flows:

• Now, add in the value of its non-operating

assets to get the total value of the firm:

g k

The Free Cash Flow Model (cont.)

• Now, to calculate the value of its equity, we

subtract the value of the firm’s debt and the value of its preferred stock:

• Since this is the total value of its equity, we

divide by the number of shares outstanding to get the per share value of the stock.

 

P D

NonOps

g k

Relative Value Models

• Professional analysts often value stocks relative to one another.

• 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.

• These models are popular, but they do have problems:

– Even within an industry, companies are rarely perfectly comparable.

– There is no way to know for sure what the “correct” price multiple is.

– There is no easy, linear relationship between earnings growth and price

multiples (i.e., we can’t say that because XYZ is growing 2% faster that it’s P/E should be 3 points higher than ABC’s – there are just too many additional

factors).

– A company’s (or industry’s) historical multiples may not be relevant today due

to changes in earnings growth over time.

The 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

• This justified P/E may be based on the industry average P/E, the company’s own historical P/E, or some other P/E that the analyst feels is justified

• To calculate the value of the stock, we merely multiply its next years’ earnings by this justified P/E:

1

EPS E

P

The P/S Approach

• In some cases, companies aren’t currently earning any money and this makes the P/E approach impossible to use (because there are no earnings)

• 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:

1

Sales S

P

Technical Analysis

Introduction

• Technical analysis is the attempt to forecast

stock prices on the basis of market-derived

data.

• Technicians (also known as quantitative

analysts or chartists) usually look at price,

volume and psychological indicators over

time.

• They are looking for trends and patterns in the data that indicate future price movements.

The Potential Rewards

• This chart, from Norman Fosbeck, shows how market

timing can benefit your returns The only problem is that you have to be very good at it

Alternative Market Strategies (1964 to 1984)

Strategy Avg Annual Gain $10,000 Grows To

Buy and Hold 11.46% $ 87,500

Avoid Bear Markets 21.48% $ 489,700

Long and Short Major Swings 27.99% $ 1,391,200

Long and Short Every 5% Swing 93.18% $ 5,240,000,000

The Potential Rewards

• This chart, from Barron’s, shows the benefit of being

smart enough to miss the worst 5 days of the year

between Feb 1966 and Oct 2001

Charting the Market

• Chartists use bar charts, candlestick, or point and figure charts to look for patterns which

may indicate future price movements.

• They also analyze volume and other

psychological indicators (breadth, % of bulls vs

% of bears, put/call ratio, etc.).

• Strict chartists don’t care about fundamentals

at all.

Drawing Bar (OHLC) Charts

• Each bar is composed of 4

• Note that the candlestick body

is empty (white) on up days,

and filled (some color) on

down days

• Note: You should print the

example charts (next two

slides) to see them more

clearly

Open

Close High

Low

Standard Bar Chart

Japanese Candlestick

Open

Close High

Low

Standard Bar Chart

Japanese Candlestick

Types of Charts: Bar Charts

• This is a bar (open, high, low, close or OHLC) chart of

AMAT from early July to mid October 2001

Types of Charts: Japanese Candlesticks

• This is a Japanese Candlestick (open, high, low, close)

chart of AMAT from early July to mid October 2001

Drawing Point & Figure Charts

• Point & Figure charts are

independent of time.

• An X represents an up move.

• An O represents a down move.

• The Box Size is the number of

points needed to make an X or

O.

• The Reversal is the price

change needed to recognize a

change in direction.

• Typically, P&F charts use a

1-point box and a 3-1-point

X X X

X O O X X X

X O O O O

Chart Types: Point & Figure

Charts

• This is a Point & Figure chart of AMAT from early July to mid October 2001

Basic Technical Tools

Trend Lines

• There are three basic

kinds of trends:

– An Up trend where prices

are generally increasing.

– A Down trend where prices

are generally decreasing.

– A Trading Range.

Support & Resistance

• Support and resistance lines

indicate likely ends of trends.

• Resistance results from the

inability to surpass prior highs.

• Support results from the

inability to break below to

prior lows.

• What was support becomes

resistance, and vice-versa.

Support Resistance

Breakout

Simple Moving Averages

• A moving average is simply the

average price (usually the

closing price) over the last N

periods.

• They are used to smooth out

fluctuations of less than N

periods.

• This chart shows MSFT with a

10-day moving average Note

how the moving average

shows much less volatility than

the daily stock price.

30 35 40 45 50 55 60

1 21 41 61 81 101 121 141 161 181 201 221 241

Date MSFT Daily Prices with 10-day MA 9/23/93 to 9/21/94