Equities

An Introduction to Security Valuation : An Introduction to Security Valuation Prepared by: CA Tarun Mahajan

Top Down Approach : The top-down, three-step approach to security valuation starts with a forecast of the direction of the general economy and moves towards an analysis of the industry and the stock. Forecast macroeconomic influences. Determine industry effects. Perform firm analysis. Top Down Approach

Industry Analysis : Industry Analysis Prepared by: CA Tarun Mahajan

Effect of Structural Economic Changes on Industry : Demographics. Demographic factors include: age distribution and population changes, changes in income distribution, ethnic composition of the population, and trends in the geographical distribution of the population. As a large segment of the population reaches their twenties, residential construction, furniture, and related industries will see increased demand. An aging of the overall population can mean significant growth for the healthcare industry and developers of retirement communities. Lifestyles. An example of the effect of changing lifestyles on industry growth prospects is the increase in meals consumed outside the home and catalog sales, as the percentage of families with two employed spouses has increased. Effect of Structural Economic Changes on Industry

Effect of Structural Economic Changes on Industry : Technology. Changes in technology have had very important consequences for many industries over time. Say pagers are out and mobile phones are in. Politics and regulation. Changes in the political climate and changes in specific government regulations can also have significant effects on particular industries. e.g., FDI norms relaxed after left parties went out of govt. in India. Effect of Structural Economic Changes on Industry

Equity: Concept & Technique : Equity: Concept & Technique Prepared By: CA Tarun Mahajan

Business Cycle Stages : Business Cycle Stages

Industry Life Cycle Stage : Pioneering phase: During the start up phase the industry experiences modest sales growth and very small or negative profit margins. Rapid accelerating growth phase: During this stage markets develop for the industry’s products and demand grows rapidly. There is limited competition among the few firms in the industry, and profit margins will be very high. Mature growth phase: Here, sales growth is still above normal, but growth is no longer accelerating. Competition increases and profit margins begin to decline. Stabilization and market maturity phase: This is the longest phase. Industry growth rates will approach the growth rate of the aggregate economy. Competition produces tight profit margins and ROEs become competitive (normal). Deceleration of growth and decline: Demand shifts away from the industry. Growth of substitute products causes declining profit margins. Industry Life Cycle Stage

Industry Life Cycle Stage : Industry Life Cycle Stage

Concentration ratio and Herfindahl Index : A concentration ratio is calculated as the percentage market share of the N largest firms in an industry. One advantage of the N-firm concentration ratio is that it is easy to understand. A 5-firm ratio of 80% gives a good idea of what the industry looks like in terms of competition. The Herfindahl index is calculated as the sum of the squared market shares of the N largest firms (an N-firm Herfindahl index) or of all the firms in the industry (Herfindahl index for the entire industry). Example: An industry has four firms with market shares of 40%, 30%, 20%, and 10%. Calculate the three-firm concentration ratio and the Herfindahl index for this industry. Concentration ratio and Herfindahl Index

Concentration ratio and Herfindahl Index : Answer: The three-firm concentration ratio is: 0.4 + 0.3 + 0.2 = 90%.The Herfindahl index is: 0.42 + 0.32 + 0.22 + 0.12 = 0.3 An advantage of the Herfindahl index is that it can distinguish between two industries that have the same concentration ratio but different market shares for the largest firms, because it puts more weight on the market shares of the largest firms by its construction. Herfindahl ratio between 0-0.1 indicates lack of concentration, between 0.1-0.18 shows some degree of concentration and above 0.18 shows high concentration. Concentration ratio and Herfindahl Index

Risk with respect to global industry analysis : Competition in markets: Looking at the relation of price to average cost can provide information about the strategies that firms are following in an industry. The viability of strategies to keep new competitors out of an industry or to drive existing competitors out of an industry can be a source of risk. Competition along the value chain: Profits and high rates of return may lead to efforts to share in these profits by labor, suppliers of intermediate products, distributors, buyers, and/or outsourcing partners. Governmental policies: Some companies are subsidized or otherwise advantaged by the policies and institutions of the governments in their home countries. In other instances, governmental regulation may disadvantage a company. Market risk factors: Risk can also be gauged by the returns-based measures of total risk and market risk (covariance risk). These measures may change over a business cycle or in response to a changed competitive structure within the industry. Risk with respect to global industry analysis

