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

Download Fundamental Stock Analysis-Investment Managment And Portfolio-Lecture Notes and more Study notes Investment Management and Portfolio Theory in PDF only on Docsity! y g ( ) Lesson # 6 FUNDAMENTAL STOCK ANALYSIS VALUATION PHILOSOPHIES: In much the same manner as Republicans and Democrats have inherent differences in political philosophy, security analysts also may be grouped into two camps: fundamental and technical analysts. The fundamental analyst believes that securities are priced in a rational manner based on macroeconomic information, industry news, and the firm's financial statements. The technical analyst believes that prices are largely determined by investor behavior and by supply and demand, even when demand may seem irrational. Technical analysis is a controversial part of finance and is covered in its own chapter, Chapter Eight. Most investment research firms have both fundamental and technical analysts on the payroll. Despite their philosophical differences, both groups agree on certain things. As we enter a new millennium, however, both fundamental and technical analysts wonder whether the old rules still work. The proliferation of seemingly high-priced Internet and technology stocks made everyone wonder whether the prices are reasonable. Many investors cannot decide whether they should remain on the sideline or whether the train is about to leave without them. Forbes ASAP ran an article with the tine "Is Internet Wealth Real7"1 in the same issue Forbes listed 53 Internet executives with a total wealth of $48 billion, which the writer calls a "blurry snapshot of a moving target." Ben Holmes, founder of an IPO research firm, says, "This wealth isn't like other wealth. On paper, Jay Walker's 62 million shares of Price line stock are worth about $4 billion, but nobody knows what they're really worth." Early in the year 2000 The Wall Street Journal ran a front page article entitled "How High Is Too High for Stocks That Lead a Business Revolution?"2 The article subtitle is "Whether old valuation rules can be ignored for some is key to volatile NASDAQ." As this chapter will show, investors historically have paid considerable attention to a firm's price-earnings ratio, widely viewed as a useful measure of relative value. PEs around 15 or 20 used to be the norm. In early 2000, however, stocks with a PE ratio in excess of 100 accounted for about 20 percent of the total market value of the NASDAQ market. 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: Everyone agrees on this basic principle, even those who would not know a balance sheet if they saw one. People postpone paying bills and prefer a paycheck now rather than one later docsity.com y g ( ) Ever tiling else being equal, the longer someone must wait for the payoff from an investment, die less the investment is worth today. Suppose a AAA-rated firm tries to issue a zero coupon consol; at what price might it sell7 It might have some collector's value, but its investment value is nil. What good is the right to receive no interest forever? Similarly, when Coca-Cola and Disney issued the 100-year bonds described in an earlier chapter, why was their initial market price such a deep discount from par? The answer is obvious: the return of the par value is two generations from now, and people are not willing to pay much for a cash flow that distant. The bond's current value comes almost entirely from the coupon stream.3 In 75 years the eventual return of the principal will start to matter, but in 1996 it had little impact on the present value of the bond. 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: Start-up companies often have zero sales. It takes time to develop products, particularly those that are innovative and brimming with technology. Some of the great success stories of recent years, like Microsoft, Yahoo and Apple, all involved a period of time when the firms spent money at a steady pace while little was coming in. Investors understand this process arid and are willing to put up seed capital to help new ventures get off the ground. The market's patience is not unlimited, however. Eventually, the shareholders expect to see their investment lead to product sales and to profits from those sales. Share price appreciation and cash dividends stem directly from the profitability of the company. The importance of earnings never subsides. In fact, most investment research deals primarily with predicting future earnings. The link between earnings, dividends, and price appreciation is well established, and all analysts know that good earnings are important. While earnings are clearly important, it is less clear how important dividends are to the contemporary investor. At one time many investors selected a stock largely on the basis of its expected dividends; the average yield was about 5% in the early 1980s. There was a bird- in-the-hand argument that placed a high priority on cash receipts now, with a much lesser emphasis on growth in corporate equity. This is much less true today. About 80% of the stocks in the SP 500 index paid a dividend in 1999. Of the top I5 performers for die year, however, 14 paid no dividend. Many highly successful, and popular, companies pay no dividends and have no plans to do so: Microsoft, Cisco Systems, AOL, MCI WorldCom, and Oracle are ready examples. It is also true that the average dividend yield has been falling for two decades. Growth of the Internet and changing attitudes toward technology are influencing the investment process in many ways, perhaps including our attitude toward dividend checks. 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 docsity.com y g ( ) Porter’s competitive strategy analysis helps evaluate industry prospects. 3. Company: Most of the rest of this chapter deals with the last part of EIC analysis: choosing specific companies. Some people refer to this activity as stock picking, or, more formally, as security analysis- Many different schools of thought offer methods on how to go about this task. We now review this topic in some detail. 