Investment Management

Chapter 3 – Security Valuation

and Analysis

1
 Topics to be Covered
• Fundamental Vs. Technical
analysis
• Economic analysis

• Industry and company analysis

• Bond valuation

• Stock valuation

• Market efficiency 2
2
 What is Technical Analysis?
• Technical analysis is the attempt to forecast
stock prices on the basis of market-derived data.
• Technicians (also known as quantitative analysts
or chartists) usually look at price, volume and
psychological indicators over time.
• They are looking for trends and patterns in the
data
that indicate future price movements. 3
 What is Technical Analysis?
• Use of published market data for analysis of
both
aggregate stock prices and individual stocks
• May produce insight into the
psychological dimensions of the market
• Used by investors and investment
advisory firms
• Oldest approach to stock analysis and
4
selection
 Premises of Technical Analysis
• Market action discounts everything.
– All relevant information are already reflected in the
market price and any new information will impact the
price as soon as they are released.

• Prices move in trends.

– Up, Down, No trend

– A trend is in effect until it reverses.

• History repeats itself.
– Patterns in human psychology do not change.
5
 Why Study Price?
• “The market price reflects…the hopes and fears
and guesses and moods, rational and irrational,
of hundreds of potential buyers and sellers…
Price is the only figure that counts.”

• Technical Analysis of Stock Trends, 8th ed.

Robert D. Edwards and John Magee
6
 What is more important than Why
• "A technical analyst knows the price of everything, but the
value
of nothing.”
• The price is the end result of the battle between the forces of
supply and demand for the company's stock.
• By focusing on price and volume, technical analysis represents
a
direct approach.
• Why did the price go up? It is simple, more buyers (demand)
than sellers (supply). After all, the value of any asset is only 7
10
 General Steps to Technical Analysis
• TOP-DOWN approach

1. Broad Market Analysis

2. Sector Analysis

3. Individual Security Analysis

The principles behind TA are

UNIVERSAL!
8
 Basic Technical Tools
• Trend Lines
– Trend lines
– Support and Resistance Lines

• Moving Averages
• Price Patterns

9
 Trend Lines
• There are three basic kinds
of trends:
– An Up trend where prices are
generally increasing: Higher
lows
– A Down trend where prices
are generally decreasing:
Lower highs
10
15
 Support & Resistance
• Support and resistance lines
indicate likely ends of
• trends.
Resistance results from the
Breakout
inability to surpass prior
highs. results from the
• Support
inability to break below
to prior lows.
• What was support Support Resistance

becomes
resistance, and vice-versa. 11
 Price Patterns
• Technicians look for many patterns in the historical time
series of prices.
• These patterns are reputed to provide information
regarding the size and timing of subsequent price moves.

12
20
 Moving Averages (MA)
• A moving average is simply the average price over the last n
periods.
• Commonly used n: 5, 20, 40, 60, 100, 200 days.
– The longer the time span, the less sensitive the moving
average to daily price changes.
– Moving averages are used to emphasize the direction of
a trend and smooth out price and volume fluctuations.

13
19
 Fundamental Analysis
• Fundamental analysis forecasts the future performance of stocks
based on economic information
• The majority of researchers in finance and economics are
proponents of fundamental analysis
• They believe:

• The stock market is efficient and investors are rational

• The stock price reflects all the information available to the

public
• The value of the stock only depends on the fundamentals of
14
29
the business
 Three Steps of Top-
Down
Fundamental Analysis
• Macroeconomic analysis: evaluates current
economic environment and its effect on industry
and company fundamentals
• Industry analysis: evaluates outlook for particular
Industries
• Company analysis: evaluates company’s strengths
and weaknesses within industry
15
 Macroeconomic Analysis
• Business Cycles
– Expansion, Peak, Contraction, Trough
– Impact of Inventory and Final Sales

