UFL Investments: Chapter 17-19
*Ch 19: Financial Statement Analysis* Market Price Ratios: Growth versus Value
*Market-Book-Value-Ratio (P/B)* market price of a share of the firm's common stock / book value = shareholders' equity per share. --> A measure of growth opportunities; and in large part determined by growth prospects. book value = tangible assets - liabilities A low P/B is seen as something providing a "margin of safety". *Price-to-earnings (P/E) ratio* = (P/B) / ROE ...or.... price to book ratio / return on equity --> measures the present value of growth options to the value of assets. A low P/E stock is more attractive than a high P/E stock.
*Ch 17: Macroeconomic & Industry Analysis* Economic Indicators
A set of cyclical indicators produced by the Conference Board to help forecast, measure and interpret short-term fluctuations in economic activity. Leading indicators -- what indicators that focus directly on decisions today that affect the economy in the near future. > Stock market price index (as prices are forward looking predictors of future profitability) > Money supply (today's monetary policy might well predict future economic activity) > Initial claims of unemployment insurance > new orders for non-defense capital goods > Yield curve slope (10yr treasury - fed funds rate) > Index of consumer expectations Coincident indicators > Employees on nonagricultural payrolls > Personal income less transfer payments > Industrial production > Manufacturing and trade sales Lagging indicators > Average duration of unemployment > Ratio of trade inventories to sales > Change in index of labor cost per unit of output > Average prime rate charged by banks Examples: Pg 568 An economic calendar is released annually to the financial press that outlines economic outlook, using 20 statistics of interest.
*Ch 19: Financial Statement Analysis* Income Statement
A summary of the profitability of a firm over a period of time, such as a year [accrual method of accounting where revenues and expenses are recognized at time of sale, not necessarily at time of payment]. This presents a firm's revenues, expenses, net earnings/profits (which are simply the difference between revenues and expenses). Four classes of expenses: 1. cost of goods sold 2. general and administrative expenses 3. interest expense on the firm's debt 4. taxes on earnings owed to federal/local govt
*Ch 19: Financial Statement Analysis* Fair value accounting (mark-to-market accounting)
Argues that financial statements would give a truer picture of the firm if they better reflected the current market values of all assets and liabilities.
*Ch 18: Equity Valuation Models* Stock Prices and Investment Opportunities
When companies compete, they consider their options between investment opportunities (using the firm's profits/expected earnings) vs. paying those earnings back to shareholders as dividends. It's foolish for a company to payout all its earnings as dividends, as the capital stock and earning capacity would remain unchanged overtime, and then earnings/dividends wouldn't grow. So... firms engage in projects that generate greater returns. They have a couple options to consider: *Dividend payout ratio* Percentage of earnings paid out as dividends *Plowback ratio* / *Earnings retention ratio* The proportion of the firm's earnings that is reinvested in the business (and not paid out as dividends). The plowback ratio = 1- dividend payout ratio. Example: Firm Wannabe Given: - $5 dividend flow per share - k = 12.5% - dividend payout ratio = 40% - plowback ratio = 60% - $100million (plant + equipment) - Return on Investment (ROE) is 15% Find: the actual dividend and plowback amounts, how much growth will be generated? And, if the stock price equals its intrinsic value, what should Wannabe sell at? Actual = .40x5 = $2 Plowback = .60x5 = $3 total earnings = $100M x .15 = $15M If 60% of the $15M is reinvested, then the value of the firm's assets will be: .60x$15M=$9M or by 9% g (growth rate) = ROE x b (plowback ratio - amount reinvested back in the firm) g = .15 x .60 = .09 If the stock price = intrinsic value, it should sell at: P,0 = D1 / k - g P,0 = $2 / .125 - .09 P,0 = $57.14 Therefore, when Wannabe reduced its dividend and reinvested some of its earnings, its stock price increased. The increase in the stock price reflects the fact that the planned investments provide an expected rate of return greater than the required rate -- they have a net present value.
*Ch 18: Equity Valuation Models* ABC stock has an expected ROE of 12% per year, expected earnings per share of $2, and expected dividends of $1.50 per share. Its market capitalization rate is 10% per year. a. What are its expected growth rate, its price, and its P/E ratio? b. If the plowback ratio were .4, what would be the expected dividend per share, the growth rate, price and P/E ratio?
