Introduction to security valuationIntroduction to security valuation

A summary

ReminderReminder

Valuation always precedes the investment decision.

Always.

ObjectiveObjective

Describe the principles and summarize the process of security analysis & valuation.

OutlineOutline

• Introduction to valuation principles, approach & techniques• Discussion of approaches and techniques• Analysis of alternative economies and security markets• Industry analysis • Individual company analysis and stock selection

Valuation philosophy, approaches, and techniquesValuation philosophy, approaches, and techniques

Valuation philosophyValuation philosophy

Acknowledges the basic principles that are important in estimating intrinsic values

Valuation approachValuation approach

Pertains to the valuation process in general

It spells out the steps of the selection process

Valuation techniques/methodsValuation techniques/methods

Refers to the quantitative methods used to estimate intrinsic values for individual securities, industries, and markets

Valuation philosophyValuation philosophy

Fundamental analysisFundamental analysis• Investors have rational expectations.• It is possible to forecast, hence to estimate intrinsic value as a

function of risk and required return

Technical analysisTechnical analysis• Investors are biased, slow in responding to new information,

and overreact• There are recurrent price patterns to be exploited.• It is more meaningful to find trends than to forecast sales,

earnings, risk, return, etc.

ImportantImportant

Valuation philosophy determines what approach and technique to use

Valuation approachesValuation approaches

Top-down (Three-step)

Valuing and selecting securities while accounting for the more general economic context

• Analysis of alternative economies and security marketsAnalysis of alternative economies and security markets• Industry analysis Industry analysis • Individual company analysis and stock selectionIndividual company analysis and stock selection

Bottom-up (Stock picking)

Valuing and selecting securities without accounting for the more general economic conditions

Valuations techniques for markets, industries and Valuations techniques for markets, industries and securitiessecurities

DCF techniquesDCF techniquesIntinsic value = PV of future cash flow

Relative valuation techniquesRelative valuation techniquesRequire the comparison of various market ratios

Both methods should be used in combination

Analysis of alternative economies and security Analysis of alternative economies and security marketsmarkets

Objective:Objective:

Estimate future macroeconomic performance

Evaluate the trend in corporate earnings and security prices

Prevailing view:Prevailing view:

General economic conditions are associated with firm performance

Markets determine individual security returns

How it is done in real lifeHow it is done in real life• Macro technique• Micro technique: DCF & relative valuation• Trend analysis & extrapolation

Macro techniqueMacro technique

Analyze macroeconomic indicators

Macroeconomic indicatorsMacroeconomic indicators

Leading indicatorsLeading indicators

Precede the economic cycle

Coincident indicatorsCoincident indicators

Synchronized with the economic cycle

Lagging indicatorsLagging indicators

Follow in the wake of the economic cycle

Leading indicatorsLeading indicators

• Initial UI claims• Construction of new houses• Manufacturer’s new orders• Stock market indices• M2 Shifts in the money supply propagate through the bond market and stock market (liquidity

transition)

• Consumer and business credit outstanding• Consumer confidence• Etc.

Most important indicators are bundled and used as indices: Unemployment Index, Inflation Index, Consumer confidence Index, etc.

Leading indicatorsLeading indicators

Are the most scrutinized

Not always easy to interpret and use

Ex:• Relationship between interest rates and bond prices: clear• Relationship between interest rates and stock prices: murky

Higher interest rates:• Increase the cost of borrowing• Signal increased demand, higher prices, and higher corporate earnings

Coincident indicatorsCoincident indicators

• Industrial production

• Employee’s payrolls

• Manufacturing sales

• Etc.

Lagging indicatorsLagging indicators

• Average UI duration

• Inventories

• Bank’s prime rate

• Etc.

Micro techniquesMicro techniques

Applied to the market as a whole

Often looks at an index of the most representative securities

Micro techniques: DCF methodMicro techniques: DCF method

Require :

• Expected growth rate in earnings/dividends/free cash flows

• Required rate of return

Estimating the market’s required return: S&P 500Estimating the market’s required return: S&P 500

Risk-free rate:from T-bills to 30-year government bonds

Equity risk premium:

Arithmetic mean (Requities - RT-bill) = approx 9.2% over 75 years

Geometric mean (Requities - RT-bill) = approx 7.6% over 75 years

Rozeff: dividend yield = 1.5% (when above 6% is time to buy)

Bottom line:According to different opinions, required return ranges from 6% to 12%

Micro techniques: Relative valuationMicro techniques: Relative valuation

Estimating future earnings (EPS)Estimating future earnings (EPS)1. Forecast GDP

2. Project corporate sales as a function of GDP

3. Forecast operating profit:• Capacity utilization rate (+)• Unit labor costs(+/-)• Inflation (+/-)• Foreign competition (-)

4. Forecast EPS

Estimating future earnings multipliers (P/E)Estimating future earnings multipliers (P/E)• Changes in EPS are not always good predictors of returns

• Helps spotting bubbles

Industry analysisIndustry analysis

Objective

Evaluate industry trends and structural changes

Methods• Cross sectional performance analysis• Trend analysis• Comparative analysis of firms within an industry

Results of empirical studiesResults of empirical studies

• Returns vary across industries

• No patterns of return as a function of time

• Returns vary within each industry: differentiation

• Consistent pattern of risk differences among industries

Industry trends and the business cycleIndustry trends and the business cycle

Wide-held belief:

Industry performance is related to business cycle.

Industry trends and the business cycleIndustry trends and the business cycle

End of recessionFinance companies do well: more loans, investments in anticipation, etc.

Rock bottomConsumer durables improve: edging consumer confidence and expected income

Upward trendCapital goods improve: expanding to meet demand

PeakOil, gold, timber, etc do well

DeclineConsumer staples do well: one has to eat and live nevertheless

Structural changesStructural changes

• Demographics

• Lifestyles

• Technology

• Politics and regulation

Individual company analysis and stock selectionIndividual company analysis and stock selection

ObjectiveObjective

Identify candidates for the investment decision

Investment decisionInvestment decision

Buy: Intrinsic value > Market price

Individual company analysis and stock selectionIndividual company analysis and stock selection

Company Overall StrategyCompany Overall Strategy• Defensive vs. offensive• Low cost vs. differentiation• Etc.

Management assessmentManagement assessment• Current rivalries

• Threat from new entrants

• Potential substitutes

• Barganning power of suppliers & buyers

• Etc.

Prospects and ChallengesProspects and Challenges• Swot analysis

Financial PerformanceFinancial Performance

ValuationValuation

• DCF

• Relative

ConclusionsConclusions

Intrinsic value is a very elusive concept, subject to personal interpretation

Security valuation, although a very complex process, is not a science.

The principles, approaches and techniques outlined above reflect the prevailing view among security analysts and portfolio managers.