• Economic Indicators
– Leading: new orders, building permits, first time
unemployment claims, stock prices, rate
spreads
– Coincident: industrial production
– Lagging: Inventory-to-sales, labor cost
16
 Fiscal & Monetary Policy
• Fiscal Policy (Keynesians)
– Government expenditures (demand)
– Tax & Debt policies
• Monetary Policy (Monetarists – M.
Friedman)
– Interest rates (discount, fed funds)
– Money supply (Open market ops):
– Reserve requirements (commercial banks)
– Margin requirements (brokerage accounts)
17
 Goals of Policy
• Full Employment
– Interest Rates
– Money Supply

• Price Stability (control

inflation)
– Interest Rates
– Money Supply

• Economic Growth
– Interest Rates
– Money Supply
18
 Impediments to Effective Policy
• Time lags between [stimulus] and [desired effect]

• Unintended consequences
– “irrational” expectations on part of policy makers

– Adverse influence of speculators

– Adverse global responses

• Consumer behavior (rational expectations)

• Incorrect analysis, actions, or timing by policy

makers
19
 Industry Analysis
• Classifying industries
– Cyclical industry - performance is positively
related to economic activity
– Defensive industry - performance is insensitive to
economic activity
– Growth industry - characterized by rapid growth in
sales, independent of the business cycle
20
 Industry Analysis
• Industry Life Cycle Theory:
– Birth (heavy R&D, large losses - low revenues)

– Growth (building market share and economies of

scale)
– Mature growth (maximum profitability)

– Stabilization (increase in unit sales may be achieved

by decreasing prices)
– Decline (demand shifts lead to declining sales
and profitability - losses) 21
 Industry Analysis
• Qualitative Issues
– Competitive Structure

– Permanence (probability of product obsolescence)

– Vulnerability to external shocks (foreign

competition)
– Regulatory and tax conditions (adverse changes)

– Labor conditions (unionization)

22
 Industry Analysis
• End use analysis
– identify demand for industry’s products

– estimates of future demand

– identification of substitutes

• Regression analysis
– determining the relationship between
variables
23
 Company Analysis: Qualitative Issues
• Sales Revenue (growth)
• Profitability (trend)
• Product line (turnover, age)
– Output rate of new products
– Product innovation
strategies
– R&D budgets

• Pricing Strategy
• Patents and technology 24
 Company Analysis: Qualitative Issues
• Organizational performance
– Effective application of company
resources
– Efficient accomplishment of company
goals
• Management functions
– Planning - setting goals/resources
– Organizing - assigning tasks/resources
– Leading - motivating achievement
25
40
 Company Analysis: Qualitative Issues
• Evaluating Management Quality

– Age and experience of management

– Strategic planning

– Marketing strategy

– Finance Strategy - adequate and

appropriate
– Employee/union relations

– Effectiveness of board of directors 26

 Company Analysis: Quantitative Issues
• Operating efficiency

• Importance of quality assurance and risk assessment

• Financial Ratio Analysis

• Regression analysis
– Forecast Revenues, Expenses, Net Income

– Forecast Assets, Liabilities, External Capital

Requirements

27
 Company Analysis: Quantitative Issues

• Balance Sheet

• Income statement

• Cash flow statement

• Are financial statements

reliable?

28
 Company Analysis: Quantitative Issues
• Financial Ratio Analysis
– Liquidity (ability to pay bills)

– Debt (financial leverage)

– Profitability (cost controls)

– Efficiency (asset management)

29
 Liquidity Ratios
• Measure ability to pay maturing obligations

• Current ratio
– Current assets / current liabilities

• Quick ratio
– (Current assets less inventories) / current
liabilities

30
 Debt Ratios
• Measure extent to which firm uses debt to finance
asset investment (risk attribute)
• Debt-equity ratio

• Total debt - total assets ratio

• Times interest earned

31
 Profitability Ratios
• Measure profits relative to sales
• Gross profit margin ( % ) = Gross profit / sales
• Operating Profit Margin = Operating profits /
sales
• Net profit margin = Net profit after taxes / sales
• ROA = Net Profit / Total Assets
• ROE = Net Profit / Stockholder Equity*
* Excludes preferred stock balances 32
 Efficiency Ratios
• Measure effectiveness of asset
management
• Average collection period (in days)

• Inventory turnover (times per year)

• Total asset turnover

• Fixed asset turnover

33
 Other Ratios
• Earnings per share
(EPS)
• Price-earnings (P/E)

• Dividend payout

• Book value per share

34
 Technical vs. Fundamental Analysis
• Technical analysis involves the development of
trading rules based on past price and volume for
individual stocks and the overall stock market.