b = (Er,1 - 1) / E1 b = (1.50-1) / 2 b = .25 *expected growth rate* g = ROE x b = 12% x .25 = 3% *expected price* Po = D1 / (k-g) Po = $1.50 / (.10-.03) Po = $21.43 *P/E Ratio* Po/E1 = $21.43/$2 Po/E1 = $10.71 If the plowback ratio were .4 Expected dividend per share .4 x $2 = $.80 expected growth g = 12% x .4 g = 4.8% Price P0 = D1 / (k - g) P0 = (1.50 x .80) / (.10 - .048) P0 = $1.20 / (.062) P0 = $23.08 P/E ratio P0/E1 = $23.08/$2.00 = $11.54
*Ch 18: Equity Valuation Models* Limitations of Book Value
*Book value* is the net worth of a company as reported on the balance sheet. Shareholders in a firm, or residual claimants, have an equity in the firm that is its net worth (assets-liabilities); however, the values of both assets and liabilities recognized in financial statements are based on historical, not current, values. Market values measure current values, instead. That said, market values tend to not match historical ones (market value = CV,assets / CV,liabilities). Book value sometimes cannot represent a "floor" (lowest point) of a stock price. Instead, the firm's *liquidation value* per share can be used. This represents the amount of money that can be realized by breaking up the firm, selling its assets, repaying its debt, and distributing the remainder to the shareholders. If firm's price falls below this value, the firm is an attractive takeover project. *replacement cost* is another measure of firm value, and is the cost to replace a firm's assets (reproduction cost). - *Tobin's q* is the ratio of market value of the firm to replacement cost. With this view, the ratio of market price to replacement cost will tend towards 1.
*Ch 17: Macroeconomic & Industry Analysis* Demand and Supply shocks
*Demand shock*: An event that affects the demand for goods and services in the economy. Usually characterized by aggregate output moving in the SAME DIRECTION as inflation and interest rates. (*Fiscal and Monetary Policies*) i.e. positives are reduction in tax rates, increase in the money supply, increase in gov't spending and increase in foreign export demand. *Supply shock*: An event that influences production capacity and costs. Usually characterized by aggregate output moving in the OPPOSITE DIRECTION as inflation and interest rates. i.e. have to do with enhancing the productive capacity of the economy, rather than increase demand for goods. So, things like changes in the price of imported oil, freezes/floods/droughts that might destroy large quantities of agriculture crops, changes in the education level of an economy's workforce, communication/transportation systems, R&D, etc.
*Ch 17: Macroeconomic & Industry Analysis* 3 factors that determine a firm's sensitivity to the business cycles
1. Sensitivity of sales (necessities = <sensitivity ; luxury = >sensitivity) 2. Operating leverage (the division between fixed and variable costs) if fixed costs < variable costs = less sensitive *Degree of operating leverage* DOL = % change in profits / % change in sales & DOL = 1 + (fixed costs/profits) If DOL > 1, there's some operating leverage (If DOL = 2, then for every 1% change in sales, profits will change by 2% in same direction, up or down) 3. Financial leverage (the use of borrowing) Investors shouldn't always prefer industries with lower sensitivity though, because although ^sensitivity=^beta=^risk, this also means you'd make more return off the ^sensitivity in the up-swings. So, weighing fair compensation for that given risk is recommended, instead.
*Ch 17: Macroeconomic & Industry Analysis* Federal Government Policy
*Fiscal Policy* - Refers to the gov'ts spending and tax actions, and is part of "demand side management." The most direct way to either stimulate/slow the economy. - However, fiscal policy requires lots of compromise between the executive and legislative branches (tax and spending policies), so it is a slow moving process. - ex: Large deficit = govt is spending more than it's taking in from taxes. So, govt will increase demand for goods (via spending) by more than it reduces the demand for goods (via taxes), to stimulate the economy. - Determined by Congress and President. *Monetary Policy* -Refers to the manipulation of the money supply to affect the macroeconomy and is the other main leg of demand-side policy -- this works largely through its impact on interest rates. - Expansionary monetary policy probably will lower interest rates and thereby stimulate investments and some consumption demand in the short run, but these circumstances ultimately will lead to only higher prices and inflation in the long run. So, the stimulation/inflation trade-off is implicit in all debate over proper monetary policy. - Monetary policy is easily formulated and implemented, but has less of an impact on the economy than fiscal policy. - Determined by Board of Governors of the Federal Reserve System (14-yr appointments) - Monetary policy tools: Open Market Operation (Fed buys/sells bonds), Discount Rate (i charged to banks/short term loans), Reserve Requirement (fraction of deposits banks must keep as cash on-hand or deposited with the Fed), Federal Funds Rate (i which banks make short-term loans overnight to each other).
