‫برنامج توعية وتدريب المحللين الماليين‬
‫الدكتور منذر بركات‬
‫إدارة البحوث والتوعية‬
‫هيئة األوراق المالية والسلع‬
‫‪1-1‬‬
Financial Analysts Awareness &
Training Program
Dr. Mounther Barakat
Securities and Commodities Authority
1-2
Pure Expectations
Maturity
1 year
2 years
3 years
4 years
5 years
Yield
6.0%
6.2%
6.4%
6.5%
6.5%
If PEH holds, what does the market expect will
be the interest rate on one-year securities, one
year from now? Three-year securities, two years
from now?
1-3
Spot and forward rates
6.2% = (6.0% + x%) / 2
12.4% = 6.0% + x%
6.4% = x%
PEH says that one-year securities will yield 6.4%,
one year from now.
1-4
Spot and forward rates
6.5% = [2(6.2%) + 3(x%) / 5
32.5% = 12.4% + 3(x%)
6.7% = x%
PEH says that one-year securities will yield 6.7%,
one year from now.
1-5
Returns
The rate of return on an investment can be calculated as
follows:
Return =
(Amount received – Amount invested)
________________________
Amount invested
For example, if $1,000 is invested and $1,100 is returned
after one year, the rate of return for this investment is:
($1,100 - $1,000) / $1,000 = 10%.
1-6
What is Risk?

Two types of investment risk




Stand-alone risk
Portfolio risk
Investment risk is related to the probability of
earning a low or negative actual return.
The greater the chance of lower than expected or
negative returns, the riskier the investment.
1-7
Probability distributions


A listing of all possible outcomes, and the
probability of each occurrence.
Can be shown graphically.
Firm X
Firm Y
-70
0
15
Expected Rate of Return
100
Rate of
Return (%)
1-8
The average and the standard deviation
Small-company stocks
Large-company stocks
L-T corporate bonds
L-T government bonds
Treasury bills
Average Standard
Return Deviation
17.3%
33.2%
12.7
20.2
6.1
8.6
5.7
9.4
3.9
3.2
.
1-9
Return comparisons
Economy
Prob.
T-Bill
A
B
C
M
Recession
0.1
8.0%
-22.0%
28.0%
10.0%
-13.0%
Below avg
0.2
8.0%
-2.0%
14.7%
-10.0%
1.0%
Average
0.4
8.0%
20.0%
0.0%
7.0%
15.0%
Above avg
0.2
8.0%
35.0%
-10.0%
45.0%
29.0%
Boom
0.1
8.0%
50.0%
-20.0%
30.0%
43.0%
1-10
T-Bills and their risk and return.




T-bills will return the promised 8%, regardless of
the economy.
No, T-bills do not provide a risk-free return, as
they are still exposed to inflation. Although, very
little unexpected inflation is likely to occur over
such a short period of time.
T-bills are also risky in terms of reinvestment rate
risk.
T-bills are risk-free in the default sense of the
word.
1-11
Asset and market returns.


A – Moves with the economy, and has a
positive correlation. This is typical.
B – Is countercyclical with the economy,
and has a negative correlation. This is
unusual.
1-12
Calculating expected returns.
^
k  expectedrateof return
^
k
n
k P
i i
i 1
^
k A  (-22.%)(0.1) (-2%)(0.2)
 (20%)(0.4) (35%)(0.2)
 (50%)(0.1) 17.4%
1-13
Summary Calculating expected returns.
A
M
C
T-bill
B
Exp return
17.4%
15.0%
13.8%
8.0%
1.7%
A has the highest expected return, and appears to be the
best investment alternative, but is it really? Have we
failed to account for risk?
1-14
Risk: Calculating the standard deviation
  Standard deviation
  Variance  2

n
 (k  k̂ ) P
i1
2
i
i
1-15
Risk: Calculating the standard deviation
n


^
(ki  k ) 2 Pi
i 1
1
(8.0 - 8.0)2 (0.1) (8.0 - 8.0)2 (0.2)  2


2
2
 T  bills   (8.0- 8.0) (0.4) (8.0 - 8.0) (0.2)   0.0%


2
 (8.0 - 8.0) (0.1)



