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INTRODUCTION |
| This section deals with the valuation of the individual
firm. Equity valuation is one of the most studied areas in finance.
Countless hours are spent by market professionals, academicians and
investors as they try to calculate the intrinsic value of a stock. Bond valuation is a
simple process compared to stock analysis. The value of stock is the
value of the firm itself. A share of stock is simply a portion of the
value of the firm. All shares combined equal the firm's total value.
The term VALUATION to accountants, financiers, and business leaders is a
difficult term to quantify. Land, for example, on a firm's balance
sheet can be valued by making an appraisal. However, even if an
appraisal is done, will all appraisers agree on its price? Probably
not. If we take that same example and extend it over the entire firm,
its assets, holdings, investments, product, and most importantly, its
earnings (and earnings potential), we may being to see how many opinions may
be formed about the firm, its value and its anticipated future value.
To begin the Top Down valuation process, it is necessary to
being with Economic Analysis. If we can envision an inverted
pyramid with three sections; the first section (from the top) holds economic
variables used to measure the health of the economy. The center
section hold industry variables. The bottom section, the smallest
section of the pyramid, holds valuation variables of the individual firm.
Economic Analysis: Business Cycles, Monetary &
Fiscal Policy, Economic Indicators, World Events &
Foreign Trade, Inflation, Public Sentiment, GDP Growth,
Unemployment, Productivity, Capacity Utilization, etc.
Industry Analysis: Industry Structure, Competition, Supply-Demand Relationships, Product Quality, Cost Elements,
Government Regulation, Business Cycle Exposure, etc.
Analysis of the Individual Firm: Forecasts of Earnings, Dividends
and
discount rates, Balance Sheet/Income Statement Analysis, Management,
Research, Return, Risk, etc
This logical progression is used by most analysts to make value judgments
on company value. The analyst would begin at the top of the pyramid,
assess the economic climate from an investment perspective, select an
industry that would best perform in the current economy, then select
individual firms within that industry that would make the best investments.
One of our assignments uses the Value Line Investment Survey. Value
Line holds a great reputation for investment research and information.
They use this Top Down approach (no surprise). We will see this as we
use this assignment.
[ A Bottom-Up approach is the opposite of Top-Down. Those engaging
in Bottom-Up investment analysis are many times called "Stock Pickers"
because they begin with a stock then investigate the industry of that stock,
then assess weather the economy is favoring that industry. Or they do no
analysis at all, meaning that they were privy to a "hot stock" tip from a
friend]
Actual article mentioning top-down and bottom-up analysis including
company earnings and a market forecast:
CLICK HERE.
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ECONOMIC VARIABLES |
 | Discussion of the general economy usually begin with the Business
Cycle. Entire economics courses are devoted to the study of past
business cycles, what they look like, why they behave the way they do
and do we need them. |
| Business Cycle - Swings in economic activity encompassing expansionary
and recessionary periods. Some economists spend their careers
studying the business cycle and trying to forecast its next move.
When business activity reaches a high point, it peaks, a low point
on the cycle is a trough. |
Business Cycle of Economic Activity: The business cycle is usually
a graph of economic activity. The graph shown below would have all of
the characteristics of a typical business cycle: Peaks, troughs,
periods of expansion, periods of reduced economic activity. This
interest rate graph of 6-month T-Bill rates is a good example of how the
economy's activity is tracked.
| GOVERNMENT POLICY: Monetary & Fiscal. |
| Monetary Policy - The Federal Reserve's primary policy variables.
Money Supply and Interest Rates. See my notes on the Fed to get a
more complete definition. |
| Fiscal Policy - Congress primary policy variables. Taxing and
Spending. The US government is known for its deficits (spending more
than income), many believe that this is sound economic policy. Great
political debates have arisen out of deficit spending conversations.