• Fundamental analysis involves economic,

industry, and company analysis that lead to
valuation of companies, which can then be
compared to market prices to aid in investment
35
50
 Advantages of Technical Analysis

• Fundamental analyst must process new information

and quickly determine a new intrinsic value, but

technical analyst merely has to recognize a movement

to a new equilibrium.

• Technicians trade when a move to a new equilibrium is

underway but a fundamental analyst finds undervalued

securities that may not adjust to “correct” prices as

36
 Market
Efficiency
• Efficient markets hypothesis (EMH) – states that
markets are efficient, with market prices
reflecting all available information at any given
time
• Three common forms of market efficiency
include:
– Weak form
– Semi-strong form 37
 Random Walk
Hypothesis
• RWH argues that technical and fundamental
analysis are not accurate analyzing tools.
• RWH suggests that stock price movements
are unpredictable.

38
 Implications of the
• EMH
For the investor the EMH implies:

1. Since all publicly available information is

reflected in current prices, there is no point
researching individual investments

2. Investment advisors advice of

recommending investments is of no value

3. Timing regarding when to buy or sell is

irrelevant
39
 Valuation of Bonds and Stock
• First Principles:
– Value of financial securities = PV of expected future cash
flows
• To value bonds and stocks we need to:
– Estimate future cash flows:
• Size (how much) and
• Timing (when and how long)
– Discount future cash flows at an appropriate rate:
• The rate should be appropriate to the risk presented
by the security.
40
Yield to Maturity -
• The rate of return that an investor would earn if he
bought the bond at its current market price and held it
until maturity. Alternatively, it represents the discount
rate which equates the discounted value of a bond's
future cash flows to its current market price.

41
 Financial Asset Valuation
0 1 2 n
R
...

Value CF1 CF2 CFn

CF 1 CF CF
2 n
PV = + + . .. + .
1 + 1 + 1 +
42
1 2 n
 Definition and Example of a Bond
• Consider a U.S. government bond listed as: 6 3/8
of
December 2009.
– The Par Value of the bond is $1,000.
– Coupon payments are made semi-annually (June 30 and
December 31 for this particular bond).
– Since the coupon rate is 6 3/8 the payment is $31.875.
– On January 1, 2002 the size and timing of cash flows
are:
$31.875 $31.875 $31.875 $1,031.87
5
1/1/ 6 / 30 / 12 / 31/ 6 / 30 / 12 / 31/
02 02 02 09 09
43
 How to Value Bonds
• Identify the size and timing of cash flows;

• Discount at the correct discount rate;

– If you know the price of a bond and the size
and timing of cash flows, the yield to maturity
is the discount rate.

44
60
 Example
• Find the present value (as of January 1, 2002), of a 6-3/8
coupon T-bond with semi-annual payments, and a maturity
date of December 2009 if the YTM is 5-percent.
– On January 1, 2002 the size and timing of cash flows are:

$31.875 $31.875 $31.875 $1,031.87

5
1/1/ 6 / 30 / 12 / 31/ 6 / 30 / 12 / 31/
02 02 02 09 09
 $1, 
$31.875 1 000 16  $1,
PV  .05 2 1 
 (1.025)16   (1.025) 089.75
45
 Stock
Important featuresValuations
of common and preferred stocks
Good investors know something about the company
before they invest in the company’s stock
Gather information to evaluate a potential investment in
a stock
Learn what the information you gather means
Are sales increasing?
Is net income increasing over time?
Are earnings per share increasing over time?

There are periods where stocks decline in value

The key to success is to allow investments to work for
you over the long-term 46
 Why investors invest in common stock?
They can make money in three ways
 Income from dividends in the form of cash or additional stock

 Dollar appreciation of stock value

 Possible increased value from stock splits

WHAT HAPPENS WHEN A CORPORATION SPLITS ITS STOCK?