A
 20.0%
B
C
M
 13.4%
 18.8%
 15.3%
1-16
Risk: Calculating the standard deviation
Prob.
T - bill
C
A
0
8
13.8
17.4
Rate of Return (%)
1-17
Standard Deviation as a Measure of Risk



Standard deviation (σi) measures total,
or stand-alone, risk.
The larger σi is, the lower the
probability that actual returns will be
closer to expected returns.
Larger σi is associated with a wider
probability distribution of returns.
1-18
Comparing Risk and Return
Security
Expected
return
8.0%
Risk, σ
A
17.4%
20.0%
B
1.7%
13.4%
C
13.8%
18.8%
M
15.0%
15.3%
T-bills
0.0%
1-19
Coefficient of Variation (CV)
A standardized measure of dispersion about the
expected value, that shows the risk per unit of
return.
Std dev 
CV 
 ^
Mean
k
1-20
Risk rankings, by coefficient of variation
T-bill
A
B
C
M


CV
0.000
1.149
7.882
1.362
1.020
B has the highest degree of risk per unit of return.
A, despite having the highest standard deviation
of returns, has a relatively average CV.
1-21
Investor attitude towards risk


Risk aversion – assumes investors dislike
risk and require higher rates of return to
encourage them to hold riskier securities.
Risk premium – the difference between
the return on a risky asset and less risky
asset, which serves as compensation for
investors to hold riskier securities.
1-22
Illustrating diversification effects of a
stock portfolio
p (%)
35
Company-Specific Risk
Stand-Alone Risk, p
20
Market Risk
0
10
20
30
40
2,000+
# Stocks in Portfolio
1-23
Breaking down sources of risk
Stand-alone risk = Market risk + Firm-specific risk


Market risk – portion of a security’s stand-alone risk
that cannot be eliminated through diversification.
Measured by beta.
Firm-specific risk – portion of a security’s standalone risk that can be eliminated through proper
diversification.
1-24
Capital Asset Pricing Model


Model based upon concept that a stock’s required
rate of return is equal to the risk-free rate of return
plus a risk premium that reflects the riskiness of
the stock after diversification.
Primary conclusion: The relevant riskiness of a
stock is its contribution to the riskiness of a welldiversified portfolio.
1-25
Beta


Measures a stock’s market risk, and shows a
stock’s volatility relative to the market.
Indicates how risky a stock is if the stock is
held in a well-diversified portfolio.
1-26
Calculating betas


Run a regression of past returns of a
security against past returns on the market.
The slope of the regression line (sometimes
called the security’s characteristic line) is
defined as the beta coefficient for the
security.
1-27
Illustrating the calculation of beta
See Excel file
1-28
Comments on beta




If beta = 1.0, the security is just as risky as the
average stock.
If beta > 1.0, the security is riskier than average.
If beta < 1.0, the security is less risky than
average.
Most stocks have betas in the range of 0.5 to 1.5.
1-29
Can the beta of a security be negative?



Yes, if the correlation between Stock i and the
market is negative (i.e., ρi,m < 0).
If the correlation is negative, the regression
line would slope downward, and the beta
would be negative.
However, a negative beta is highly unlikely.
1-30
Beta coefficients
40
_
ki
A: β = 1.30
20
T-bills: β = 0
-20
0
20
_
kM
40
B: β = -0.87
-20
1-31
Comparing expected return and beta
coefficients
Security
A
M
C
T-Bills
B
Exp. Ret.
17.4%
15.0
13.8
8.0
1.7
Beta
1.30
1.00
0.89
0.00
-0.87
Riskier securities have higher returns, so the rank
order is OK.
1-32
The Security Market Line (SML):
SML: ki = kRF + (kM – kRF) βi


Assume kRF = 8% and kM = 15%.
The market (or equity) risk premium is RPM
= kM – kRF = 15% – 8% = 7%.
1-33
What is the market risk premium?