For the first time in over 30 years, the federal government ran a surplus
(income exceeded spending) in year 2000. |
| Economic Indicators - Primary economic variables that are used to
determine our position on the business cycle. It is not important
for us to memorize these; the most important one for us in this class is
Stock Prices (S&P 500) as a major leading indicator.
 | Leading Indicators - 10 variables that may indicate where the economy
will be in the next 3 to 6 months.
 | The 10 Leading Indicators: |
| Workweek |
| Unemployment Claims |
| Orders for Consumer Goods |
| Slower Deliveries |
| Plant and Equipment Orders |
| Building Permits |
| Stock Prices (S&P500) |
| Money Supply |
| Interest Rate Spread |
| Consumer Expectations |
| (This list is regularly printed in the Wall Street Journal) |
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| Coincident Indicators - Economic indicators that change direction at
roughly the same time as the general economy.
| Employees on Non-Agricultural Payrolls |
| Personal Income Less Transfer Payments |
| Industrial Production |
| Manufacturing and Trade Sales |
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| Lagging Indicators - Economic indicators that usually change direction
after business conditions have changed.
| Average duration of unemployment, in weeks |
| Ratio, manufacturing and trade inventories to sales |
| Change in labor cost per unit of output in manufacturing |
| Average Prime Rate charged by Banks |
| Commercial and Industrial Loans Outstanding |
| Ratio, consumer installment credit outstanding to personal income |
| Changes in Consumer Price Index for services |
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| The economic indictors are the property of The Conference Board -
www.conference-board.org. |
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| OTHER ECONOMIC INDICATORS
| Public Attitudes - Consumer confidence. |
| Domestic Legislation - Laws and regulations. |
| Inflation - A general increase in the price of goods and services. |
| Gross Domestic Product (GDP) Growth - GDP is the measure of output
from US factories and related consumption in the US. It does not include
products made by US companies in foreign markets. |
| Unemployment - The percent of the population that wants to work and
are currently not working. |
| Productivity - Output per worker. |
| Capacity Utilization - Output by the firm. |
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INDUSTRY VARIABLES |
| An analyst will focus on, or specialize in a particular industry.
They accumulate all of the knowledge possible on the industry then they
"follow" (analyze by maintaining a mathematical model on the
firm's financials) one or several firms in that industry. The end of
their analysis is to present earnings forecasts and investment
recommendations on the firms that they follow. |
| Industry Structure - An industry is a collection of firms that sell a
like product or engage in a like activity. Examples: The steel
industry, computer industry, travel industry, auto industry. |
| Pure Competition - Firms that are classified as being in a "Purely
Competitive" environment are one of many firms. These firms all sell
the same goods and services at the same price, they are said to be Price
Takers. Pure Competition is a theoretical economic concept. A
convenience store may be the closest example of a purely competitive
business. Entrance into this industry is unlimited. |
| Imperfect Competition is a more realistic example of an actual firm
than is pure competition. Although there are may convenience stores,
they can sell different products and services and can have some variation
in prices. They are too small, however, to be price makers, they are
dictated prices by the demand of the good or service that they are
providing. |
| Oligopoly is a collection of a few, large firms, like the auto
industry. There are large barriers to enter this industry as it is
capital intense. An oligopolistic firm attempts to differentiate its
product from other firms in its industry. Through advertising,
Toyota makes every attempt to differentiate itself away from other car
makers; they, through advertising, want us to believe that their product
is superior to Nissan or Chevrolet. |
| Monopoly. This is a single firm that has a good or service with
no close substitutes. The barriers to entry are many times
impossible. Monopolists are price makers. |
This is a graph of the typical Industry Life Cycle.
When an industry is young, it is in the Introduction or Development Stage, sales or profits are not strong but developing.
Ideally, the industry, if at all successful, will expand at a
rate superior to the over-all economy. We all want
investment that are in the Growth & Expansion phase, the
steep portion of the graph. How many of us dreamed of
being one of the few who invested in Microsoft, Dell, Wal-Mart, Home Depot, etc., from the start of the firm's life!