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: A value investor believes that securities should be purchased only when the underlying fundamentals (macroeconomic information, industry news, and a firm's financial statements) justify the purchase, even when these fundamentals seem to be inconsistent with the belief of the overall marketplace. Value investors consider financial statement information such as the price to book ratio, return on assets, and return on equity.7 Value players evaluate earning growth within a particular industry, many of which have low growth rates. They attempt to spot those companies that have above-average earnings growth in that industry. The value investor is willing to wait to reap the rewards from his or her research-Value investors often seek out new corporate ventures with sound ideas and experienced management, but they prefer not to chase pie-in-the-sky ideas or subscribe to the bandwagon approach to investing. They don't mind sitting out the next dance if they view it as a passing fad with no long-term prospects. Value investors also believe in a regression to the mean. They think securities have long- term expected returns that are consistent with the level of risk associated with them. Suppose you live in an area where the average annual temperature is 59°. If the current temperature were 75°, in the absence of any other information you would predict that temperatures will fall over the next few months. Similarly, if it is currently 25° outside, your long-range forecast should be for rising temperatures. Value investors subscribe to this logic with stock prices and the associated returns- When a stack's returns have been below their expected long-term level, the stock is likely to make up the difference in the future, rising more than other securities Conversely, returns that have been unusually good probably will not persist; instead, future re- A turns are likely to be depressed until the long-term average is back in line with the associated level of risk. Stated another way, a security may perform unusually well for a while, but this over- performance will likely be subdued in subsequent periods when the returns are less than expected. The trick is to find securities mat are currently below their long run trend and buy them. Similarly, a value investor would consider selling securities that are performing above their long-run expected rate of return. Figure illustrates this concept. A study in the Financial Analysts Journal looked at the performance of 29 companies identified in the best-selling book In Search of Excellence: Lessons from America's Best- Run Companies, by Thomas Peters and Robert Waterman. Using the same financial ratios as in the book, the author of the FAJ article found that the financial health of these firms began to decline once the book identified them. At the same time, a control group of companies that ranked low according to the Peters and Waterman criteria showed docsity.com y g ( ) substantial improvement over the subsequent five years-These results are consistent with the notion of security performance reverting to some long-term mean value. Value investors are willing to wait. The Growth Approach to Investing: In the investment community, the term growth is used as both an investment objective and as an investment style. In this latter case, a growth investor seeks steadily growing companies. The two factions within the growth investor camp are the information trader and the true growth investor. The Information Trader: The information trader is in a hurry and believes that profits are to be made by processing the news better than the next person. The information trader also believes that information differentials characterize the marketplace. That is, some people have access to better quality information than others, and some people are better at processing the available information. By using more complete information and using it more effectively than the next person, an information trader believes that above-average profits are possible.11 As an example, one of Wall Street's most widely watched statistics is the weekly unemployment figure, released every Friday morning at 8:30 EST. When the actual statistic deviates from what was expected, the bond market reacts instantly because of the implications for inflationary pressure on the economy. As an example, the keynote speaker for the annual Chicago Board of Trade/Chicago Board Options Exchange Risk Management conference is often at the podium when the unemployment data are released. The audience of portfolio managers and risk managers is extremely interested in "the number," and at about 8:32 an exchange employee hands the speaker a note to read containing the just-released statistic. If the number is a surprise, some people scurry out of the conference in their rush to get to a phone. Information traders are in a hurry; they believe information differentials in the marketplace can be profitably exploited. The True Growth Investor: The true growth trader is more willing to wait than the information trader, but shares the belief that good investment managers can earn above-average returns for their clients. A growth trader often focuses on companies that are currently in favor in the financial community. The proliferation of home computers and information superhighway developments led to significant price rises for firms like Intel, Microsoft, and Gateway (GTW, NYSE). Sometimes the notion of whether the existing level of earnings is sufficient to justify a particularly high stock price is unclear. Growth traders are willing to pay more than might seem reasonable because they like the stack's future prospects; they are buying future earnings that may or may not develop. How Price Relates to Value: Categorizing an investment approach as either growth or value oriented is not really a new idea. The book that holds the distinction as all-time best seller in