Fundamental Analysis Lec1-Investment Managment And Portfolio-Lecture Notes, Study notes of Investment Management and Portfolio Theory

Download Fundamental Analysis Lec1-Investment Managment And Portfolio-Lecture Notes and more Study notes Investment Management and Portfolio Theory in PDF only on Docsity! y g ( ) Lesson # 11 FUNDAMENTAL ANALYSIS VALUATION PHILOSOPHIES: Value comes from utility; utility comes from a variety of sources. Fundamental analysts believe securities are priced according to fundamental economic data. Technical analysts think supply and demand factors play the most important role. Investors' Understanding of Risk Premiums: Investors are almost always risk-averse. Investors often cannot explicitly define risk, but they have an intuitive understanding of it. They do not like taking risks, but will do so in order to increase potential investment return- Preceding chapters have discussed how investors can use the variance of investment returns as a proxy for risk. This balance between risk and return is the reason un-bonds have higher yields to maturity than U.S. Treasury bonds, and why some shares of stock sell for more than others. The Time Value of Money: Everything else being equal, the longer someone must wait for the payoff from an investment, the less the investment is worth today. The Importance of Cash Flows: Most investment research deals with predicting future corporate earnings. The Tax Factor: Taxes are supposedly "one of the two certainties in life. Investors also know that, in addition to being a certainty, the tax code is complicated and not all investments are taxed equally. For this reason, municipal bonds (paying tax-free interest) can sell with a lower expected rate of return than a taxable corporate bond of equal risk, and some investors will favor growth stocks (with tax deferral of appreciation) over income stocks (with immediate taxation of dividends). EIC Analysis: 4. Economic Analysis 5. Industry Analysis 6. Company VALUE VS GROWTH INVESTING: The two factions within the fundamental analysts' camp are the value investors and the growth investors. These terms became popular in the 1980s and are now a standard part of the investment lexicon. The Value Approach to Investing The Growth Approach to Investing The Information Trader: docsity.com y g ( ) Information traders are in a hurry; they believe information differentials in the marketplace can be profitably exploited. The True Growth Investor How Price Relates to Value: The modern perspective: Value is inextricably intertwined with price. The most efficient and productive company in the world is a poor investment if the stock price is too high. Value Stocks and Growth Stocks: How to Tell by Looking The Price to Book Ratio The Price-Earnings Ratio Differences between Industries Neither the price-earnings ratio nor the price to book ratio is a stand-alone statistic. Important industry differences need to be considered. A firm whose primary asset is brainpower (such as a software company) has fewer capital assets than a smokestack company (like a steel mill). The software industry would normally have a higher price to book ratio than the steel industry. For this reason, relative ratios are commonly computed for both the PE and the price to book statistics. This calculation provides the ratio of the firm's statistic to the industry average statistic. SOME ANALYTICAL FACTORS: Growth Rates: Calculate dividend growth rates using the geometric mean rather than the arithmetic mean. The Dividend Discount Model: gk D gk gID po      10 )( In this equation, Do is the current dividend; D1 is the dividend to be paid next year; g is the expected dividend growth rate; and k is the discount factor according to the riskiness of the stock.20 the model assumes that the dividend stream is perpetual and that the long-term growth rate is constant. g p gID k    0 0 )( Note that the expression for k, the shareholders' required rate of return, is the sum of two components: the expected dividend yield on the stock and the expected growth rate. If the dividend yield is a constant, g represents the anticipated capital appreciation in the stock price. The shareholders’ required rate of return is the sum of the expected sum of the expected dividend yield and the expected stock price appreciation. docsity.com y g ( ) at other firms including Cascade International, Maxwell Communication Corp., Chambers Development, MiniScribe, Cendant, and numerous others. Unfortunately, there is not much the analyst can do about fraud. As Patricia McConnell, a respected analyst at Bear Steams says, "A well-perpetrated fraud is impossible to detect." The important thing to remember is that the marketplace is full of many types of risk, and fraud is one of them. Fundamental analysts believe securities are priced according to economic data; technical analysts believe supply and demand factors are most important. Most investment research deals with predicting future earnings. A value investor believes a security should only be purchased when the underlying fundamentals justify the purchase. They believe in a regression to the mean of security returns. A growth investor seeks rapidly growing companies. Value investors place a great deal of importance on a stock’s price to book ratio and its price-earnings ratio. A future earning growth rate is unobservable. Most analysts use several methods to estimate this statistic to determine a likely range for the value rather than a single number. The dividend discount model (also called Gordon’s growth model) can be used to value stock as a growing perpetuity. The shareholders’ required rate of return is an input to the model. False growth in earnings occurs any time a firm acquires another firm with a lower price-earning ratio. Cash flow from operations is a firm’s lifeblood. This value is often used as a check on the quality of a firm’s earnings. The evidence shows that small-cap stocks outperform mid- or large-cap stocks. Some analysts believe that mid-cap stocks are particularly fertile hunting ground for the security analyst because they receive less attention from the marketplace. Spectacular gains are occasionally associated with initial public offerings (IPO).these gains usually disappear within the first year or two of the new stock’s life. Intrinsic Value and Market Price: After making careful estimates of the expected stream of dividends and the required rate of return for a common stock, the