Porter’s five factors that determine industry competition : Rivalry among the existing competitors. Rivalry is high when many equal-sized firms compete within an industry. Slow growth leads to competition when firms fight for market share, and high fixed costs lead to price cutting as firms try to operate at full capacity. Threat of new entrants. The easier it is to enter the market, the greater the potential for competition. Barriers to entry help limit competition. Threat of substitute products. The profit potential in an industry is limited when many substitute products exist. There are higher levels of competition and lower profit margins for more commodity-like products. Bargaining power of buyers. A limited number of buyers or a high concentration of buyers relative to sellers places the buying firms in an advantageous position over sellers. This means the buying firms have significant control over prices. Bargaining power of suppliers. A limited number of selling firms or a high number of sellers relative to buyers places the selling firms in an advantageous position over buyers. This means the selling firms have significant control over prices. Porter’s five factors that determine industry competition

Company Analysis & Stock Selection : Company Analysis & Stock Selection Prepared by: CA Tarun Mahajan

Differentiate Between : Differentiate Between Growth Company: ones that consistently earn higher returns than required by their risk. Defensive company is a company that has earnings that are relatively insensitive to downturns in the economy. A utility company is a good example. These types of firms typically have low business risk and moderate financial risk. Growth stock : is one that earns higher returns than other stocks of equivalent risk. Typically growth stocks have higher P/E ratios. Defensive stock is a stock that will not decline as much as the market when the overall market declines.. Defensive stocks are characterized by having low beta values.

Differentiate Between : Differentiate Between cyclical company is a company with earnings that tend to follow the business cycle. An automobile company is a good example. Cyclical companies often have high levels of fixed costs (business risk) and/or leverage (financial risk). speculative company is a company that has assets that are very risky, but have the potential to generate very large earnings. An oil exploration company is a good example. cyclical stock is a stock with rates of return that will change more than changes in the return on the overall market. These are stocks with betas greater than one. A speculative stock is a stock that is highly likely to have very low or negative returns, & low probability of a enormous return.

EPS, P/E ratio and Stock Valuation : We know that MPS = EPS x P/E A firm’s earnings per share (EPS) can be estimated using the following equation: Expected EPS = [(sales)(EBITDA %) – depreciation – interest](1 – tax rate) A firm’s expected earnings multiplier (P/E) can be calculated using either of two methods: Macro analysis approach estimates the company’s P/E ratio by comparing it to industry and market P/E ratios. Microanalysis approach calculates a point estimate of the firm’s expected P/E ratio: (on next slide) EPS, P/E ratio and Stock Valuation

Slide 18 : Microanalysis approach: Estimate the firm’s projected dividend payout ratio, D1/E1. This is done with comparative analysis of the firm’s payout history, stated goals, and industry. Estimate the firm’s required rate of return on equity: k = RFR + [E(RMKT – RFR)]Beta Estimate the firm’s expected growth rate: g = (retention rate)(ROE) Compute the firm’s future earnings multiplier: (P/E)1 = (D1/E1) / (k – g) Now the above intrinsic value is compared with current market price to arrive at the decision.

Security Valuation (Part II) : Security Valuation (Part II) Prepared by: CA Tarun Mahajan

Basic Concept : An Investor can earn return in various ways like, dividend, capital gain, Interest on bonds etc. Investment returns can also be measured as earnings per share of common stock, operating cash flow, or some other cash flow measure. Value of anything is directly related to its performance and inversely related to expectations. Higher the performance higher the value and higher the expectations lower the value and vice versa. Basic Concept

Value of preference share using DDM : Example: Value the preferred stock of a company that pays a $5 annual dividend. The firm’s bonds are currently yielding 8.5% and preferred shares are priced to yield 50 basis points below the firm’s bond yield. Step 1: Determine the discount rate. 8.5% - 0.5% = 8% Step 2: Value the preferred. Value of preference share using DDM

