Study Session 14 - Industry and Company Analysis

An Introduction to Security Valuation and Industry Analysis

Two basic valuation techniques:

1. valuation based on PV of expected future cash flows
2. relative valuation based on expected multiple of firm's expected performance e.g. earnings per share or sales per share (more appropriate when market itself is neither severely under or over valued)

• if firm pays dividends and is mature (growth is stable), use PV of expected future dividends discounted at the cost of equity
• if firm does not pay dividends, use PV of operating free cash flow or free cash flow to equity discounted at WACC

LOS 56a - Explain the top-down approach, and its underlying logic to the security valuation process

go from general to specific in your evaluation:

• economic analysis -> industry analysis -> stock analysis

1. Forecast Macroeconomic Influences

aggregate demand may be affected by:

• fiscal policy
• tax cuts (increases demand)
• tax increases
• government spending (increases demand)
  Monetary policy can have many effects:
• decrease in money supply = interest rate rise = costs rise = demand shrinks
• increase in money supply = interest rate fall = costs fall = demand grows
• increase money supply too quickly can cause inflation
• rising interest rates reduce demand for investment funds

2. Determine Industry Effects

• Identify industries that should prosper or suffer from the economic outlook
• are the industries sensitive to economic change?
• are they cyclical industries?

3. Perform firm analysis

• Compare firms within each attractive industry from #2 using financial ratios and cash flow analysis
• or, if shorting, identify those that should suffer
• not only past performance, but prospects

LOS 56b - State the various forms of investment returns

many forms:

• cash flows from projects
• interest income on bonds
• dividend income on stocks
• capital gains (increase in the price of an asset)
• earnings per share
• operating cash flow

LOS 56c: Calculate and interpret the value of both a preferred stock and a common stock using the dividend discount model

Valuing perferred stock is like valuing a perpetuity:

• pref. stock value = Dp/kp

where kp is the discount rate i.e. the yield on the preferred shares

NB do not confuse the dividend rate with the discount rate or the par with the price

default risk involved means that firm's required rate on perferred (kp) should be above the firms bond rate but the fact that 80% of dividends are tax exempt means that they preferred yields are below the yields on the firm's highest grade bonds

We are calculating what the price "should" be i.e. its instrinsic value

One year holding period so this is just the holding period return i.e. the future expected sum of the dividend and the stock price discounted at the required rate of return ke (which can be found using CAPM)

• value = (dividend to be rec'd/(1 + ke)) + (year end price/(1 + ke))

so predict the year end dividend to be received (D1) by multiplying prior dividend by 1 + g

Two year holding period so this is just like valuing a bond in some ways. It is the NPV of all the cash flows where the final cash flow is the sum of the final dividend plus the stock price (all discounted at ke)

Infinite Period DDM is just like valuing a perpetuity because that is exactly what it is for firms with a constant growth rate so...

• PVo = D1/(ke - g)
• where D1 is D0 multiplied by 1 + g
• rearranging the terms we get ke = (D1/PVo) + g which we have seen in WACC analysis
• also note that this is the same as valuing preferred stock but where g = 0

relationship between ke and g:

• As difference between ke and g widens, the value of the stock falls and vice versa
• Small changes in ke and g cause large changes in stock's value

assumptions of the infinite period DDM

• stock pays dividends and they grow at a constant rate
• constant growth rate g is never expected to change
• ke must be greater than g if not the math will not work

if any of these assumptions is not met, the model breaks down

NB look for words like "indefinitely", "forever", "infinitely" to determine infinite DDM. Also look for words like "just paid" or "recently paid" for ref to last dividend and "will pay" or "is expected to pay" for D1.

value of a Common Stock for a Company Experiencing Temporary Supernormal Growth

• value = (D1/(1+ke)) + (D2/(1+ke)²) + ... + (Dn/(1+ke)ⁿ) + (Pn/(1+ke)ⁿ)
• where:
• Dn = last dividend of supernormal growth period
• Dn+1 = first dividend that will grow at constant rate g forever
• Pn = Dn+1/(ke - g)

this is actually intuitive: find the NPV of the supernormal growth period and add it to the infinite DDM value (discounted for the number of periods away from t = 0) of the post supernormal (stable) period to obtain the value.

