EC7092 Investment Management - University of Leicester · EC7092 Investment Management Suresh...

EC7092 Investment Management

Suresh Mutuswami

November 6, 2011

Suresh Mutuswami EC7092 Investment Management

Road Map

Valuation models

Intrinsic value and holding period returns

Dividend discount models

P/E ratios

Macroeconomic analysis

Industry analysis

Readings

Bodie, Kane and Marcus, Chapters 17 and 18 (up to 18.4included).Other readings (optional): BKM, Section 18.5, Chapter 19.

The Problem

Stock markets are not completely efficient

security prices may not reflect all relevant information about aparticular stock.

Prices are determined by earnings, dividends, risk, the cost ofmoney (interest rate), and the future growth rate.

How do we identify mispriced securities?

Approach described in this lecture as fundamental analysis tovalue equities.Alternative approach is technical analysis which looks at trendsin past prices (not covered in this course).

Valuation Model

Converts a set of observations (or forecasts) of a company’sattributes and relevant macroeconomic variables into aforecast of the market value of company’s stock

Input (future earnings, future dividends, variability of earnings,etc.)

=⇒ Valuation model=⇒ Output (that is expected value or price of stocks and

hence expected returns).

Valuation Model (continued)

Why and when to use the different approaches

Discounted cash flow valuation approach

broadly used in the finance profession.differences are in the specification of cash flows.Difficulties: very dependent on inputs (cash flows growth rate,discount rate) [remember GIGO!]

Relative valuation approach

provides information about how the market is currently valuingsecurities.appropriate when: 1) you have a good set of comparableentities (companies similar in terms of industry, size etc.), 2)the companys industry and the whole market are not valued atthe extreme (serious under/overvaluation).

Technique 1: Expected HPR

The expected one-period return on a genric stock is

E (r) =E (P1)− P0

E (D1)

The first term is the expected appreciation and the secondone is the expected dividend yield.

The required rate of return on the same stock (in equilibrium)is provided by the CAPM:

E (r)CAPM = rf + β(rm − rf )

We say that mispricing occurs when E (r) 6= E (r)CAPM.

Technique 2: Intrinsic Value

The basic concept is that the value of a share of stock isequal to the present value of the cash flows that theshareholder expects to receive from holding the stock.

Generally it is equivalent to the present value of all futuredividends.

Discounted cash flow:

V0 =E (D1) + E (P1)

where k is the market capitalization rate (or required rate ofreturn) obtained from the CAPM.

Mispricing occurs when V0 6= P0.

Example

HSBC is currently quoted at P0 = $125, E (P1) = $134,E (D1) = $5. Further we know that current HIBOR rate is4.3% and the expected risk premium on the HSI is(rM − rf ) = 1%, and the estimated beta on HSBC is 0.60.

We have

E (rHSBC) =134− 125 + 5

125= 0.104

E (rHSBC)CAPM = 0.043 + 0.6× 0.01 = 0.053

Suggestion: BUY or HOLD (HSBC is undervalued).

Example (continued)

What about HSBC intrinsic value?

V0 =134 + 5

1 + 0.053= $132, P0 = $125

Suggestion: BUY (HSBC is undervalued)

Dividend discount models

Intrinsic value one period ahead is

V0 =D1 + P1

where D1 and P1 are unknown future values. How can wecalculate P1 then?Assuming that next period (say year) the stock will sell at theintrinsic value, we have

P1 = V1 =D2 + P2

Substituting in the equation for V0, we get

V0 =D1

1 + k+

D2 + P2

(1 + k)2

Proceeding in a similar way, we obtain

V0 =D1

1 + k+

(1 + k)2+

(1 + k)3+ . . .

Present value rule

Value of a share of stock equals . . .

present value of finite stream of expected future dividends +present value of expected terminal share price.equivalently, present value of infinite stream of expected futuredividends.

Dividends, not earnings

discounting future earnings would amount to double counting,since retained earnings would be counted when they wereearned and when they were paid out subsequently as dividendsto shareholders.

Do I have to wait forever . . .?

In theory, need to forecast the dividend growth rate each year.

In practice, cannot estimate growth forecasts in the distantfuture.

need to make simplifying assumptions about the pattern offuture growth DDM models.

Constant growth model:

dividends grow indefinitely at a constant rate.

Multistage growth models:

constant growth for a finite number of years, followed byslower/faster growth for the indefinite future.constant growth for a finite number of years, followed by aperiod in which growth declines gradually to some steady-statevalue, which then persists indefinitely.

DDMs graphically

Caveat . . .

