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

Securities Analysis, Section IV

Security Valuation

&

EIC Analysis

(Part 1)

Lecture Presentation Software to accompany

Investment Analysis and Portfolio Management

Sixth Editionby

Frank K. Reilly & Keith C. Brown

Chapters 11,14,15, & 18

Copyright © 2000 by Harcourt, Inc. All rights reserved

The Investment Decision Process

• Determine the required rate of return• Evaluate the investment to determine if its market

price is consistent with your required rate of return– Estimate the value of the security based on its expected

cash flows and your required rate of return

– Compare this intrinsic value to the market price to decide if you want to buy it

• But how do you narrow down the list of potential investments to a reasonable level?


Valuation Process

• Two general approaches:1. Top-down, three-step approach

2. Bottom-up, stock valuation, stock picking (stock screening) approach

• The difference between the two approaches is the perceived importance of economic and industry influence on individual firms and stocks


Top-Down, Three-Step Approach1. General economic influences

– Decide how to allocate investment funds among countries, and within countries to bonds, stocks, and cash

2. Industry influences– Determine which industries will prosper and which

industries will suffer on a global basis and within countries

3. Company analysis– Determine which companies in the selected industries

will prosper and which stocks are undervalued


Does the Three-Step Process Work?

• Studies indicate that most changes in an individual firm’s earnings can be attributed to changes in aggregate corporate earnings and changes in the firm’s industry

• If you are trying to stay ahead of the market quarter by quarter, then this is your best bet


Does the Three-Step Process Work?

• Studies have found a relationship between aggregate stock prices and various economic series such as employment, income, or production

• An analysis of the relationship between rates of return for the aggregate stock market, alternative industries, and individual stocks showed that most of the changes in rates of return for individual stock could be explained by changes in the rates of return for the aggregate stock market and the stock’s industry


Theory of Valuation

• The value of an asset is the present value of its expected returns

• You expect an asset to provide a stream of returns while you own it

• To convert this stream of returns to a value for the security, you must discount this stream at your required rate of return

• This requires estimates of:– The stream of expected returns, and– The required rate of return on the investment


Stream of Expected Returns

• First item to estimate• Two considerations:• Form of returns

– Earnings– Cash flows– Dividends– Interest payments– Capital gains (increases in value)

• Time pattern and growth rate of returns


Required Rate of Return

• Second item to estimate

• Determined by– 1. Economy’s risk-free real rate of return, plus– 2. Expected rate of inflation during the holding

period, plus– 3. Risk premium determined by the uncertainty

of returns


Uncertainty of Returns

There are many different sources of uncertainty:• Internal characteristics of assets

– Business risk (BR)

– Financial risk (FR)

– Liquidity risk (LR)

– Exchange rate risk (ERR)

– Country risk (CR)

• Market determined factors– Systematic risk (beta) or

– Multiple APT factors


Investment Decision Process: A Comparison of Estimated Values and

Market Prices

If Estimated Value > Market Price, Buy

If Estimated Value < Market Price, Don’t Buy


Top-Down Approach, Step One

Two Components:

• Geographic (International) Allocation– Which region / country?

• Asset Allocation– Bonds?– Preferred Stocks?– Common Stocks?


Valuation of Bonds

• Valuation of Bonds is relatively easy because the size and time pattern of cash flows from the bond over its life are known

1. Interest payments usually every six months (semiannually) equal to one-half the coupon rate times the face value of the bond

2. Payment of principal on the bond’s maturity date


Valuation of Bonds

• Example: in 2000, a $10,000 bond due in 2015 with 10% coupon

• Discount these payments at the investor’s required rate of return (if the risk-free rate is 9% and the investor requires a risk premium of 1%, then the required rate of return would be 10%)


Valuation of BondsPresent value of the interest payments is an

annuity for thirty periods at one-half the required rate of return:

$500 x 15.3725 = $7,686

The present value of the principal is similarly discounted:

$10,000 x .2314 = $2,314

Total value of bond at 10 percent = $10,000


Valuation of Bonds

The $10,000 valuation is the amount that an investor should be willing to pay for this bond, assuming that the required rate of return on a bond of this risk class is 10 percent


Valuation of Bonds

• If the market price of the bond is above this value, the investor should not buy it because the promised yield to maturity will be less than the investor’s required rate of return

• But typically there is little mispricing in bonds• “Home Run” in bond investing is:

1. Investing in bond just before unanticipated upgrade

2. Lengthening duration just before interest rate decrease


Valuation of BondsAlternatively, assuming an investor requires a 12

percent return on this bond, its value would be: $500 x 13.7648 = $6,882

$10,000 x .1741 = 1,741Total value of bond at 12 percent = $8,623

Higher rates of return lower the value!(and vice versa)

Compare the computed value to the market price of the bond to determine whether you should buy it.