value of the stock today is estimated using the DDM. The value is often called intrinsic value of the stock, which we denote as Vo. Note that intrinsic value simply means an estimated value or a formula value. This is the end objective of a discounted cash flow technique such as the DDM. If Vo > Po, the asset is undervalued and should be purchased or held if already owned. If Vo < Po, the asset is overvalued and should be avoided, sold if held, or possibly sold short. If Vo = Po, this implies an equilibrium in that the asset is correctly valued. Security analysis has traditionally been thought of as the search for undervalued or overvalued stocks. To do this, one can calculate the estimated or intrinsic value of the stock or compare this value to the current market price if the stock. Most investors believe that stocks are not always priced at their intrinsic values, thereby leading to buy and sell opportunities. The P/E Ratio or Earnings Multiplier Approach: The P/E ratio or earnings multiplier approach is the best-known and most widely used valuation technique. Analyst are more comfortable talking about earnings per share (EPS) docsity.com y g ( ) and P/E ratios, and this is how their reports are often worded. Talk about EPS and P/Es ratios is the typical language of Wall Street. Without question, the P/E ratio is one of the most widely mentioned and discussed variables pertaining to a common stock, and will almost always appear in any report from an analyst or an investment advisory service. For this reason, we develop the P/E ratio in detail. What is the P/E Ratio? As a definition, the P/E ratio is simply the number of times investors value earnings as expressed in the stock price. For example, a stock priced at $100, With most recent 12-month earnings of $5, is said to selling for a multiple of 20, In contrast, if another stock had earnings of $2.50 and was selling for $100, investors would be valuing the stock at 40 times earnings, thus, the P/E ratio as reported daily in such sources as The Wall Street Journal is simply an identity calculated by-dividing the current market price of the stock by the latest 12-month earnings. As such, it tells investors the price being paid for each $1 of-most recent 12-month earnings. Determinants of P/E Ratio: What variables affect the P/E ratio? To shed some light on this question, the P/E ratio can be derived from the dividend discount model, which, as we have seen, is-the foundation of valuation for common stocks. Note, however; that this process directly applies only for the case of constant growth. If a multiple period growth model is applicable to the' stock being considered, a different formulation from the one presented here will be needed. In fact, using the P/E ratio for multiple growth rate companies can be misleading and should be done with care. Understanding the P/E Ratio: Most investors intuitively realize that the P/E ratio should be higher for companies whose earnings are expected to grow rapidly. However, how much higher is not an easy question to answer? The market will assess the degree of risk involved in -the expected future growth of earnings, if the higher growth rate carries a high level of risk, the P/E ratio will be affected accordingly. Furthermore, the high- growth rate may be attributable to several different factors, some of which are more desirable than others. For example, rapid growth in unit sales owing to strong demands for a firm's products is preferable to favorable tax situations, which may change, or liberal accounting procedures, which one day may cause reversal in the firm's situation. P/E ratios reflect investors' expectations about the growth potential of a stock and the risk involved. These two factors can offset each other. Other things being equal, the greater the risk of a stock, the lower the P/E ratio; however, growth prospects may offset the risk and lead to a higher P/E ratio. The Internet companies that were so popular in the late 1990s were clearly very risky, but investors valued their potential very highly, and were willing to pay very high prices for these companies. The P/E ratio reflects investor optimism and pessimism. It is related to the required rate of return. As the required rate of return increases, other things being equal, the P/E ratio decreases. The required rate of return, in turn, is related to interest rates, which are the required returns on bonds. As interest rates increase, required rates of return on all securities, including stocks, also generally increase. As interest rates increase, bonds become more attractive compared to stocks on a current return basis. Based on these relationships, an inverse relationship between docsity.com y g ( ) P/E ratios and interest rates-is to be expected. As interest rates rise (decline), other things being equal, P/E ratios should decline (rise). Which Approach to Use? We have described the two most often used approaches in fundamental analysis, discounted cash-flow techniques and relative valuation techniques. Which should be used? In theory, the discounted cash-flow approach is a correct, logical, and sound position. Conceptually, the best estimate of the current value of a company's common stock is the present value of the (estimated) cash flows to be generated by that company. However, some analysts and investors feel that this model is unrealistic. After all; they argue, with regard to the DDM, no one can forecast dividends into the distant future with very much accuracy. Technically, the model calls for an-estimate of all dividends from now to infinity, which is an impossible task. Finally, many investors want capital gains and not dividends, so for some investors focusing solely on dividends is not desirable. The previous discussion dealt with these objections that some raise about the dividend discount model. Can you respond to these objections based on this discussion? Possibly because of the objections to the dividend discount model cited here, or possibly because it is easier to use, relative valuation techniques such as the earnings multiplier or P/E model remain a popular approach to valuation. They are less sophisticated less formal and more intuitive models. In fact, understanding the P/E model can help investors to understand the DDM. Because dividends are paid out of earnings, investors must, estimate the growth in earnings before they can estimate the growth in dividends or dividends themselves. docsity.com