the investment business is probably Security Analysis by Benjamin Graham and David Dodd. In this book, the authors describe a precursor to the present-day value-versus-growth dichotomy called historical optimism and growth selectivity. Graham and Dodd state: docsity.com y g ( ) “The principle of selectivity was an old and obvious guidepost in Wall Street. It was no more than the truism that some companies are better than others, and hence some stocks will fare better than others in the market- In the 1920s, however, selectivity took on a new character by reason of the overshadowing placed on expected future growth as the prime criterion of an attractive investment.” A remarkable thing about investment theory in the early days of the market is the minor role that price played, Graham and Dodd summarize the attitude in one statement: "A stock with good long-term prospects is always a good investment" As the stock market soared in the late 1920s, the primary determinant of value, in the minds of many people at least, was its growth potential. A stock that experienced high earnings growth was a quality stock, and no external factor could change that, not even a stock price run-up to exorbitant levels. The Great Crash of 1929 and resulting depression changed a lot of minds about the source of value. Firms whose equity was reasonably backed by assets and a popular product fared far better than firms peddling fanciful visions of what might some-day be. Since the Depression, the economy has traversed both recessions and economic expansions. The stock market severely penalizes growth stocks without a firm foundation during the recessions, but falls in love with them during boom times. Most of today's investment managers look favorably upon a history of earnings and dividend growth, but also look at the firm's financial statements to see if future growth can reasonably be expected. Unlike their predecessors, though, contemporary analysts understand that value is inextricably intertwined with price, and that the most efficient and productive company in the world is a poor investment if the stock price is too high. 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: No precise definition of value stock or growth stock will satisfy everyone. However, a firm's price to book ratio and its price-earnings ratio play important roles in this segregation. Morningstar Mutual Funds is a popular source of information on public investment portfolios called mutual funds the principal topic of Chapter Nineteen. This service sorts mutual funds into three groups; value, blend, and growth. The placement criteria are the fund's relative price to book and PE ratios. For each fund, its PE is divided by the market average to produce a relative PE; an average fund has a relative PE of 1.0. The same thing is done with the price to book ratio. Adding these two values gives the magic number. An average fund, by definition, has a rating of 2.00. If a fund's magic number is below 1.75, Morningstar classifies the fund as a value fund. Ratings over 2-25 are growth funds, with those in between classified as blend funds. While the Morningstar system is not definitive, some variant of it is probably used by many value-oriented investors. Morningstar explains their rating rationale as follows: We have opted to combine both the price-earnings ratio (PE) and the price to book ratio for each of the funds, thus emphasizing relative, rather than absolute, numbers. After all a PE of 15 can be cheap in one market, but dear in another; what's really important is knowing how that compares with other funds. By combining each fund's relative PE and price to book docsity.com y g ( ) Of the two common ways of determining growth rates, the first method uses the company's past history of dividends. The other method uses the firm's earnings retention rate coupled with the firm's return on equity. We will look at each of these methods. Calculate dividend growth rates using the geometric mean rather than the arithmetic mean. The Dividend Discount Model: Stock potentially has an infinite life. If the stack's dividends increase by a known growth rate each year, it is valued as a growing perpetuity. Standard present value tables cannot be used for a growing perpetuity, but fortunately a mathematical identity makes present value determinations a simple task. Equation (7-3) shows a relationship known as the dividend discount model (DDM), also called Gordon's growth 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. The DDM is sometimes used to get an idea of how risky the market thinks a particular stock is at the moment. In equation (7-3), we can observe the current stock price and the current dividend. We can estimate the dividend growth rate. The one variable we cannot observe is the discount rate k. This value, however, can be calculated if we know the other variables in the equation. The variable k is sometimes called the shareholders' required rate of return. 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. The Importance of Hitting the Earnings Estimate: Corporate CFOs know the importance of hitting Wall Street's earnings estimates. Analysts are in frequent contact with the company, know its operations well, and usually base their estimates on sound information- The market often penalizes a company's stock substantially when the earnings report is disappointing. This is especially true when the required rate of return and the estimated growth rate are high. Suppose a company has a dividend payout ratio of 50%, analysts expect earnings of $1.10 in the coming year, the consensus median dividend growth rate is 15%, and the current stock price is $27'/2, According to the DDM, the shareholders' required rate of return is 17%: docsity.com y g ( ) P0 = D1 = 0.5 ($1.08) = $10.80 k – g 0.18 - 0.13 %1715.0 50.27$ )10.1($5.0 0 1  g p DR Suppose also that the expected earnings in the upcoming quarter are $0.29, but the company reports only $0.27- This is a negative surprise, meaning that actual earnings were below