As an industry matures, it's profits (sales) level off. The firm is
not expected to grow faster than the over-all economy. At this
point, the mature firm is making money and not expanding
like the growth phase. Investors (owners) expect the firm to begin
paying dividends. The auto industry is a great example of an
industry in maturity. Their plants are built, they change the
manufacturing process for each model year and continue
making their product. The auto industry is also an example
of an industry that makes durable goods - those goods are
designed to last for more than a year. A durable goods
industry is one that performs poorly in a recession. It is not
a "recession resistant" industry. What would a consumer stop buying if
they felt their job was unstable? Durable goods. They would not
commit to big purchases if they did not have to. They would wait for
the bad economic times to pass, then perhaps update the "big ticket" items
like cars. A recession resistant industry would be food, pet food,
etc. Where bad economic times barely alter our purchases of these
items. When a recession is coming, many professional money managers
sell out of industries that fare poorly and buy into industries that survive
recessions.
We will discuss the subject of dividend paying stocks very completely in
class. The act of a firm paying dividends is a signal to investors
that they are (1) not able to reinvest the money into the firm profitably;
(2) they are beyond Phase B; (3) the amount of the dividend is "usually
equal to the percentage return of a savings account." A very important
figure.
| Other Factors that Affect Industry Firms:
| Competition |
| Supply/Demand Relationships |
| Product Quality |
| Cost Elements |
| Government Regulation |
| Business Cycle Exposure |
| Financial Norms and Standards |
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COMPANY VARIABLES |
| In this section, we will look at the Wall Street Journal stock
tables to identify the elements of a typical stock listing and also make
calculations on different stocks using typical valuation methods. |
| Dividend Yields and Earnings calculations are the two valuation
methods most commonly referred to in financial publications (like the
WSJ). |
| Forecasts of Earnings - Earnings are the proverbial "bottom line" of
the business. Analysts digest all of the variables listed on this
site, plus perhaps hundreds or even thousands more, all to estimate the
earnings of the firm. A firm's earnings add to capital, which
increases net worth, which brings a higher stock price. |
| Dividends and Discount Rates - Dividends are a divided portion of
earnings distributed to the owners (stockholders) of the firm. The
discount rates apply to the analysis of a firm's stock price by making
calculations on its dividends. We will use a stock valuation model
that shows this. |
| Financial Statements (Balance Sheet and Income Statement) - The two
primary financial statements of the firm. |
| Flow of Funds - Sometimes called the cash-flow statement, this is
another financial statement of the firm, one that examines liquidity and
cash flow. We will NOT use this. |
| Analysis of Accounting Policy and Footnotes - Accounting policies that
affect the industry or firm. |
| Management - Quality of management. |
| Return - Return on assets, return to shareholders, returns of stock
prices. |
| Risk - VOLATILITY of stock prices. Risk of the industry in the
current economic climate, etc. |
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STOCK VALUATION |
| A beginning point on stock valuation is to calculate the
required rate of return of the stock that we are valuing.
Since every company functions differently, even those in the same industry,
their risk/return combinations will be unique. As an investor, one of
our first tasks will be to choose firms that have risk/return elements that
will fit our own investment objective. |
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The Required Rate of Return of a Risky Asset |
| Before the 1950's, investment professionals and investors
had a loose definition of risk and how it related to the expected return of
an investment. The Capital Asset Pricing Model is a
mathematical formula to assist investors in understanding where an
investment may be on the risk-return graph. We know that risk and
return are direct variables. When one increases, the other variable is
expected to increase.
Risk in this model is measured by the volatility of a stock compared to
market volatility. The Beta (ß).
The Beta of the market is always equal to one. If a stock has a beta
of one, it is expected to be as volatile as the market. A beta of 1.5
is indicative of a security that is 50% more volatile than the market.
The more volatility in an investment, the more risk.
The Capital Asset Pricing Model
is used to calculate the required rate of return on a risky asset -
a share of stock. |
| The Model:
Ke = RF
+ ß (RF +
Premium - RF ) Ke is the required rate of
return of a risky asset.
We also need to mention here that the
expected return of the market is equal to:
RF + Premium. and is
usually denoted as Km.
The above model can be
re-written as: Ke = RF
+ ß (Km - RF )
RF is the risk free rate of money. This can be
measured as the rate of return on a bank savings account or usually the rate
on a treasury bill.
Premium is the equity risk premium. This is the rate of return
required to entice an investor out of risk free investments into risky ones.