*Ch 19: Financial Statement Analysis* How to evaluate Inventories
*LIFO (last-in first-out)* This method assumes that the last unit to arrive in inventory is sold first. The older inventory, therefore, is left over at the end of the accounting period. For the 200 loaves sold on Wednesday, the same bakery would assign $1.25 per loaf to COGS, while the remaining $1 loaves would be used to calculate the value of inventory at the end of the period. LIFO is preferred when calculating economic earnings; it understates the current value of the remaining inventory in an inflationary environment, despite accurately measuring the cost of goods sold today. *FIFO (First-in First-out)* This method assumes that the first unit making its way into inventory is the first sold. For example, let's say that a bakery produces 200 loaves of bread on Monday at a cost of $1 each, and 200 more on Tuesday at $1.25 each. FIFO states that if the bakery sold 200 loaves on Wednesday, the COGS (on income statement) is $1 per loaf because that was the cost of each of the first loaves in inventory. The $1.25 loaves would be allocated to ending inventory (on balance sheet).
*Ch 17: Macroeconomic & Industry Analysis* Industry Analysis
*NAICS codes* (North American Industry Classification System) -- Defines industry groups and organized by a code to like-groups of firms for statistical analysis. The first two digits denote broad industry classifications, and the next define the industry more narrowly. See page 575. S&P 500 reports on the performance of 100 industry groups by computing the stock price indexes for each, which is useful in assessing past investment performance. Value Line Investment Survey reports on the conditions and prospects of about 1,700 firms grouped into about 90 industries, forecasting the performance of industry groups as well as of each firm.
*Ch 17: Macroeconomic & Industry Analysis* Business Cycle (The recurring pattern of economic recession and recovery)
*Peak*: Transition from the end of an expansion to the start of a contraction (high point) *Trough*: Occurs at the bottom of a recession just as the economy enters a recovery (bottom point) - At a trough right before we leave a recession, *cyclical industries*, those with above-average sensitivity to the state of the economy (producers of durable goods and capital goods), would tend to outperform other industries. Cyclical will show the best results when economic news is positive, but the worst when that news is bad = high betas. *Defensive industries*: have little sensitivity to the business cycle, such as food producers, pharmaceuticals and public utilities. These industries will outperform during a recession. Low betas.
*Ch 18: Equity Valuation Models* Comparative valuation ratios that combine P/E Analysis and the DDM Pg 615-616
*Price-to-book* (an indicator of how aggressively the market values the firm) *Price-to-cash-flow ratio* (earnings can be manipulated, but cash flow is less affected by accounting decisions so some prefer to use this valuation) *price-to-sales ratio* (popular benchmark for startup firms that don't have earnings yet to claim)
*Ch 19: Financial Statement Analysis* Ratio Analysis: DuPont Analysis
*The DuPont analysis* is a framework for analyzing fundamental performance of a firm. DuPont analysis is a useful technique used to decompose the different drivers of return on equity (ROE). Decomposition of ROE allows investors to focus on the key metrics of financial performance individually to identify strengths and weaknesses. There are three major financial metrics that drive return on equity (ROE): *operating efficiency*, asset use efficiency and financial leverage. Operating efficiency is represented by net profit margin or net income divided by total sales or revenue. *Asset use efficiency* is measured by the asset turnover ratio. *Leverage* is measured by the equity multiplier, which is equal to average assets divided by average equity. *DuPont forumla: ROE = (net profit/pretax profit) x (pretax profit/EBIT) x (EBIT/sales) X (sales/assets) X (assets/equity)* *DuPont forumula: ROE = tax burden x interest burden x margin x turnover x leverage* Pretax profit/EBIT = EBIT - Interest expense/EBIT ^*interest-burden ratio* or you can find the *interest coverage ratio* of EBIT/Interest expense. (page 647) EBIT/sales = the firm's operating *profit margin* or *Return on sales (ROS)* sales/assets = *total asset turnover (ATO)*. ^the efficiency of sales of the firm's use of assets. So, if it's 1.0, then sales of $1 per year were generated per $1 of assets. So > 1.0 is great, and < 1.0 is bad. assets/equity = measures the firm's degree of leverage, so it's called the *leverage ratio*. The leverage ratio is equal to (1 + debt-to-equity ratio).
*Ch 19: Financial Statement Analysis* Major issues with interpreting financial data from international firms
- reserving practices - depreciation - intangibles pg. 663-664
*Ch 19: Financial Statement Analysis* Financial ratios are published here:
1. US Department of commerce 2. Dun & Bradstreet 3. Risk Management Association 4. RMA
*Ch 18: Equity Valuation Models* a. Calculate the price of a firm with a plowback ratio of .60 if its ROE is 20%. Current earnings, E1, will be $5/SH and k=12.5%. b. What if ROE is 10%, which is less than the market capitalization rate? Compare the firm's price in this instance to that of a firm with the same ROE and E1, but a plowback ratio of b=0.