expectations. This might cause the analyst to reduce the estimate of future growth and, because of the uncertainty, to boost the discount rate. Perhaps the analyst adjusts the growth rate to 13% and the required rate of return to 18%. If future estimates for the year remain on track, the anticipated earnings per share will be only $1.08. How does this affect the stock price? You might first think that being off by two cents is not a big deal, but as the following equation shows, the stock price is hit hard by this news. It falls by nearly 61%. These results indicate why the whisper number is important and why CFOs do not like to feed incomplete information to the analysts who follow their companies. The Multistage DDM: Small firms often show initially high levels of growth that cannot reasonably be expected to persist. In such a case, it is appropriate to use two (or more) growth rates. Suppose a firm currently pays a $1 dividend that is expected to grow by 20 percent for the net two years, and then grow by 5 percent annually thereafter. A growth rate that can reasonably be expected to persist is called a customable growth rate. What is the most an investor can pay for this stock if the required rate of return is 17%? To find out, solve for P0 in the following equation. 2 2 2 21 0 )1( )/().1( )1()1( k gkgD k D k DP       The term for the dividend in year three is discounted only twice because the formula for tile growing perpetuity is based on next year's dividend. Therefore, the numerator is discounted only twice, not three times. Caveats about the DDM: The dividend discount model is a useful tool in security analysis. It is not, however, a method to predict the future. As with most analytical techniques, the DDM helps an analyst make a better decision, but it does not make the decision. Users should understand the shortcomings of the DDM. First, the DDM requires that g. If the dividend growth rate is greater than or equal to the shareholders' required rate of return, the equation cannot be used. Dividing by zero or by a negative number obviously gives an absurd result. Also, the results are sensitive to the estimate of g. Minor differences in the growth rate selected can materially affect the results. As shown, there are numerous ways of estimating g. Another consideration is the assumption that the dividend yield remains constant. A change in dividend policy can affect the apparent growth rate. A change in the growth rate will produce different values from the model. Finally, the model implicitly assumes the long- term ROE is constant. The DDM does not require that every year's growth be identical. Rather, it requires that the long-term growth rate be constant in other words, a long-term trend about which the annual values fluctuate. docsity.com y g ( ) False Growth: Historical data must always be scrutinized carefully when used to determine a growth rate. Remember that in the investing business the future is much more important than the past Sometimes accounting changes, mergers, or other unusual events can muddy the water for the financial analyst. One such situation occurs when one firm acquires another firm through a stock swap. Some shareholders may-decide not to tender their shares, but most are likely to do so. In any event, after the merger, when the accounting records of the two firms are consolidated, we see that A's earnings per share have risen. This appreciation is due solely to the merger and is a phenomenon called false growth. False growth occurs anytime a firm acquires another firm with a PE ratio lower than its own. The stock price does not matter; the PE ratio determines the outcome. When using historical data to estimate a stack's dividend growth rate, an analyst should be alert for instances of false growth contained in the data- If acquisitions occurred during the period, the analyst may need to consider that fact in arriving at an estimate of the growth rate. False Growth occurs anytime a firm acquires another firm with a lower price-earnings ratio. A Firm's Cash Flow: Earnings are important to individual and institutional investors alike. Increasing earnings are a good sign, and investors like to see growth in this statistic. The trained financial analyst knows, however, that taking stated earnings at face value can be a mistake. For this reason, security analysts pay particularly close attention to cash flow, the movement of funds into and out of the firm. The Wall Street Journal once reported in an editorial. “A lot of executives apparently believe that if they can figure out a way to boost reported earnings, their stock prices will go up even if the higher earnings do not represent: any underlying economic change. In other words, the executives think they are smart and the market is dumb. The market is smart. Apparently the dumb one is the corporate executive caught up in the earnings-per-share mystique." The formal definition of cash flow is net: income after taxes plus non-cash expenses. The most important non-cash expense is depreciation. Depreciation is a tax-deductible business expense, but no check is written for it. No funds leave the firm to pay for depreciation expense; it is non-cash. Some financial analysts calculate a variation known as free cash flow, often defined as net income after taxes plus non-cash expenses minus required capital expenditures. This concept recognizes that even though the checking account contains certain funds, they are not necessarily available for discretionary use. If a firm must replace a fleet of trucks next month, the money to do so is encumbered and should not be viewed as profit to be distributed or invested in new ventures. Some evidence indicates that market valuation is more a function of corporate cash flow than corporate earnings. A famous study by Kaplan and Roll examined market reaction to changes in depreciation-methods.24 Switching from straight-line to an accelerated method will decrease earnings but increase cash flow; switching from an accelerated method to docsity.com