watch out i often mess up by how many periods i should discount the perpetuity part of this equation because it is misleading. Discount back the number of periods that there is supernormal growth e.g. if you have two dividends during the supernormal period and then a dividend at the constant growth rate, find the value of the perpetuity and discount back two periods.

if dividends are not paid during the supernormal growth period, you need only find the PV of the infinite DDM for the stock and dividend when the stable period begins

LOS 56d: Show how to use the DDM to develop an earnings multiplier model and explain the factors in the DDM that affect a stock's price-to-earnings (P/E) ratio

DDM related to P/E like this: take the infinite DDM model where P0 = D1/(ke - g) and divide both sides by next year's projected earnings E1 and you get:

P0/E1 = ((D1/E1)/(ke - g))

So P/E is a function of:

• D1/E1 = the expected dividend payout ratio
• k = the reuqired rate of return on the stock
• g = the expected constant growth rate of dividends

So ceteris paribus the P/E ratio will increase with:

1. a higher dividend payout rate
2. a higher growth rate
3. a lower required rate of return

key facts about earnings multiplier approach to valuation is that:

• the main determinant of size of the P/E ratio is the difference between k and g since it has a significant impact on sotkc price
• the relevant P/E ratio is the expected or leading P/E ratio i.e. P0/E1 not the historical P/E ratio
• the P/E ratio is just a restatement of the DDM, so anything that influences stock prices in the DDM will have the same effect on the P/E ratio

problems with using P/E analysis

• Earnings are historical cost accounting numbers and may be of differing quality
• Business cycles may affect P/E ratios
• like infinite DDM, when k <>

LOS 56e: Explain the components of an investor's required rate of return (i.e. the real RFR, the expected rate of inflation, and a risk premium) and discuss the risk factors to be assessed in determining an equity risk premium for use in estimating the required return for the investment in each country

• RFRreal is determined the supply and demand for capital in the country i.e. the RFR is the rate investors would require if there were absolutely no risk or inflation
• inflation premium (IP) is the premium required to compensate investors for expected loss of purchasing power
• a risk premium (RP) to compensate for the uncertainty of returns expected from an investment.
• RFRnominal is approximated as RFR + IP
• so required return = (1+RFRreal)(1+IP)(1+RP)-1
• or approx. RFRreal + IP + RP
• so CAPM (required return) is just RFRnominal + beta adjusted risk premium
• a real rate is without inflation, nominal rates include inflation. if it doesn't specify, it is probably nominal

Estimating required return for foreign securities

variables and models are the same world over but the equity risk premium for foreign securities must take into account:

1. Business risk - variability of country's economic activity and degree of operating leverage of firms within the country
2. Financial risk will be different in different countries
3. Liquidity risk is often found in countries with small or inactive capital markets
4. Exchange rate risk
5. Country risk from unexpected economic and political events

LOS 56f: estimate the dividend growth rate given the components of the required rate of return incorporating the earnings retention rate and current stock price

g = (RR)(ROE)

which makes sense since growth will be determined by how much money is retained (RR) by the company and plowed back in to fuel growth

Since Retention Rate (RR) is the money kept back, it follows that (1-RR) is the dividend payout

ROE = net profit margin * asset turnover * financial leverage

key facts about dividend growth:

• if a firm's net profit margin increases, ROE will increase
• if ROE increases, g will increase because g is (RR)(ROE)
• if g increases, the difference between k and g will decrease
• if k-g decreases, price of stock will increase

LOS 56g: Describe a process for developing estimated inputs to be used in the DDM, including the required rate of return and expected growth rate of dividends

Dm holds that the value of a share of stock is the PV of its cash flows (including cash flow from sale of stock itself) so it requires three inputs:

1. estimate of stock's future cash flows i.e. dividends and future price
2. dividend growth rate
3. discount rate, which is the appropriate required return on equity

Once PV of the asset has been estimated, compare it to the current market price

Full Example of Application

For XYZ company:

• stock price = $18
• earnings per share = $2
• ROE = 10% (and stable for the future)
• dividend payout is 40% (and stable for the future)
• nomrinal RFR i= 7%
• expected market return = $12
• Beta for XYZ = 1.2

So...