Value of common stock using DDM : The infinite period DDM model assumes that the growth rate (g) in dividends is constant. Next year’s dividend D1 is just D0(1 + g) and the second year’s dividend is just D0 (1 + g)2. The equation using this assumption is: This equation simplifies to the infinite period dividend discount model. Value of common stock using DDM

Earning Multiplier Model : Example: A firm has an expected dividend payout ratio of 60%, a required rate of return of 11%, and an expected dividend growth rate of 5%. What is the firm’s expected P/E ratio? If you expect next year’s earnings (E1) to be $3.50, what is the value of the stock today? Step 1: Estimate the P/E ratio: 0.6/(0.11 - 0.05) = 10 Step 2: Calculate the value estimate: (E1)(P/E1) = ($3.50)(10) = $35.00 Salient features of P/E: The main determinant of the size of the P/E ratio is the difference between k and g. The relevant P/E ratio you should study is the expected (P0/E1) ratio not the historical (P0/E0) ratio. The P/E ratio is just a restatement of the DDM. So anything that influences stock prices through the DDM will also have the same effect on the P/E ratio. Earning Multiplier Model

Components of Investors’ required rate of return : The required rate of return is influenced by: The real risk-free rate (RFRreal) which is determined by the supply and demand for capital in the country. The real risk-free rate is the rate investors would require if there were absolutely no risk or inflation. An inflation premium, which investors require to compensate for their potential loss of purchasing power. A risk premium to compensate investors for the uncertainty of returns expected from an investment. Since different investments have different patterns of return and different guarantees, risk premiums can differ substantially. The required return formula is:RFRnominal = (1 + RFRreal)(1 + IP)(1 + RP) - 1 Components of Investors’ required rate of return

Types of Risk : Business risk is a function of variability of economic activity within a country, and depends on operating leverage used by individual firms. Financial risk is different among firms because many assume vastly different financing structures. Liquidity risk is often found in countries with small or inactive capital markets. Exchange rate risk is the added uncertainty of returns caused by changes in exchange rates for the currency of another country. Country risk arises from unexpected events in a country - usually political or economic. Types of Risk

Analysis of Growth Rate : Growth rate used in DDM is ROE x RR. It means that higher return will result in higher growth but higher dividend will result in lower growth. Example: What is the firm's growth rate given that the firm earns 10% on equity of $100 and pays out 40% of earnings in dividends? Analysis of growth: Earnings growth = ($10.60 - $10)/$10 = 6% and dividend growth = ($4.24 - $4)/$4 = 6%.Analysis of stock price: assume k = 10%.Price at the beginning of period 1 = D1/(k - g) = $4/(0.10 - 0.06) = $100.Price at the beginning of period 2 = D2/(k - g) = $4.24/(0.10 - 0.06) = $106The stock's price will grow at a 6% rate just like earnings and dividends. Analysis of Growth Rate

Price Multiples : Price Multiples Prepared by: CA Tarun Mahajan

Introduction : In all the price multiples, Market price share comes in the numerator while the other variables are kept in denominator. The popular ratios are P/E, P/BV, P/S and P/CF. Price Earning ratio: trailing P/E = Market price per share EPS for previous 12 months leading P/E = Market price per share Forecasted EPS over next 12 months Introduction

Price Earning Ratio : Lakeland Investments, Inc., reported USD22 million in earnings during fiscal year 2007. An analyst forecasts an EPS over the next 12 months of USD2.00. Lakeland has 44 million shares outstanding at a market price of USD18.00 per share. Calculate Lakeland's trailing and leading P/E ratios. 2002 EPS = USD22,000,000 / 44,000,000 = USD0.50Trailing P/E = USD18.00 / USD0.50 = 36.0Leading P/E = USD18.00 / USD2.00 = 9.0 Companies which have higher future growth prospects and good quality of reported earning have higher P/E ratio. Price Earning Ratio

P/E Ratio: pros & cons : Rationales for Using the P/E Ratio: Earnings power, as measured by earnings per share (EPS), is the primary determinant of investment value. The P/E ratio is popular in the investment community. Empirical research shows that P/E differences are significantly related to long-run average stock returns. Drawbacks of Using the P/E Ratio: Earnings can be negative, which produces a useless P/E ratio. The volatile, transitory portion of earnings makes the interpretation of P/E difficult for analysts. Management discretion within allowed accounting practices can distort reported earnings and thereby lessen the comparability of P/E ratios across firms. P/E Ratio: pros & cons

