P0/E1 - based on expected earnings, leading P/E ratio
P0/E0 - trailing P/E ratio
Leading P/E = Trailing P/E x[ 1/(1+g)]
Given the growth rate is constant, use DDM to determine P/E ratio as:
P0/E1 = (D1/E1) / (k - g)
P0= D1 / (k - g)
E1 = (1+g) E0
ROE = (net income /sales) (Sales / total assets) (total assets / equity)
P/E ratio increase if
· Increase dividend payout D1/E1
· Increase growth rate g
· Decrease k
· Increase ROE, g=ROE x retention ratio
Problem of using P/E analysis
· Earnings are based on historical caosst and with different quality
· Business cycle
· The model cannot be used if k is smaller than g
Showing posts with label Security Valuation. Show all posts
Showing posts with label Security Valuation. Show all posts
Thursday, November 27
Investors’ Required Rate of Return
Required rate of return
= (1+ RFR) (1+ Inflation rate) (1+Risk premium)
=(Real RFR + Expected inflation) + Risk premium.
= Nominal RFR + Risk premium
= Nominal RFR + Beta x (Market return - Nominal RFR)
The risk premium include:
Internal risk
· business risk
· financial risk
· liquidity risk
· exchange rate risk
· country risk
External risk
· market risk factors, macroeconomic in nature and not diversifiable)
= (1+ RFR) (1+ Inflation rate) (1+Risk premium)
=(Real RFR + Expected inflation) + Risk premium.
= Nominal RFR + Risk premium
= Nominal RFR + Beta x (Market return - Nominal RFR)
The risk premium include:
Internal risk
· business risk
· financial risk
· liquidity risk
· exchange rate risk
· country risk
External risk
· market risk factors, macroeconomic in nature and not diversifiable)
Dividend discount model (DDM)
Preferred stock valuation
Dividend is fixed and the income stream continues forever.
Preferred stock value = Dividend / Required rate of return = D/k
Common Stock Value
One-year holding period
P0 = (D1+P1)/(1+k)
Two-year holding period
P0 = D1/(1+k) + (P1+ D2) / (1 + k)2
n-year holding period
P0 = D1/(1+k) + D2/(1+k)2 + .....+ Dn/(1+k)n
Infinite period model (a.k.a constant growth model)
P0= D1 / (k - g) = [D0 x (1+g)] / (k - g)
Where:
the growth rate (g) is lower than the cost of capital (k) and stays constant forever.
Note:
· From the constant growth model, increase in k and decrease in g will lead to decline in stock value. However, just increase in D cannot conclude to increase stock value as it also lead to decrease in growth, under the assumption that ROE is fixed.
DDM with supernormal growth
Assume the company dividends will grow at a high rate for a period of time before declining into a constant growth rate.
P0 = D1 / (1 + k) + D2 / (1 + k)2 + … + Dn / (1 +k)n + Pn/ (1 +k)n
Where:
Pn = Dn+1 / (k - gc) and gc is the constant growth rate
Estimated inputs to be used in DDM
· Dividend
· Future price
· Required rate of return
· Expected growth rate
Required Rate of Return (K)
k = (Rseries = Rf + ßseries(Rmarket - Rf)
Expected Growth Rate (g)
g= (retention rate)(ROE)
Dividend
Last year’s earnings x payout ratio x (1+g)
Future Price
The future price for the company can be derived with next year’s dividend divided by the difference in the company’s required rate of return and its growth rate.
Implied Dividend Growth Rate
A company’s dividend growth rate can be derived from a company’s ROE and its retention rate.
Growth rate = (retention rate)(ROE)
The retention rate of a company is the amount of earnings a company retains for its internal growth. A company’s ROE is the return on the funds invested back into the company.
Dividend is fixed and the income stream continues forever.
Preferred stock value = Dividend / Required rate of return = D/k
Common Stock Value
One-year holding period
P0 = (D1+P1)/(1+k)
Two-year holding period
P0 = D1/(1+k) + (P1+ D2) / (1 + k)2
n-year holding period
P0 = D1/(1+k) + D2/(1+k)2 + .....+ Dn/(1+k)n
Infinite period model (a.k.a constant growth model)
P0= D1 / (k - g) = [D0 x (1+g)] / (k - g)
Where:
the growth rate (g) is lower than the cost of capital (k) and stays constant forever.
Note:
· From the constant growth model, increase in k and decrease in g will lead to decline in stock value. However, just increase in D cannot conclude to increase stock value as it also lead to decrease in growth, under the assumption that ROE is fixed.
DDM with supernormal growth
Assume the company dividends will grow at a high rate for a period of time before declining into a constant growth rate.
P0 = D1 / (1 + k) + D2 / (1 + k)2 + … + Dn / (1 +k)n + Pn/ (1 +k)n
Where:
Pn = Dn+1 / (k - gc) and gc is the constant growth rate
Estimated inputs to be used in DDM
· Dividend
· Future price
· Required rate of return
· Expected growth rate
Required Rate of Return (K)
k = (Rseries = Rf + ßseries(Rmarket - Rf)
Expected Growth Rate (g)
g= (retention rate)(ROE)
Dividend
Last year’s earnings x payout ratio x (1+g)
Future Price
The future price for the company can be derived with next year’s dividend divided by the difference in the company’s required rate of return and its growth rate.