A. The price of the firm at a .60 plowback is $400 Find the growth rate g = ROE x b g = .20 x .60 g = 12% Find the dividend rate D1 = .4 x E1 D1 = .4 x $5 D1 = $2 Find the stock price Po = (E1 / k) + PVGO *Po = D1 / (k-g)* Po = 2/(.125-.12) Po = $400 B. If ROE is $10, the stock price will drop to $30.77. In contrast if b=0, then Po = $5/.125=$40.
*Ch 18: Equity Valuation Models* QUESTION 1: Preferred stock that pays a fixed dividend can be valued using the constant-growth dividend discount model. The constant-growth rate of dividends is simply zero. For example, to value a preferred stock paying a fixed dividend of $2 per share when the discount rate is 8%, we compute: QUESTION 2: What is the expected future dividend of a stock for the next three years with a growth rate of .05 and who's dividend just recently paid 3.81? What is the intrinsic value if the market capitalization rate is 12%?
ANSWER 1: V,0 = D,1 / k-g V,0 = 2 / .08-0 = $25 ANSWER 2: First, solve for expected future dividends D,1 = D,0(1+g) = 3.81 x 1.05 = 4.00 D,2 = D,0(1+g)^2 = 3.81 x (1.05)^2 = 4.20 D,2 = D,0(1+g)^3 = 3.81 x (1.05)^3 = 4.41 then, solve for intrinsic value V,0 = D1 / k-g V,0 = 3.81(1+.05) / (.12-.05) V,0 = 4.00 / .07 v,0 = $57.14
*Ch 19: Financial Statement Analysis* Financial leverage and ROE
An analyst interpreting the past behavior of a firm's ROE or forecasting its future value must pay careful attention to the firm's debt-equity mix and to interest rate on its debt. The exact relationship among ROE, ROA, and leverage is as follows: *ROE = (1 - tax rate)[ROA + (ROA-interest rate)xdebt/equity]* If a company has no debt or if the firm's ROA = the interest rate on the debt, its ROE will simply equal (1 - tax rate) X ROA. So, if ROA exceeds the borrowing rate, the firm earns more on its money than it pays out to creditors. example: In a normal year, YZ has a ROE of 6%, which is .6(1 -tax rate) times its ROA of 10%. However, AB, which borrows at an interest of 8% and maintains a debt-to-equity ratio of 2/3, has a ROE of 6.8%. Find ROE. ROE = (1 - tax rate)[ROA + (ROA-interest rate) x debt/equity] ROE = .6[10% + (10% - 8%) x 2/3] ROE = .6(11.3) ROE = 6.8%
*Ch 17: Macroeconomic & Industry Analysis* Sector Rotation
An investment strategy which entails shifting the portfolio into industry sectors that are forecast to outperform others based on macroeconomic forecasts. Peak = good time for investing in firms engaged in natural resource extraction and processing (stable), as the economy might be overheated with high inflation and interest rates. Contraction/recession = defensive industries that are less sensitive, pharmaceuticals, good and necessities are good investments/performers. Trough = Economy is poised for recovery and expansion, so firms might be spending on purchases of new equipment, so this would be a good time to invest in capital goods industries, such as equipment, transportation, or construction. Expansion = cyclical industries such as consumer durables, luxury items and banks will be most profitable. Investor pessimism = + non-cyclical industry investments Investor optimism = + cyclical industry investments
*Ch 19: Financial Statement Analysis* ROA = Margin x Turnover .... Margin vs. Turnover
Consider two firms with the same ROA of 10% per year. The first is a discount supermarket chain, the second is a gas electric utility. --> The supermarket chain has a LOW profit margin of 2% and achieves a 10% ROA by "turning over" its assets five times per year. --> The capital-intensive utility, on the other hand, has a "low" asset turnover ratio of only .5 times per year and achieves its 10% ROA through its higher, 20% , profit margin. Margin X ATO = ROA 2% x 5.0 = 10% (supermarket) 20% x 0.5 = 10% (utility) The point here is that a "low" margin or asset turnover ratio need not indicate a troubled firm. Each ratio must be interpreted in light of industry norms.
*Ch 18: Equity Valuation Models* Dividend discount models (DDM) -uses dividend, capital gains, present value and time.