Models 1-3

offer increasing potential to forecast accurately the futureshare price.make increasing demands on the equity analyst to supply notonly more data, but also data that is itself increasingly difficultto forecast.

More distant forecasts are likely to contain more random noise

eventually, a point of diminishing returns is reached.where this point is depends on the forecasting skills of theequity analyst.

The constant growth DDM

Assume that dividends grow indefinitely at a constant growthrate g .

The constant growth DDM (continued)

Present value of future dividend stream:

D1 = D0(1 + g),D2 = D1(1 + g) = D0(1 + g)2, . . .

V0 = D0(1 + g)

(1 + k)+ D0

(1 + g)2

(1 + k)2+ . . .

The expression for V0 can be simplified to

V0 =D0(1 + g)

k − g=

k − g

Note that this expression is only valid when k > g .

When g > k , the growth rate assumed for dividends would beunsustainable. We need to look at alternative models likemultistage models.

Growth versus Income stocks

Growth stocks

investors buy these because they expect capital gains, and areinterested in the future growth of earnings rather than nextperiod’s dividend.

Income stocks

investors buy these for cash dividends.

The constant growth DDM and investment opportunities

Companies do not pay all earnings in dividends

They compare the returns on potential investments and withthe market required rate (i.e. CAPM).

Dividends become a fraction b of earnings (i.e. retention ratioor plowback ratio) and the intrinsic value is

V0 =E1(1− b)

k − ROE× b

where E1 are expected earnings and ROE is the return onequity (or investment)

Question: what is the impact of the stock price if b increases(more earnings are retained)?

The constant growth DDM and investment opportunities(continued)

Example: consider two firms A and B. Expected earnings pershare are $5. Both pay initially all earnings as constantdividend of $5 (i.e. zero growth) and the market required ratek = 12.5%. Their intrinsic value is

VA = VB =5

0.125= $40

Consider now that potential investments can yield ROE =15% per year. Company B decides to apply a retention rate of60% (only 40% of earnings are paid in dividends)

New investments will generate higher earnings and thereforehigher dividends (given the constant retention rate)

For company B the new dividend growth rate is

0 = gA < gB = ROE× b = 0.15× 0.6 = 0.09

which, in turn, implies:

VA =E1

E1(1− b)

k − gB=

0.125− 0.09= 57.14

Therefore the intrinsic value of a company increases with thepotential impact of investment opportunities (present value ofgrowth opportunities or PVGO).

We can think of the value of a firm as a sum of twocomponents:

V0 =E1

k+ PVGO

The first term is to be interpreted as the no-growth value pershare.

Caveat . . .

The price predicted by the dividend growth model

V0 =D1

k − g

is highly sensitive to changes in k or g .

For example, suppose D1 = 1, k = 10%.

If g = 9%, then V0 = 100. But if g = 8% then V0 = 50.

Also, the one-period model is very simple as it assumes thatthe firm will maintain a stable dividend policy (i.e. keep itsretention rate constant) and earn a stable return on newequity investment over time

Two-period model

Extension of constant growth DDM. High growth ratefollowed by a lower average growth rate.

Motivation: beyond some point in the future (say 5-years),equity analysts cannot differentiate among firms on the basisof dividend growth alone.

Two-period model (continued)

The value of one share of stock (omitting time subscripts) is

1 + k+

D1(1 + g)

(1 + k)2+ . . .+

D1(1 + g)N−1

(1 + k)N+

(1 + k)N

After N periods, form grows at constant rate g2; hence

PN =DN+1

k − g2

Dividend at the end of period N + 1 can be expressed in termsof dividend at the end of period 1:

DN+1 = D1(1 + g)N−1(1 + g2)

Three-period model: Extension of the two-period model

The three-period model does not assume that the dividendgrowth rate drops instantly at the end of period N. Rather, itassumes a gradual fall in growth rate.

Example: Three-period model

Suppose the following information has been provided by astock analyst.

China Mobile has earned $10 per share at the end of period 1(E1).Earnings growth rate is assumed to be g1 = 10% for the next 4years and then decline for 3 years. At the end of year 9 it willreach the steady-state level of g2 = 6%.Firm pays dividend with a retention rate b of 60% for the first5 years and 40% from year 6 onwards.Required market rate k = 7.5%.

What is the intrinsic value of China Mobile stock?

What should we do if the market price of China Mobile stockis $465?