The risk premium, measured over time has been about 7%.
Beta was described above. |
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THE DIVIDEND DISCOUNT MODEL (DDM) |
| Before the 1980's, dividends on stocks comprised an average
of 46% of the total return on a stock investment, the remaining 54% came
from capital gains.
The 1980's brought the technology boom and numerous
rapidly growing companies that served investors healthy returns and no
mention of dividends.
The "tech-wreck" of 1999-2001, renewed many investor's interest in stable
firms that provided both ingredients of total return: capital gains
and dividends. Check out this article
from Money Magazine on the subject, it will supplement the lecture on the
idea of dividends on stocks.
"Dividends Are Back in Style"
Another article that I found on "The Motley
Fool" (August, 2006) reiterated how important stock dividends are to
investor's total return:
The Secret of Dividends.
A traditional stock valuation model that will appear in almost every
finance text on investments is the Dividend Discount Model or
the Dividend Valuation Model. [If you typed that title in your
favorite internet search engine, you will get some 30,000 hits on the
subject.] The idea is similar to bond valuation. Finance
professionals get excited over any idea that has a known cash flow; first
because it is known (as opposed to being unknown), secondly because it is
cash. A present value calculation can be made on these cash flows to
form a value. With dividends comprising such a large part of total
return, this model was and still is a popular valuation method.
The Value of a Stock is the present value of its expected dividends plus
the present value of the expected share price at some point in the future.
One model that I found on the internet is:
The dividend discount model:
where
| t, n -- the year |
| V -- the value of the stock. |
| D -- the dividend. |
| R -- the discount rate (the required rate of return for a
risky asset, as required by the investor) |
We can see in this "compact" version of the model that the dividends are
represented by "D" and that part of the equation is added to the "V" (stock
value component). The large [greek] Sigma letter in front of the
formula is simply saying that we are summing or adding several components.
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| The models that we use in this class are: The General
Dividend Model and the Constant Growth model.
The General Model:
This model has only a dividend (D) in the numerator; the dividend is divided
by the investors required rate of return for this stock (ke). The
present value of the dividend is being taken using the required rate of
return as the "i" in a present value formula. The (1+ke)1
looks like (1+i)n in a present value model. The negative
sign on the exponent is not present because (1+ke)1
is in the denominator, this is mathematically equivalent to a negative
exponent in the numerator. I know that you are confused.
Vo = D1/(1+ke)1 +
D2/(1+ke)2 + D3/(1+ke)3
+ D4/(1+ke)4 + V4/(1+ke)4
The Constant Growth Model:
Vo = D1(1+g)1 / (1+ke)1
+ D2(1+g)2 / (1+ke)2 + D3(1+g)3
/ (1+ke)3 +D4(1+g)4 / (1+ke)4
+ V4(1+g)4 / (1+ke)4
This model has a growth rate in the numerator (1+g)1
If dividends of the firm are being increased over time, a growth rate
must be added to the model. In the general model, there was no
dividend growth, the firm is paying the same dividend quarter after quarter.
This model is more cumbersome to calculate due to the added component, but
it is more realistic. Firms that pay dividends want to increase
dividends over time. We are increasing dividends by applying the
future value of a single sum formula then, dividing it by the present value
of a single sum formula! The dividends are being appropriately
increased by the growth rate, the present value must be taken to value those
amounts today. |
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What Investopedia says about Dividend Signaling:
A theory that suggests company announcements of an increase in dividend
payouts acts as an indicator of the firm possessing strong future prospects.
The rationale behind dividend signaling models stems from game theory. A
manager that has good investment opportunities is more likely to "signal",
than one who doesn't, because it is in their best interest to do so.
Over the years the concept that dividend signaling can predict positive
future performance has been a hotly contested subject. Many studies
have been done to see if the markets reaction to a "signal" is significant
enough to support this theory. For the most part the tests have shown that
dividend signaling
does occur when companies either increase or decrease the amount of
dividends they will be paying out.
The theory of dividend signaling is also a key concept used by proponents of
inefficient markets.
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Motley Fool Article about Stock
Dividends and how important they are |
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