DDM states that the intrinsic value of a firm is the PV of all expected future dividends. Intrinsic value: v,0 = D,1/1+k + D,2/(1+k)^2 + ..... + D,H + P,H/ (1+k)^H ^^ For a holding period of H years, the stock value is the PV of dividends over the H years, plus the ultimate sale price, P,H. Constant growth DDM: V,0 = D,1 / k - g g = stable growth rate k = risk adjusted rate D,1 = expected future dividend
*Ch 19: Financial Statement Analysis* *Average Collection Period or Days Sales in Receivables*
Days sales outstanding (DSO) is a measure of the average number of days that it takes a company to collect payment after a sale has been made. *ACP (or DSO) = (Accts Receivable / Total Credit Sales) x # Days* Assume accts receivable over two years was 36 and 43.2 million, and sales revenue was 144 million. [(36+43.2)/2] / 144 x 365 = 100.4 days If the industry average was only 60, this statistic tells us that XYZ's average receivable per dollar of sales exceeds its competitors and, again, implies a higher required investment in working capital and, ultimately, a lower ROA.
*Ch 19: Financial Statement Analysis* What's the difference between economic earnings and accounting earnings?
Economic earnings measure the sustainable cash flow that can be paid out to stockholders without impairing the productive capacity of the firm. In contrast, accounting earnings are affected by several conventions regarding the valuation of assets such as inventories and how capital investments are recognized overtime (ie. as depreciation expenses). Economic depreciation = depreciation is the amount of a firm's operating cash flow that must be reinvested in the firm to sustain its real productive capacity at the current level. Accounting depreciation = the amount of the original acquisition cost of an asset that is allocated to each accounting period over an arbitrarily specified life of the asset. This figure is reported in financial statements. Inflation and difference depreciation methods for taxes cause problems (page 659).
*Ch 17: Macroeconomic & Industry Analysis* Suppose the govt wants to stimulate the economy without increasing i rates. What combination of fiscal and monetary policy might accomplish this goal?
Expansionary fiscal and monetary policy will stimulate the economy, with the loose monetary policy keeping down interest rates.
*Ch 18: Equity Valuation Models* Cash cows
Firms with considerable cash flow but limited investment prospects. The cash these firms generate is best taken out of, or milked from the firm.
*Ch 19: Financial Statement Analysis* Economic value added (EVA)
Helps shareholders determine how their capital is performing vs. other potential investments. The spread between ROC and k, multiplied by the capital invested in the firm. Therefore, it's a measure of the dollar value of the firm's return in excess of its opportunity cost. EVA is the incremental difference in the rate of return over a company's cost of capital. Essentially, it is used to measure the value a company generates from funds invested into it. If a company's EVA is negative, it means the company is not generating value from the funds invested into the business. Conversely, a positive EVA shows a company is producing value from the funds invested in it Stern Stewart calls this *Residual Income* EVA = earnings - opportunity cost of capital EVA = NOPAT - (Invested Capital x WACC) NOPAT - Net Operating Profit After Tax WACC - Weighted Average Cost of Capital EX: In 2012, Intel had a WACC of 7.8%. Its return on capital was 13.9%, fully 6.1% greater than the opportunity cost of capital on its investments in plant and equipment. In other words, each dollar invested in Intel earned about 6.1 cents more than the return that investors could have anticipated by investing in equivalent-risk stocks. Intel earned this superior rate of return on capital base of $56.34 billion. Its EVA, was therefore ___________. EVA = NOPAT - (Invested Capital x WACC) EVA = .139 -.078 x $56.34 EVA = $3.44 billion
*Ch 19: Financial Statement Analysis* The Graham Technique
Identify bargain stocks: purchase stocks at less than their book value (working-capital value) or net current asset vaue, giving no weight to the plant or other fixed assets, and deducting all liabilities in full from the current assets.
*Ch 18: Equity Valuation Models* Convergence of price to intrinsic value (pg 600)
If the market price is different than the stock price (i.e. market price $48/share but intrinsic value is $50/sh), then will this discrepancy disappear and, if so, when? Projected value is $4. Now: Next Year: Vo = $50 V1= $50 x 1.04 = $52 Po = $48 P1= $48 x 1.04 = $49.02 Vo-Po = $2 V1-P1= $2 - 1.04 = $2.08 E,HPR = D1/Po + g = $4/$48 + .04 = .1233
*Ch 19: Financial Statement Analysis* Components of financial statement analysis
Income Statement Balance Sheet The statement of cash flows
*Ch 19: Financial Statement Analysis* Turnover and other Asset Ratios *Inventory turnover ratio (ITR)*
Inventory turnover ratio is the ratio of cost of goods sold per dollar of average inventory -- so, this ratio measures the SPEED with which inventory is turned over. IF XYZ had total cost of goods sold (minus depreciation) and average inventory from 2012-2013 as follows: $48k - $57,600 and $108,000 - $129,600, then its ITR is: ITR = cost of goods sold / average inventory ITR = [(48000+57600)/2] / [108000+129600)/2] ITR = 52,800 / 118,800 ITR = .44 Industry standard ITR was .5. Therefore, XYZ was burdened with a higher level of inventories per dollar of sales than its competitors. This, in turn, resulted in XYZ having a higher level of assets per dollar of sales or profits and a lower ROA than its competitors.