Price to Book Value ratio : P/B ratio = market value of equity / book value of equitywhere: book value of equity = (Total assets - total liabilities) - Preferred stock Rationales for Using the P/BV Ratio: Book value is a cumulative amount that is usually positive, even when the firm reports a loss and EPS is negative. Thus, a P/BV can typically be used when P/E cannot. Book value is more stable than EPS, so it may be more useful than P/E when EPS is particularly high, low, or volatile. Book value is an appropriate measure of net asset value for firms that primarily hold liquid assets. Examples include finance, investment, insurance, and banking firms. P/BV can be useful in valuing companies that are expected to go out of business. Empirical research shows that P/BV ratios help explain differences in long-run average returns. Price to Book Value ratio

Price to Book Value ratio : Drawbacks of Using the P/BV Ratio: Different accounting conventions can obscure the true investment in the firm made by shareholders, which reduces the comparability of P/BV ratios across firms and countries. For example, research and development costs (R&D) are expensed in the U.S., which can understate investment and overstate income over time. Inflation and technological change can cause the book and market value of assets to differ significantly, so book value is not an accurate measure of the value of the shareholders’ investment. This makes it more difficult to compare P/BV ratios across firms. P/BV ratios can be misleading when there are significant differences in the asset size of the firms under consideration. P/BV ratios do not recognize the value of nonphysical assets such as human capital. Price to Book Value ratio

Price to Sales Ratio : P/S ratio = market value of equity / total sales Rationales for Using the P/S Ratio: P/S is meaningful even for distressed firms, since sales revenue is always positive. This is not the case for P/E and P/BV ratios, which can be negative. Sales revenue is not as easy to manipulate or distort as EPS and book value, which are significantly affected by accounting conventions. P/S ratios are not as volatile as P/E multiples. This may make P/S ratios more reliable in valuation analysis. P/S ratios are particularly appropriate for valuing stocks in mature or cyclical industries, and start-up companies with no record of earnings. Like P/E and P/BV ratios, empirical research finds that differences in P/S are significantly related to differences in long-term average stock returns. Price to Sales Ratio

Price to Sales Ratio : Drawbacks of Using the P/S Ratio: High growth in sales does not necessarily indicate operating profits as measured by earnings and cash flow. P/S ratios do not capture differences in cost structures across companies. While less subject to distortion, revenue recognition practices can still distort sales forecasts. For example, analysts should look for company practices that speed up revenue recognition. An example is sales on a bill-and-hold basis, which involves selling products and delivering them at a later date. This practice accelerates sales into an earlier reporting period and distorts the P/S ratio. Price to Sales Ratio

Price to Cash Flow Ratio : P/CF ratio = market value of equity / cash flowwhere: cash flow = adjusted CFO, FCFE, or EBITDA Here CFO = net income + Non cash expenses + Adjustment for working capital. Adjusted CFO = CFO + (interest outflow) (1-t) Free Cash flow = CFO – Net capital expenditure Free Cash Flows to Equity = CFO + borrowing – repayment –net capital expenditure. Price to Cash Flow Ratio

Price to Cash Flow Ratio : Rationales for Using the P/CF Ratio: Cash flow is harder for managers to manipulate than earnings. Price to cash flow is more stable than price to earnings. Reliance on cash flow rather than earnings handles the problem of differences in the quality of reported earnings, which is a problem for P/E. Empirical evidence indicates that differences in price to cash flow are significantly related to differences in long-run average stock returns. Price to Cash Flow Ratio

Price to Cash Flow Ratio : Drawbacks of Using the P/CF Ratio: Items affecting actual cash flow from operations are ignored when the EPS plus noncash charges estimate is used. For example, noncash revenue and net changes in working capital are ignored. From a theoretical perspective, free cash flow to equity (FCFE) is probably preferable to cash flow. However, FCFE is more volatile than straight cash flow. Price to Cash Flow Ratio