1. calculate required return using CAPM: k = 7% + 1.2(12%-7%) = 13%
2. calculate growth rate: (RR)(ROE)
   so calc RR = (1 - 0.4) = 0.6
   calc (RR)(ROE) = (0.6)(0.10) = 0.06 i.e. 6%
3. determine last year's dividend: Do = E0(dividend payout) = $2(0.4) = $0.80
4. determine next year's dividend: D1 = Do (1 + g) = $0.80 * 1.06 = $0.85
5. Estimate the value using infinite DDM = D1/(k-g) = $0.85/(0.13-0.06) = $12.14
6. Compare to stock price of $18, you would not buy (and possibly short)

LOS 57: Describe how structural economic changes (e.g. demographics, technology, politics, and regulation) may affect industries

Not sure how far to go into this one because they seem a little obvious e.g younger people in their 20's would consume houses, furniture whereas if older people dominate population, expect uptick in retirement community sales etc. Technology helps and hurts differently based on the technology. Regulation can cause extra costs and decrease in sales or protectionist tariffs can temporarily boost domestic domand.

Trends and lifestyles and cause temporary boons for the item in vogue.

Issues from problem sets

Some of the supernormal growth questions were confusing in their words e.g.

• "Assume that a stock is expected to pay dividends at the end of year 1 and year 2 of $1.25 and $1.56 respectively. Dividends are expected to grow at 5% rate thereafter. Assuming that ke is 11%, the value of the stock is closest to:"

NB This means that the second dividend is where the stable growth begins i.e. $1.56 is the dividend rate for the normal constant infinite growth period and so you would calculate it using D1/ke-g or $1.56/0.11-0.05 and add it to the $1.25 then discount the sum by 11% over one period (not sure why it is one period rather than one period for the 1.25 and two periods for the stock price).

Price/Earnings Ratio or Earnings Mutiplier

This is not very well explained in Schweser and I'll probably look it up elsewhere to fully understand what its purpose is.

The P/E is sometimes referred to as the "multiple", because it shows how much investors are willing to pay per dollar of earnings. If a company were currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay $20 for $1 of current earnings

So P/E = ((stock price using infinite DDM)/E) -> I am weak on this use

• if you don't have dollar amount for a dividend, use the payout rate e.g. 0.6 for the dividend and divide by ke - g
• P/E ration based on the DDM is:
• (1-RR)/[k - RR(ROE)]
• this is just substituting dividend payout rate (1-RR) for D1 and (RR)(ROE) for g to demonstrate the relationship between the features.

COMPANY ANALYSIS AND STOCK VALUATION

Company vs. Stock Analysis

LOS 58a: Differentiate between 1) a growth company and a growth stock 2) a defensive company and a defensive stock 3) a cyclical company and a cyclical stock, 4) a speculative company and a speculative stock, and 5) a value stock and a growth stock

• Growth company = managers consistently make investments with positive NPV
• Growth stock = stock consistently outperforms other stocks of equivalent risk
• NB all of this good stuff may be already priced into the stock price and bandwagon effect can make it an unwise investment; if a stock's intrinsic value is lower than its current price, it can be a growth stock
• Defensive company = company's earnings are not sensitive to downturns in economy e.g. utility and retail grocery chains.
• Defensive Stock will not decline as much as the market when the overall market declines (low betas)
• Cyclical Company earnings tend to follow business cycle e.g. steel, automobile, heavy equipment producers - high levels of fixed costs (business risk) or leverage (financial risk)
• Cyclical Stock = beta greater than 1, change more than market either up or down
• Speculative company = risky assets but potential for assets to generate very large earnings e.g. diamond mining, oil exploration, some real estate etc.
• Speculative Stock = highly likely to have low or negative returns compared to market because almost always overpriced but slight chance of enormous return
• Growth stock = earnings growth rate of stock;
• Value stock = stocks that are priced low in relation to their current earnings (rather than expected growth in their earnings) or in relation to the value of their fixed assets, real estate or cash.
• Value stocks are characterised by low price-book ratios, low price-earnngs ratios, and often high dividends.