A stock split happens when the shares owned by existing stockholders are divided into a
larger number of shares

47
Valuation of Preferred stock
Determining value of preferred stock is so easy as the cash flow from
such stock is known certainly. So, preferred stock value is PV of
dividends which is constant and known. It is PV of Dividend for
infinite time period, perpetuity.
P0= D1/r

where,

P0= price of preferred stock at current year

D1 = Dividend of at year 1
r = is required rate of return
48
 The Present Value of Common Stocks

• Dividends versus Capital Gains

• Valuation of Different Types of

Stocks
– Zero Growth

– Constant Growth

– Differential Growth

49
 Case 1: Zero Growth
• Assume that dividends will remain at the same level
forever

Div1  Div 2 
Div 3 
 Since future cash flows are constant, the value of a zero
Div1 Div 2 Div 3
 is the 1present
P0 stock
growth   a perpetuity:
value of 
(1 R) (1 (1
R) 2 R) 3
Div
P  R
0

50
 If g = 0, the dividend stream is
a
perpetuity.
0 1 2 3
R=13%

2.00 2.00 2.00

^
PMT $2.00
P0 = = =
R $15.38.
0.13

51
70
 Stock Value = PV of Dividends

^ D1 D2 D3 D∞
P0 = + +…+
+
(1+R)1 (1+R)2 (1+R)3 (1+rs)∞

Case 2
What is a constant growth stock?
• One whose dividends are expected to grow
forever
at a constant rate, g.
• Is it a realistic assumption? 52
 Case 2
For a constant growth
stock:
D1 = D0(1+g)1
D2 = D0(1+g)2
Dt = D0(1+g)t

If g is constant and
^ R,Dthen:
less than 0(1+g) D1
P =
0 =
R-g R-
g
53
 Intrinsic Stock Value
D0 = 2.00, R = 13%, g =
Constant growth 6%.
model:
^ D0(1+g) D1
P0 = =
R-g R-
g
$2.12 $2.12
= = $30.29.
0.13 - 0.07
0.06
54
 Case 3: Differential Growth
• Assume that dividends will grow at different rates in
the foreseeable future and then will grow at a constant
rate thereafter.
• To value a Differential Growth Stock, we need to:
– Estimate future dividends in the foreseeable future.
– Estimate the future stock price when the stock
becomes a
Constant Growth Stock (case 2).
– Compute the total present value of the estimated
future dividends and future stock price at the
55
 Case 3: Differential Growth
 Assume that dividends will grow at rate g1
for N
years and grow at rate g2 thereafter
Div  Div
Div21  Div10 (1
(1 gg11 ))  Div 0 (1 2

g1 ) .
.
Div N  Div N 1 (1
. g1 )  Div 0 N

(1 g1 )
N
Div N 1  Div N (1 g 2 )  Div 0 (1 g1 ) (1 g 2 )
.
.
. 56
 Case 3: Differential Growth
We can value this as the sum of:
an N-year annuity growing at rate g1

C  (1 T 
PA  1

1 g(1
) T
R  g1  
R)
plus the discounted value of a perpetuity growing
at
rate g2 that starts in year N+1
 Div N1
 R  
PB  2 
g
(1 

R) N 57
 Case 3: Differential Growth
To value a Differential Growth Stock, we can
use

 Div N 1 
 R  
P C  (1 g )  
1 T

R 1 (1   g
(1
2

1
g R)T R) N
 Or we can cash flow it
out.

58
 A Differential Growth Example

A common stock just paid a dividend of $2. The

dividend is expected to grow at 8% for 3 years, then
it will grow at 4% in perpetuity if R = 12%.

What is the stock worth?

59
 With the Formula
 Div N 1 

P C  (1 g )   R 
1 T
2 
R 1 1 (1   g(1 
g R) T
R) N
 $2(1.08) 3 (1.04)
$2  (1.08)  .12
P (1.08) 3
  

.12  1    .04
(1.12)
  (1.12)  
3
3
 .08
P  $54  1 .8966
(1.12) 3
$32.75
P  $5.58  P 60
80
End

61