Introduction to security valuation
A summary
Reminder
Valuation always precedes the investment decision.
Always.
Objective
Describe the principles and summarize the process of
security analysis & valuation.
Outline
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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 techniques
Valuation philosophy
Acknowledges the basic principles that are important in estimating
intrinsic values
Valuation approach
Pertains to the valuation process in general
It spells out the steps of the selection process
Valuation techniques/methods
Refers to the quantitative methods used to estimate intrinsic values
for individual securities, industries, and markets
Valuation philosophy
Fundamental analysis
• Investors have rational expectations.
• It is possible to forecast, hence to estimate intrinsic value as a
function of risk and required return
Technical 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.
Important
Valuation philosophy determines what approach and technique to use
Valuation approaches
Top-down (Three-step)
Valuing and selecting securities while accounting for the more
general economic context
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Analysis of alternative economies and security markets
Industry analysis
Individual 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
securities
DCF techniques
Intinsic value = PV of future cash flow
Relative valuation techniques
Require the comparison of various market ratios
Both methods should be used in combination
Analysis of alternative economies and security
markets
Objective:
Estimate future macroeconomic performance
Evaluate the trend in corporate earnings and security prices
Prevailing view:
General economic conditions are associated with firm performance
Markets determine individual security returns
How it is done in real life
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Macro technique
Micro technique: DCF & relative valuation
Trend analysis & extrapolation
Macro technique
Analyze macroeconomic indicators
Macroeconomic indicators
Leading indicators
Precede the economic cycle
Coincident indicators
Synchronized with the economic cycle
Lagging indicators
Follow in the wake of the economic cycle
Leading indicators
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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 indicators
Are the most scrutinized
Not always easy to interpret and use
Ex:
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Relationship between interest rates and bond prices: clear
Relationship between interest rates and stock prices: murky
Higher interest rates:
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Increase the cost of borrowing
Signal increased demand, higher prices, and higher corporate earnings
Coincident indicators
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Industrial production
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Employee’s payrolls
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Manufacturing sales
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Etc.
Lagging indicators
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Average UI duration
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Inventories
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Bank’s prime rate
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Etc.
Micro techniques
Applied to the market as a whole
Often looks at an index of the most representative securities
Micro 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 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 valuation
Estimating future earnings (EPS)
1. Forecast GDP
2. Project corporate sales as a function of GDP
3. Forecast operating profit:
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Capacity utilization rate (+)
Unit labor costs(+/-)
Inflation (+/-)
Foreign competition (-)
4. Forecast EPS
Estimating future earnings multipliers (P/E)
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Changes in EPS are not always good predictors of returns
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Helps spotting bubbles
Industry analysis
Objective
Evaluate industry trends and structural changes
Methods
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Cross sectional performance analysis
Trend analysis
Comparative analysis of firms within an industry
Results 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 cycle
Wide-held belief:
Industry performance is related to business cycle.
Industry trends and the business cycle
End of recession
Finance companies do well: more loans, investments in anticipation, etc.
Rock bottom
Consumer durables improve: edging consumer confidence and expected income
Upward trend
Capital goods improve: expanding to meet demand
Peak
Oil, gold, timber, etc do well
Decline
Consumer staples do well: one has to eat and live nevertheless
Structural changes
• Demographics
• Lifestyles
• Technology
• Politics and regulation
Individual company analysis and stock selection
Objective
Identify candidates for the investment decision
Investment decision
Buy: Intrinsic value > Market price
Individual company analysis and stock selection
Company Overall Strategy
Prospects and Challenges
• Defensive vs. offensive
• Low cost vs. differentiation
• Etc.
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Management assessment
• Current rivalries
Swot analysis
Financial Performance
• Threat from new entrants
• Potential substitutes
• Barganning power of suppliers &
buyers
Valuation
• Etc.
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DCF
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Relative
Conclusions
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.