Additional return over the risk-free rate needed
to compensate investors for assuming an
average amount of risk.
Its size depends on the perceived risk of the
stock market and investors’ degree of risk
aversion.
Varies from year to year, but most estimates
suggest that it ranges between 4% and 8% per
year.
1-34
Calculating required rates of return

kA

kM
kC
kT-bill
kB



= 8.0% + (15.0% - 8.0%)(1.30)
= 8.0% + (7.0%)(1.30)
= 8.0% + 9.1%
= 17.10%
= 8.0% + (7.0%)(1.00) = 15.00%
= 8.0% + (7.0%)(0.89) = 14.23%
= 8.0% + (7.0%)(0.00) = 8.00%
= 8.0% + (7.0%)(-0.87)= 1.91%
1-35
Expected vs. Required returns
^
k
k
^
A
17.4% 17.1% Undervalued ( k  k)
^
M
15.0
15.0
Fairly valued ( k  k)
^
C
13.8
14.2
Overvalued ( k  k)
^
T-bills
8.0
8.0
Fairly valued ( k  k)
^
B
1.7
1.9
Overvalued ( k  k)
1-36
Illustrating the Security Market Line
SML: ki = 8% + (15% – 8%) βi
ki (%)
SML
A
kM = 15
kRF = 8
-1
.
B
. T-bills
0
.
.
C
1
2
Risk, βi
1-37
The three basic concepts of valuation




Investors can only spend cash so "Cash is
good and more cash is better."
Cash today is worth more than cash
tomorrow.
Risky cash flows are worth less than safe
cash flows.
These three imply the value of a company
depends on the size, timing, and riskiness of
its cash flows.
1-38
Valuation of a Simple Company

Investors are:


Debtholders
Stockholders
1-39
Valuation example…



Simple Co.’s shares of stock also compete
in the market for investors.
Stockholders are the owners of the firm, and
the value of ownership is the value of the
asset, less any debt that is owed.
For example: Suppose Simple Co. is worth
$501 million. It owes $150 million to
debtholders. So Simple Co.’s equity is
worth $501 – 150 = $351 million.
1-40
The Corporate Valuation Model


PV of cash flows available to all
investors—called free cash flows (FCFs).
Discount free cash flows at the average rate
of return required by all investors—called
the weighted average cost of capital
(WACC)
1-41
Steps in the corporate value
model



Determine weighted average cost of capital
Estimate expected future free cash flows
Find value of company
1-42
Estimating the Weighted Average Cost of
Capital (WACC)

Company has two types of investors




Debtholders
Stockholders
Each type of investor expects to receive a
return for their investment
The return an investor receives is a “cost of
capital” from company’s viewpoint.
1-43
Cost of Debt



Simple Co.’s cost of debt: rD = 9%.
But Simple Co. can deduct interest, so cost
to Simple Co. is after-tax rate on debt.
If tax rate is 40%, then after-tax cost of debt
is:

After-tax rD = 9%(1-0.4) = 5.4%.
1-44
Cost of Equity

Cost of equity, rs, is higher than cost of debt
because stock is riskier.

Simple Co.: rs = 12%
1-45
Weighted Average Cost of Capital


WACC is average of costs to all investors,
weighted by the target percent of firm that is
financed by each type.
For Simple Co., target percent financed by equity:


wS = 70%
For Simple Co., target percent financed by debt:

wD = 30%
(More….)
1-46
WACC (Continued)
WACC = wD rD (1-T) + wS rS
= 0.3(9%)(1 - 0.4) + 0.7(12%)
= 10.02%
1-47
Free Cash Flow (FCF)


FCF is the amount of cash available from
operations for distribution to all investors
(including stockholders and debtholders)
after making the necessary investments to
support operations.
A company’s value depends upon the
amount of FCF it can generate.
1-48
Calculating FCF

FCF = net operating profit after taxes minus
investment in operating capital
1-49
Operating Current Assets

Operating current assets are the CA needed
to support operations.