*Ch 19: Financial Statement Analysis* Turnover and other Asset Ratios *Fixed-Asset Turnover*
It's helpful understanding a firm's ratio of sales to assets to compute comparable efficiency-of-utilization, or turnover, ratios for subcategories of assets. If you think about turnover relative to fixed assets (FAT): *Fixed-asset turnover = sales / fixed assets* IF XYZ had total sales and assets from 2012-2013 as follows: $120,000 - $144,000 and $432,000 - $518,400, then its total asset turnover for 2013 would be: (432000 + 518,400) / 2 = 475,200 TOA = sales/total assets TOA = 144,000 / 475,200 TOA = .303 Now, if fixed assets for both year totaled 216,000 and 259,200, what would the FAT be? FAT = sales / fixed assets FAT = 144,000 / [(216,000 + 259,200) / 2] FAT = 144000 / 237600 FAT = .606 ^^ So, for every $1 of fixed assets, there were $.606 in sales.
*Ch 19: Financial Statement Analysis* In a period of rapid inflation, companies A and B have the same reported earnings. A used LIFO inventory accounting, has relatively fewer depreciable assets, and has more debt than B. B uses FIFO inventory accounting. Which company has the higher real income, and why?
LIFO accounting results in lower reported earnings than does FIFO. Fewer assets to depreciate resulting lower reporting earnings because there is less bias associated wit the use of historic cost. More debt results in lower reported earnings because the inflation premium in the interest rate is treated as part of interest expense and not as repayment of principle. If A has the same reported earnings as B despite these three sources of downward bias, its real earnings must be greater.
*Ch 19: Financial Statement Analysis* Liquidity Ratios
Leverage is one measure of the safety of a firm's debt, as with liquidity. *Liquidity* is the ability (for a firm) to convert assets into cash at short notice. There are 3 ways to measure liquidity: 1. *current ratio* CurrentR = current assets / current liabilities --> measures the ability of the firm to pay its current liabilities by liquidating its current assets and indicates its ability to avoid insolvency in the short run. current assets = cash & marketable securities, accounts receivable, inventories (not plant/equipment). current liabilities = accts payable and short-term debt (not long-term debt) 2. *quick ratio / acid test ratio* QuickR = (cash + marketable securities + receivables) / current liabilities --> a better measure of liquidity for firms whose inventory is not readily convertible into cash. 3. *cash ratio* CashR = cash + marketable securities / current liabilities --> an even better measure of liquidity, as cash is more liquid than a company's receivables.
*Ch 18: Equity Valuation Models* Intrinsic Value vs. Market Price Examples using: 1-year holding period ABC stock, Expected Dividend, E(D1) of $4 Price per share P,0 is $48 Expected price at yearend, E(P1) is $52. r𝑓 = 6% E(r,m) - r𝑓 = 5% β = 1.2
MARKET PRICE What's the Expected holding period return? *E,HPR = E(D1) + [E(P,1) - P,0] / P,0* E,HPR = 4 + (52-48) / 48 = .167 or 16.7% What is the required rate of return for ABC? Denote RRR as k *k = r𝑓 + βp[E(rm) - r𝑓]* k = 6 + 1.2(5) = 12% E,HPR > k by a risk margin of (16.7-12) 4.7%. Naturally, the investor will want to include more ABC stock in the portfolio than a passive strategy would indicate. INTRINSIC VALUE (V,0) (the present value of all cash payments to the investor of the stock, discounted at the appropriate risk-adjusted rate, k. What's the intrinsic value of ABC? V,0 = E(D1) + E(P,1) / 1 + k V,0 = 4 + 52 / 1.12 = $50 So, at a price of $50, an investor would make a 12% rate of return; however, at the current price of $48, the stock is underpriced compared to intrinsic value. So, investors would want to buy more ABC as it's a positive-alpha stock. ^^If intrinsic value was less than the current market price, investors should buy less of it than under the passive strategy.
