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Fundamental Analysis • Macroeconomics Analysis • Industry Analysis • Equity Valuation Model (Dividend Discount Model- DDM) • Financial Statement Analysis Macroeconomics Analysis • Global Economy Analysis – affects export, price competition and profits – exchange rate: purchasing power and earnings • Domestic Economy – The ability to forecast the macroeconomy can translate into great investment performance – outperform other analysts to earn extra profits Many variables can affect economy –Gross Domestic Product (GDP): measures the economy’s total output of goods and services – Employment rate: measures the extent that the economy is operating at full capacity – Inflation measures the general level of prices increase Phillip’s curve – Interest Rate high interest rate reduces PV of cashflows, thus stock values – Budget Deficit large deficit means more borrowing, which implies higher interest rate. – Sentiment consumers and producers confidence Business Cycles • • • • business cycles: pattern of recession and recovery peak: the end of expansion and start of recession trough: the bottom of the recession stock returns are decreasing when at peak and increasing at trough • cyclical industries: do well in expansionary periods but poorly in recession, e.g., durable goods such as automobile and wash machines • defensive industries: little sensitive to business cycles, such food Industry Analysis • Select a good industry to invest. It is difficult for a firm to do well in a troubled industry • Standard Industry Classification (SIC) code • Value line Investment Survey - reports 1700 firms in 90 industries • Two factors that determine the sensitivity of a firm’s earnings to business conditions: business risk, financial risk Business risk • Sales sensitivity to business condition some industries are robust (food) while others are not (movie) • operating leverage: the division between fixed and variable costs. – firms with greater amounts of variable cost relative to the fixed cost are subject less to business fluctuations, thus profits are more stable Financial Risk • the degree in using financial leverage (the amount of interest payment) • leverage firm is more sensitive to business cycles Industry cycles Start-up Build-up Maturity Decline Start-up: increasing growth Build-up/consolidation: stabilized growth maturity: slower growth Decline: shrinking growth Equity Valuation Model • Dividend Discount Model (DDM) V0= (D1+P1)/(1+k) = D1/(1+k) + D2/(1+k)2 ...+ Dn/(1+k)n • constant growth assumption V0 = D1/(1+k) + D1(1+g)/(1+k)2 +D1(1+g)2/(1+k)3 + ... = D1/(k-g) or k = expected return = D1/P0 + g Multistage Growth Model • Growth profile may not be constant such as: Expected Growth g1 g2 n Time V=D0(1+g1)/(1+k)+...+D0(1+g1)n/(1+k)n + D0(1+g1)n(1+g2)/(1+k)n+1+ ... and so on Illustration of two-stage Growth Model • A stock pays $1 dividend now and its g1=30% for 6 yrs. Thereafter, its g2=6%, its k=15% • yr 1: $1(1+0.3) =1.13 yr 2: 1(1+0.3)2=1.69 yr 3: 1(1+0.3)3=2.20 yr 4: 1(1+0.3)4 =2.86 . yr 7: 1(1+0.3)6(1+6%) =5.12 yr 8: 1(1+0.3)6(1+6%)2 =5.42 . Market Value (equity) Market value is the present value of its future dividends Time 0 1 2 3 PV(Dt) 34.0 37.8 41.78 45.85 Growth rate 11.17% 10.52 9.74 At time 1: FV(Dividends) = 34.00(1.15) - 1.3= 37.8 At time 2: FV(dividends) = 37.80(1.15) - 1.69=41.78 Expected return at time 0 (15%) = Yr end dividend/current price + growth rate = 1.3/34 + 11.17% P/E Ratio Behaviors • Price = No growth value/share P0 = E1/k + PVGO or • P0/E1= [1+ PVGO]/k E1/k P/E average Time Pitfalls in P/E Analysis • Denomination of P/E ratio is the accounting earnings (arbitrary rules or historical cost will distort the earnings figures) • Earning should be based on economic earnings (i.e., net of economic deprecation) • Earnings are future figures vs P/E ratio (which uses past accounting earnings) Earnings Forecast • Models for forecasting: Ei,t = gi + Ei,t-4 +ai(Ei,t-1-Ei,t-5) where g: growth factor a: adjustment factor E: Earnings • Time Series Analysis ARMA model Exponential smoothing • professional institution forecast • Performance Evaluation MSE or others Financial Statement Analysis • Preparation of Source/Use Fund Statement • Ratio Analysis – Performance Analysis – Du Pont Analysis Use/source of Fund Statement • Sources C. Paper $ 5.8 A/P 17.8 Div/P 1.4 S/T debt 4.6 S/T Lease 3.8 L/T Debt 20.6 L/T Lease 25.0 C/S 3.2 P/I Cap 0.6 NI 54.4 Depreciation 48.6 Total 185.8 Uses Cash $ 0.4 A/R 16.2 Inv 34.8 Prep. Ex 0.4 Lease 82.8 Others 3.6 Tax 1.0 Div. 46.6 185.8 Analysis of Use/Source • Sales growth=3.5% • Uses- major component A/R =8.72%; Inventory = 18.73%; Lease = 44.6% Dividend = 25.1% • Sources A/P = 9.5%; L/T debt = 11.1%; L/T lease = 13.4% Operation profits = 55.4% (NI+depreciation) • Why issue shares? • S/T-/LT capital increases so much? Ratio Analysis • Assets Sales Profit • Liquidity Ratio • Risk Ratio • Du Pond Analysis ROE=Net Income(NI)/Equity (E) = NI Pretax Prof EBIT Sale TA P.Prof EBIT Sales TA E TB IB GPM TAT EM Pretax profit =EBIT - Interest TB = Tax burden IB = interest burden