LOS 58b: Describe and estimate the expected earnings per share (EPS) and earnings multiplier for a company and use the multiple to make an investment decision regarding the company

EPS can be estimated by ((est. forecast sales * est. net profit margin)/shares outstanding)

• A company's earnings multiplier (P/E ratio) can be estimated by macroanalysis of the market and the industry or by microanalysis to estimate the company's dividend payout ratio, sustainable growth rate, and required rate of return.
• if you know the current share price is $32 and dividend will be $0.96 and earnings will be $3 and the year end P/E will be 12 then year end price will be Earnings * P/E = year end expected price or 3 * 12 = $36
• and HPY is P1-P0+D/P0 so (($36-$32+$0.96)/$32) = 15.5% which is the expected return.
• NB this is the opposite process to the CAPM problems. Here we are finding the expected return and comparing it to the known required return.
• To make an investment decision, est. stock's value by multiplying its estimated EPS and expected P/E ratio and compare this value to the current stock price to determine whether under or over-valued

LOS 59a: Discuss the rationals for, and the possible drawbacks to, the use of price-to-earnings ratio (P/E), price-to-book value (P/BV), price-to-sales ratio (P/S), and price-to-cash flow (P/CF) in equity valuation.

All methods are significantly related to long-run average stock returns

Advantages of P/E ratios in valuation:

• widely used in investment community
• earnings power is the primary determinant of investment value

Disadvantages of P/E

• earnings can be negative = useless P/E
• the volatile, transitory portion of earnings makes the interpretation of P/E ratios difficult for analysts
• management disretion in accounting practices can distort reported earnings and thus P/E

Advantages of using P/BV

• usually positive
• BV more stable than EPS, so more useful than P/E when EPS is very high/low/volatile
• BV = appropriate measure for firms with primarily liquid assets e.g. banks, insurance, finance, etc.
• P/BV good for valuing companies that are expected to go out of business

Disadvantages of P/BV

• does not recognise value of assets not on balance sheet such as human capital
• can be misleading when there are significant differences in the net balance sheet values of the assets used by the firms being compared
• diff. accounting conventions can obscure the true investment in the firm made by shareholders
• inflation and tech change can cause the book and market value of assets to differ significantly

Advantages of using P/S ratios are:

• the ratio is meaningful, even for distressed firms
• sales figures are not as easy to manipulate or distort as EPS and BV
• not as volatile as P/E
• particularly appropriate for valuing stocks in mature or cyclical industries as well as start up fims with no record of earnings

Disadvantages of using P/S ratios

• high sales do not necessarily indicate operating profits as measured by earnings and cash flow
• P/S ratios do not capture differences in cost structures across companies
• affected by revenue recognition methods (although less prone to distortion than earnings)

Advantages of using P/CF

• cash flow harder to manipulate than earnings
• more stable than P/E
• addresses problem of differences in quality of earnings that arises when using P/E

Disadvantages of using P/CF

• some items affecting actual cash flow from operations are ignored when the EPS plus noncash charges estimation method is used. e.g. noncash revenue and net changes in working capital are ignored
• some measure of free cash flow is theoretically perferred to operating cash flow; free cash flow to equity can be used, but can be negative and is generally more volatile than operating cash flow

LOS 59b: Calculate and interpret P/E, P/BV, P/S, and P/CF

• all are mkt price per share/some income measure per share
• trailing P/E = mkt price per share/EPS over prev. 12 months
• leading P/E = mkt price per share/expected EPS over next 12 months
• P/BV = mkt price per share/book value per share
• book value of equity = (total assets - total liabilities) - preferred stock
• P/S = mkt price per share/sales per share
• P/CF = mkt price per share/cash flow per share
• cash flow can be CF, FCFE, adjusted CFO or EBITDA

Problem set issues

• Sometimes you will not be given the share price and will have to work it out first using DDM; clues would be when they give you ke etc.
• If they give you a date for a dividend and do not give you any other dates, it seems to imply that this is Do so D0 * (1 + g) = D1
• Sales per share = revenue per share
• accounting standard differences cause problems for most ratios to varying degrees including P/BV, P/E and P/S (although P/S is less prone to distortion)
• BV = shareholder's equity
• calculate margin call price