*Ch 19: Financial Statement Analysis* Measuring Firm Performance
Managers have two key responsibilities: 1. Investment decisions (the firm's USE of capital) 2. Financing decisions (the firm's SOURCES of capital) Profitability measures: *Return on assets, ROA* ^which tells us the income earned per $ used by the firm ROA = EBIT / Total Assets (ebit = earnings before interest and taxes) but also can be: EBIT x (1-tax rate) *Return on capital, ROC* ^which tells us the income earned per $ of long-term capital invested in the firm. ROC = EBIT / Long-term capital Accounting measure: *Return on equity, ROE* ^Tells us a firm's growth rate of earnings ROE = net income/ shareholders' equity
*Ch 17: Macroeconomic & Industry Analysis* Competitive Strategy
Michael Porter's 5 determinants of competition: 1. Threat of entry from new competitors 2. Rivalry between existing competitors 3. Price pressure from substitute products 4. Bargaining power of buyers 5. Bargaining power of suppliers
*Ch 18: Equity Valuation Models* Present value of growth opportunities *PVGO*
PVGO is the value of the firm as the sum of the value of assets already in place, or the no-growth value of the firm, plus the net present value of future investments the firm will make. Price = No-growth value per share + PVGO Po = (E1 / k) + PVGO Example: Firm Wannabe Given: - $5 dividend flow per share - k = 12.5% - dividend payout ratio = 40% - plowback ratio = 60% - $100million (plant + equipment) - Return on Investment (ROE) is 15% - P,0 = $57.14 57.14 = (5/.125) + PVGO 57.14 = 40 + PVGO $17.14 = PVGO
*Ch 18: Equity Valuation Models* Free Cash flow valuation approaches
Particularly useful for firms that pay no dividends, for which the Dividend Discount Model would be difficult to implement. One approach is to discount the *free cash flow for the firm (FCFF)* at the weighted average cost of capital to obtain the value of the firm, and subtract the then-existing value of debt to find the value of equity. Free cash flow of the firm: FCFF = EBIT(1-t,c) + Depreciation - Capital expenditures - Increases in NWC EBIT = earnings before interest and taxes t,c = the corporate tax rate NWC = net working capital Or, alternatively, you could use the cash flow available to equityholders. FCFE = FCFF - Interest expense x (1 - t,c) + Increases in debt uses a *terminal value* to avoid adding the present values of an infinite sum of cash flows.
*Ch 17: Macroeconomic & Industry Analysis* The Global Economy
Political issues that influence economic growth and investment returns: protectionism, trade policy, free flow of capital, status of a nation's workforce and budget deficits. Issues that affect investment rates: political risks, national economic environment, exchange rate,
*Ch 19: Financial Statement Analysis* The Balance Sheet
Provides a "snapshot" of the financial condition, of assets and liabilities, of the firm at a particular moment [accrual method of accounting where revenues and expenses are recognized at time of sale, not necessarily at time of payment]. Share/stockholder's equity = net worth/book value of the firm (total net assets- total net liabilities = Net Worth) Listed in order: Assets 1a. current assets 1b. long-term/fixed assets (tangible fixed assets such as building, equipment, vehicles, etc. and intangible assets such as expertise and the premium paid over a company's book value to purchase it) Liabilities 2a. short-term or current liabilities (accounts payable, accrued taxes, debts due within 1 year) 2b. long-term debt (due in more than 1 year)
*Ch 17: Macroeconomic & Industry Analysis* Fundamental Analysis
Research to predict stock value that focuses on such determinants as earnings and dividends prospects, expectations for future interest rates, and risk evaluation of the firm.
*Ch 18: Equity Valuation Models* Multistage Growth Models
Some multistage growth models allow for more flexible patterns of growth and dividends per share to grow at several different rates as the firm matures. 3 stages: 1. high dividend growth 2. sustainable growth 3. transitional period where dividend growth tapers off from initial rapid rate to the ultimate stable rate
*Ch 18: Equity Valuation Models* Constant Growth DDM (otherwise known as the Myron "Gordon Growth Model")
The Gordon Growth Model is used to determine the intrinsic value of a stock based on a future series of dividends that grow at a constant rate. It is a popular and straightforward variant of a dividend discount model (DDM). Constant growth DDM: V,0 = D,1 / k - g g = stable growth rate (as g increases, stock prices also rise) k = market capitalization/RRR D,1 = expected future dividend The Constant Growth rate implies that the stock's value will be greater: 1. The larger its expected dividend per share. 2. The lower the market capitalization rate, k. 3. The higher the expected growth rate of dividends. ONLY VALID when g (growth rate) is less than k (market capitalization/RRR).
*Ch 17: Macroeconomic & Industry Analysis* The Domestic Macroeconomy
The ability to forecast macroec. can translate into spectacular investment performance. Here are some key economic statistics used to describe the state of the macroeconomy. *GDP*: the measure of the economy's total production of goods and services. ^Industrial production is a sub-measure here of manufacturing. *Employment*: the unemployment rate is the percentage of the total labor force yet to find work and measures the extent to which the economy is operating at full capacity. ^capacity utilization rate, the ratio of actual output from factories to potential output *Inflation*: The rate at which the general level of prices rise. *Interest rates*: real interest rates are key determinants of business investment expenditures, as high i = less attractive investment opportunities and low i = good for investors. *Budget Deficit*: The difference between government spending and revenues. *Sentiment*: Consumers' and producers' optimism or pessimism concerning the economy. I.e. Strong confidence in future income levels = more willing to spend and invest.