What Determines the Price Volatility for Bonds

• The maturity effect

• The coupon effect

• The yield level effect

• Some trading strategies


The Duration Measure

• Since price volatility of a bond varies inversely with its coupon and directly with its term to maturity, it is necessary to determine the best combination of these two variables to achieve your objective

• A composite measure considering both coupon and maturity would be beneficial


The Duration Measure

Developed by Frederick R. Macaulay, 1938

Where:

t = time period in which the coupon or principal payment occurs

Ct = interest or principal payment that occurs in period t

i = yield to maturity on the bond

price

)(

)1(

)1(

)(

1

1

1

n

tt

n

tt

t

n

tt

t CPVt

i

Ci

tC

D


Characteristics of Duration• Duration of a bond with coupons is always less than its

term to maturity because duration gives weight to these interim payments

– A zero-coupon bond’s duration equals its maturity

• An inverse relation between duration and coupon

• A positive relation between term to maturity and duration, but duration increases at a decreasing rate with maturity

• An inverse relation between YTM and duration

• Sinking funds and call provisions can have a dramatic effect on a bond’s duration


Duration and Bond Price Volatility

An adjusted measure of duration can be used to approximate the price volatility of a bond

m

YTM1

durationMacaulay duration modified

Where:

m = number of payments a year

YTM = nominal YTM


Duration and Bond Price Volatility• Bond price movements will vary proportionally with

modified duration for small changes in yields

• An estimate of the percentage change in bond prices equals the change in yield time modified duration

iDP

P

mod100

Where:

P = change in price for the bond

P = beginning price for the bond

Dmod = the modified duration of the bond

i = yield change in basis points divided by 100


Trading Strategies Using Duration• Longest-duration security provides the maximum price

variation

• If you expect a decline in interest rates, increase the average duration of your bond portfolio to experience maximum price volatility

• If you expect an increase in interest rates, reduce the average duration to minimize your price decline

• Note that the duration of your portfolio is the market-value-weighted average of the duration of the individual bonds in the portfolio


Valuation of Preferred Stock

• Owner of preferred stock receives a promise to pay a stated dividend, usually quarterly, for perpetuity

• Since payments are only made after the firm meets its bond interest payments, there is more uncertainty of returns

• Tax treatment of dividends paid to corporations (80% tax-exempt) offsets the risk premium



pk

DividendV

• The value is simply the stated annual dividend divided by the required rate of return on preferred stock (kp)



pk

DividendV


Assume a preferred stock has a $100 par value and a dividend of $8 a year and a required rate of return of 9 percent



pk

DividendV



.09

$8V



pk

DividendV



.09

$8V 89.88$



Conversely, given a market price, you can derive its promised yield:



Given a market price, you can derive its promised yield

Price

Dividendk p



Given a market price, you can derive its promised yield

At a market price of $85, this preferred stock yield would be

Price

Dividendk p

0941.$85.00

$8k p


Top-Down Approach, Step Two

• Industry Analysis


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


Links Between the Economyand 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


The Stock Market and the Business Cycle

Figure 19.2



Figure 19.2

trough

peak



Figure 19.2

Financial Stocks Excel

trough

peakConsumer Durables

Excel

Capital Goods Excel

Basic Industries

Excel

Consumer Staples Excel


Cyclical Economic Factors

• Inflation

• Interest rates

• International economics

• Consumer sentiment– All give clues about when to rotate

portfolio


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


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?


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)


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


Sales Forecasting and Industry Life Cycle

• Pioneering development• Rapidly accelerating industry

growth• Mature industry growth• Stabilization and market maturity• Deceleration of growth and decline


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


Sales Forecasting and the Industry-Economy Relationship

• Compare industry sales to aggregate economic series related to the goods and services provided by the industry


Forecasting Earnings Per Share

• Analysis of industry competition

• Analysis of competitive structure

• Porter’s concept of competitive strategy


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

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

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