Op CA include: cash, inventory, receivables.
Op CA exclude: short-term investments,
because these are not a part of operations.
1-50
Operating Current Liabilities

Operating current liabilities are the CL
resulting as a normal part of operations.


Op CL include: accounts payable and accruals.
Op CA exclude: notes payable, because this is a
source of financing, not a part of operations.
1-51
Balance Sheet: Assets
Op. CA
Total CA
Net PPE
Tot. Assets
2005
162,000.0
162,000.0
199,000.0
361,000.0
2006
168,000.0
168,000.0
210,042.0
378,042.0
2007
176,400.0
176,400.0
220,500.0
396,900.0
1-52
Balance Sheet: Claims
Op. CL
Total CL
L-T Debt
Total Liab.
Equity
TL & Eq.
2005
57,911.5
57,911.5
136,253.0
194,164.5
166,835.5
361,000.0
2006
62,999.7
62,999.7
143,061.0
206,060.7
171,981.3
378,042.0
2007
66,150.0
66,150.0
150,223.0
216,373.0
180,527.0
396,900.0
1-53
Income Statement
Sales
Costs
Op. prof.
Interest
EBT
Taxes (40%)
NI
Dividends
Add. RE
2005
400,000.0
344,000.0
56,000.0
11,678.7
44,321.3
17,728.4
26,592.7
21,200.0
5,392.7
2006
420,000.0
361,994.2
58,005.8
12,262.8
45,743.0
18,297.2
27,445.8
22,300.0
5,145.8
2007
441,000.0
374,881.6
66,118.4
12,875.5
53,242.9
21,297.2
31,945.7
23,400.0
8,545.7
1-54
NOPAT (Net Operating Profit After
Taxes)


NOPAT is the amount of after-tax profit
generated by operations.
NOPAT is the amount of net income, or
earnings, that a company with no debt or
interest-income would have.
NOPAT
= (Operating profit) (1-T)
= EBIT (1-T)
1-55
Calculating NOPAT
NOPAT = (Operating profit) (1-T)
= EBIT (1-T)
NOPAT07 = 66.1184 (1-0.4) = 39.67104
million.
1-56
Calculating Operating Capital

Operating capital (also called total operating
capital, or just capital) is the amount of
assets required to support the company’s
operations, less the liabilities that arise from
those operations.


The short-term component is net operating
working capital (NOWC).
The long-term component is factories, land,
equipment.
1-57
Net Operating Working Capital
NOWC = Operating current assets
– Operating current liabilities
This is the net amount tied up in the “things”
needed to run the company on a day-to-day
basis.
1-58
Net Operating Working Capital
NOWC = Operating CA – Operating CL
NOWC07 = $176.4 – $66.15
= $110.25 million
1-59
Operating Capital

Operating capital =
Net operating working capital (NOWC)
plus
 Long-term capital, such as factories, land,
equipment.

1-60
Operating Capital
Operating Capital = NOWC + LT Op. Capital
Capital07 = $110.25 + $220.50
= $330.75 million
This means in 2007 Simple Co. had $330.75
million tied up in capital needed to support its
operations. Investors supplied this money. It
isn’t available for distribution.
1-61
Investment in Operating Capital



Operating capital in 2006 was $315.0423
million
Operating capital in 2007 was $330.75
million
Simple Co. had to make a net investment of
$330.75 – $315.0423 = $15.7077 million in
operating capital in 2007.
1-62
Calculating FCF
FCF = NOPAT – Investment in operating capital
FCF07 = $39.67104 – (330.75 – 315.0423)
= $39.67104 – $15.7077
= $23.96334 million
1-63
Uses of FCF
There are five ways for a company to use FCF
1. Pay interest on debt.
2. Pay back principal on debt.
3. Pay dividends.
4. Buy back stock.
5. Buy nonoperating assets (e.g., marketable
securities, investments in other companies, etc.)
1-64
Reinvestmen
Free Cash Flow
1-65
How Did Simple Co. use its FCF?