*Ch 18: Equity Valuation Models* Relationship between P/E ratio and plowback
The higher the plowback rate, the higher the growth rate, but a higher plowback rate does not necessarily mean a higher P/E ratio. Higher plowback increases P/E only if investments undertaken by the firm offer an expected rate of return greater than the market capitalization rate. Otherwise, increasing plowback hurts investors because more money is sunk into projects with inadequate rates of return. Pg 610
*Ch 17: Macroeconomic & Industry Analysis* *Industry life cycle*
The industry lifecycle traces the evolution of a given industry based on the business characteristics commonly displayed in each phase. Four stages: 1. Rapid growth (start-up) 2. stable growth (consolidation) 3. slowing growth (maturity) 4. negative growth (relative decline) Peter Lynch uses a 6-tier industry classification system by placing firms in the following groups (pg 581) 1. Slow Growers 2. Stalwarts 3. Fast Growers 4. Cyclicals 5. Turnarounds 6. Asset plays
*Ch 18: Equity Valuation Models* Market Capitalization rate
The market-consensus estimate of the appropriate discount rate for a firm's cash flows. In short: the expected return on a security.
*Ch 18: Equity Valuation Models* Earnings management
The practice of using flexibility in accounting rules to improve the apparent profitability of the firm. reporting "pro forma earnings" measures became common in the 90's. Pro-forma earnings most often refer to earnings that exclude certain costs that a company believes result in a distorted picture of its true profitability. Pro-forma earnings are not in compliance with standard GAAP methods and are usually higher than those that comply with GAAP. The term may also refer to projected earnings included as part of an initial public offering or business plan. With this, we could find that P/E should vary across industries and that they have a clear relationship with growth.
*Ch 18: Equity Valuation Models* Price-Earnings Ratio and Growth Opportunities
The ratio of price per share to earnings per share (P/E ratio). P/E might serve as a useful indicator of expectations for growth opportunities. i.e. Wannabe and XYZ both had an EPS (earnings-per share) of $5, but Wanna be reinvested 60% earnings with a ROE of 15%, while XYZ had a price of $40 and paid out all earnings as dividends. XYZ had a P/E of 40/5 = 8.0. Yet, Wanna be had a P/E $57.14/5 = 11.4. Determinant of P/E ratio: Po/E1 = 1/k ( 1 + [PVGO/(E1/k)] ) P/E Ratio: P0/E1 = (1-b) / (k - ROExb) P/E increases with ROE (because high ROE projects give the firm good opportunities to grow). P/e ratio increases with plowback, b, as long as ROE exceeds k. When a firm has good investment opportunities, the market will reward it with a higher P/E multiple if it exploits those opportunities more aggressively by plowing back more earnings into those opportunities.
*Ch 19: Financial Statement Analysis* Quality of earnings
The realism and conservatism of the earnings number and the extent to which we might expect the reported level of earnings to be sustained. these factors influence quality of earnings: - allowance for bad debt - nonrecurring items (asset sales, exchange rate movements, unusual investment income, etc.) - earnings smoothing - revenue recognition (how a firm manipulates when to realize a sale) - Off-balance-sheet assets and liabilities
*Ch 18: Equity Valuation Models* Fundamental Analysts
Those analysts who use information concerning the current and prospective profitability of a company to assess its FMV. This chapter (18) describes the valuation models that stock market analysts use to uncover mispriced securities.
*Ch 19: Financial Statement Analysis* The Statement of Cash Flows
Tracks the cash implications of transactions [not an accrual method of accounting and only shows an increase/decrease in available cash when the bill is paid -- difference between noting when you write a check vs. cash/pay the check]. It's a away to highlight the well-being of a firm. Listed in order: 1. Cash from operating activities, 2. Cash from investing activities, 3. Cash from financing activities, 4. A fourth category, disclosure of noncash activities, is sometimes included when prepared under the generally accepted accounting principles, or GAAP. Listed in order (another way of putting it) 1a. Net income 1b. Modification of net income for components of income that have been recognized, but for which cash has not changed hands yet. Note: the statement of cash flows recognizes depreciation as a major addition to income. The statement of cash flow recognizes the cash implication of an expenditure when it occurs, not as it "depreciates" or the cost is spread out over a given amount of time.