Example: Three-period model (continued)

Year Earnings Growth 100% retention rate Dividend

1 10.00 40% 4.00

2 11.00 10% 40% 4.40

3 12.10 10% 40% 4.84

4 13.31 10% 40% 5.32

5 14.64 10% 40% 5.86

6 15.96 9% 60% 9.58

7 17.24 8% 60% 10.34

8 18.45 7% 60% 11.07

9 19.56 6% 60% 11.74

Example: Three-period model (continued)

We have:

V0−5 =4.00

1.075+

1.0752+

1.0753+

1.0754+

1.0755= 19.49

V5−8 =9.58

1.0756+

1.0757+

1.0758= 18.64

V9−∞ =

(11.74

1.0759

0.075− 0.06= 438.84

V0 = 19.49 + 18.64 + 438.84 = 476.97

P/E ratios

Useful indicator of expected growth opportunities.

Recall that in our example companies A and B had both $5earnings per share. However intrinsic values were different. Ifwe assume that differences between intrinsic values andmarket prices are quickly absorbed we can calculate

5= 8 <

5= 11.14

P/E ratios can give us some idea on which stock to select.

P/E ratios

Using the results of the constant growth DDM:

V0 = P0 =E1(1− b)

k − ROE× b=⇒ P0

1− b

k − ROE× b

P/E ratio increases with ROE:

projects with high return on investment offer goodopportunities for growth.

P/E ratio increases with b, provided ROE > k .

if firm has good investment opportunities, market will assign ita higher P/E ratio.if ROE < k, investors will prefer the firm to pay out itsearnings as dividends.

How to use P/E ratios

P/E ratios are taken commonly as proxies for the expectedgrowth in dividends (or earnings).

Rule of thumb:

expected growth in dividends (or earnings) ought to be equalto the P/E ratio or alternativelythe ratio of P/E to g (= PEG ratio) ought to be (roughly)equal to 1.0.

In One Up on Wall Street, Peter Lynch has said (pp 198):’’The P/E ratio of any company that is fairly

priced will equal its growth rate. I’m talking

here about growth rate of earnings . . . If the P/E

ratio is less than the growth rate, you might

have found yourself a bargain.’’

PEG ratios (in the USA)

Dangerous things, these P/E ratios . . .

Reported earnings are subject to accounting conventions.

In periods of high inflation

use of historical costs to calculate depreciation and to valueinventory underestimates replacement costs and tends toinflate earnings.P/E ratios tend to be lower and markets judge companiesearnings to be of “lower quality.”

Earning ’management’ is very common. It is used to improvethe reported profitability of the firm. What expenses areconsidered?

Example: Nasdaq 100 firms reported in 2001 $82 billionprofits, GAAP for the same year reported for the same firms$19 billion losses!

P/E ratios must be interpreted and used with caution.

P/E ratios and inflation

Overview of the valuation process

Did we miss something?

The analysis discussed so far does not include in the picturetwo preliminary steps:

Global/economy analysisIndustry analysis

Are they important?

The prospects of a firm are strongly tied to those of thebroader economy. Therefore equity (fundamental) analysismust consider the business environment in which the firmsoperate.

The global economy

The domestic macroeconomy

The macroeconomy is the environment where all firmsoperate. The ability to forecast the macroeconomy results inhigh investment performance (you must forecast better thanothers!)

Key variables: Gross Domestic Product (GDP), inflation rate,employment rate, interest rates.

Market shocks (demand and supply) and fiscal/monetarypolicy. However, this leads to business cycle.

The business cycle

Business cycle = recurring pattern of expansions andcontractions

Important to forecast (companies sensitivity to business cycle)

cyclical industriesdefensive industries

Industry analysis

After identifying the prospects of the whole economy it isimportant to understand how macroeconomic performance isspread among sectors/industries (identifying future winnersand losers).

Industry analysis (continued)

The relationship between dividends, payout rates, investmentrates and future value growth also depend on the industrylife-cycle (example biotechnology vs. public utility industry inthe US).

An example: Henry Fund

An endowed equity-only portfolio created in 1994 (HenryRoyer and Henry Tippie donated $50,000) at the University ofIowa.

Managed by 12 selected MBA students enrolled in the AppliedSecurity Management course.

The 12 students work on 10 economic sectors: basicmaterials; communications; consumer cyclicals; consumernon-cyclicals; consumer and commercial services; energy andutilities; financial services); healthcare; industrials andtransportation; and technology.

The Henry funds portfolio is divided into three accounts:active, passive and cash.

About 95% of the funds asset are used to perform activeportfolio strategies.

An example: Henry Fund (continued)

Irrational exuberance

Irrational exuberance (continued)

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