Paid dividends: $23.4 million
Paid after-tax interest of: $12,875.5 (1-0.4) =
$7.7253 million
For a total of $31.1253 million! This is $7.162
million more than the $23.9 million FCF
available! Where did it come from?
Simple Co. increased its borrowing by $150.223 –
$143.061) = $7.162 million to make up the
difference.
1-66
Corporate Valuation


Forecast financial statements and use them
to project FCF.
Discount the FCFs at the WACC
This gives the value of operations
1-67
Value of Operations

FCFt
VOp  
t
t 1 1  WACC 
Of course, this requires projecting free cash flows out
forever.
1-68
Constant growth

If free cash flows are expected to grow at a
constant rate of 5%, then this is easy:
FCF
2007
23.963
2008
25.161
2009
26.419
20010
27.740
201
29.127
2012
30.584
There is an easy formula for the present value of free
cash flows that grow forever at a constant rate…
1-69
Constant Growth Formula

The summation can be replaced by a single
formula:
FCF1
VOp 
WACC  g 
FCF0 (1  g)

WACC  g 
1-70
The value of operations
FCF0 (1  g )
VOp 
WACC  g 
$23.96334 (1  0.05)
VOp 
0.1002  0.05
 $501.225 million
1-71
Value of Equity

Sources of Corporate Value



Claims on Corporate Value



Value of operations = $501.225 million
Value of non-operating assets = $0 (in this case)
Value of Debt = $150.223 million
Value of Equity = ?
Value of Equity = $501.225 - $150.223 =
$351.002 million, or just $351 million.
1-72
Value of Equity
Price per share
= Equity / # of shares
= $351 million / 10 million shares
= $35.10 per share
1-73
A picture of the breakdown of
Simple Co.’s value
Debt
Equity
1-74
Return on Invested Capital (ROIC)
ROIC can be used to evaluate Simple Co.’s
performance:
ROIC = NOPAT / Total operating capital in
place at the beginning of the year
1-75
Return on Invested Capital (ROIC)
ROIC07 = NOPAT07 / Capital06
ROIC07 = 39.67104 / 315.0423 = 12.6%.
This is a good ROIC because it is greater than
the return that investors require, the WACC,
which is 10.02%. So Simple Co. added
value during 2007.
1-76
Economic Value Added (EVATM)
(also called Economic Profit)




EVA is another key measure of operating
performance.
EVA is trademarked by Stern Stewart, Inc.
It measures the amount of profit the
company earned, over and above the
amount of profit that investors required.
EVA = NOPATt – WACC(Capitalt-1)
1-77
Calculating EVA
EVA = NOPAT- (WACC)(Begng. Capital)
EVA07 = NOPAT07 – (0.1002)(Capital06)
EVA07 = $39.67104 – (0.1002)(315.0423)
= $39.67104 – $31.56742
= $8.1038 million
(More…)
1-78
Economic profit…
This shows that in 2007 Simple Co. earned
about $8 million more than its investors
required.
Another way to calculate EP is
EVAt = (ROIC – WACC)Capitalt-1
= (0.125923 – 0.1002)$315.0423
= $8.1038 million
1-79
Intuition behind EVA
If the ROIC – WACC spread is positive, then
the firm is generating more than enough
“profit,” and is increasing value. But, if the
ROIC – WACC spread is negative, then the
firm is destroying value, in the sense that
investors would be better off taking their
money and investing it elsewhere.
1-80
Fundamental Analysis
Practice Examples

See XLS
1-81