Implied Dividend Growth Rate
A company’s dividend growth rate can be derived from a company’s ROE and its retention rate.
Growth rate = (retention rate)(ROE)
The retention rate of a company is the amount of earnings a company retains for its internal growth. A company’s ROE is the return on the funds invested back into the company.
Forms of Investment Returns
Capital gain yield - from price change
Current yield (coupon yield) – from actual cash received during the investment horizon eg dividend and interest.
Current yield (coupon yield) – from actual cash received during the investment horizon eg dividend and interest.
Wednesday, November 26
Estimate Earning Per Share and Industry’s Earning Multiplier
Estimate Earning Per Share (EPS)
EPS = [(Sales x EBITDA margin%) - Depreciation - Interest expense] x (1 - Tax rate)
Estimate Industry's Earning Multiplier
Macroanalysis
· Assume there is a relathionship between market required rate of return (k) and growth rate (g) with the industry, adjust the industry multplier upwards / downwards based on projected market mulitplier.
Microanalysis
Specific mulitplier approach (more preferable method)
1. Estimate payout ratio (D1/E1), required rate of return (k), growth rate (g)
2. Calcuate expected P/E = (D1/E1)/ (k-g)
Where:
E1 - Next year's EPS
k - Required rate of return derived from the CAPM model (Rseries = Rf + Bseries(Rmarket - Rf). If the required rate of return increases, the multiplier decreases.
g - Expected growth rate derived from both the retention rate (1-payout rate) and corporate ROE. (g = (retention rate)(ROE)). If the expected growth rate increases, the multiplier increases.
D1 - Next year's dividend. Calculate last year's dividend first and then next year's dividend, given last year's corporate earnings as well as the corporate payout ratio.
Direction of change approach
· Study industry variables and then adjust upwards or downwards
EPS = [(Sales x EBITDA margin%) - Depreciation - Interest expense] x (1 - Tax rate)
Estimate Industry's Earning Multiplier
Macroanalysis
· Assume there is a relathionship between market required rate of return (k) and growth rate (g) with the industry, adjust the industry multplier upwards / downwards based on projected market mulitplier.
Microanalysis
Specific mulitplier approach (more preferable method)
1. Estimate payout ratio (D1/E1), required rate of return (k), growth rate (g)
2. Calcuate expected P/E = (D1/E1)/ (k-g)
Where:
E1 - Next year's EPS
k - Required rate of return derived from the CAPM model (Rseries = Rf + Bseries(Rmarket - Rf). If the required rate of return increases, the multiplier decreases.
g - Expected growth rate derived from both the retention rate (1-payout rate) and corporate ROE. (g = (retention rate)(ROE)). If the expected growth rate increases, the multiplier increases.
D1 - Next year's dividend. Calculate last year's dividend first and then next year's dividend, given last year's corporate earnings as well as the corporate payout ratio.
Direction of change approach
· Study industry variables and then adjust upwards or downwards
Speculative Company vs. Speculative Stock
Speculative company
A company that invests in a business with an uncertain outcome e.g. oil exploration company
Speculative stock
A stock that has potential for a large return, as well as the potential for considerable losses.
A company that invests in a business with an uncertain outcome e.g. oil exploration company
Speculative stock
A stock that has potential for a large return, as well as the potential for considerable losses.
Cyclical Company vs. Cyclical Stock
Cyclical company
A company whose earnings are affected relative to a business cycle.
Cyclical stock
A stock that will move with the market in relation to the business cycle.
A company whose earnings are affected relative to a business cycle.
Cyclical stock
A stock that will move with the market in relation to the business cycle.
Defensive Company vs. Defensive Stock
Defensive company
A company whose earnings are relatively unaffected in a business cycle downturn, e.g. food company
Defensive stock
A stock that will hold its value relatively well in a business cycle downturn.
A company whose earnings are relatively unaffected in a business cycle downturn, e.g. food company
Defensive stock
A stock that will hold its value relatively well in a business cycle downturn.
Growth company vs. growth stock
Growth company
A company that consistently select investment which earns higher returns than required by their risk.
Growth stock
A stock that earn higher rate of return than others with similar risk, ie. with price below intrinsic value.
Note:
· A company could be a growth company, but its stock could be a value stock if it is trading below its peers of similar risk.
A company that consistently select investment which earns higher returns than required by their risk.
Growth stock
A stock that earn higher rate of return than others with similar risk, ie. with price below intrinsic value.
Note:
· A company could be a growth company, but its stock could be a value stock if it is trading below its peers of similar risk.
Porter’s five competitive forces within an industry
· Rivalry among the existing competitors
· Threat of new entrants
· Threat of substitute products
· Bargaining power of buyers
· Bargaining power of suppliers
· Threat of new entrants
· Threat of substitute products
· Bargaining power of buyers
· Bargaining power of suppliers
Risk elements in global industry analysis
· Government Policies
· Market Competition
· Market risk factors
· Competition along the Value Chain
· Market Competition
· Market risk factors
· Competition along the Value Chain
Industry life cycle
1) Pioneering Phase
Characteristics: low demand for the industry’s product, large upstart costs.
2) Growth Phase
Characteristics: little competition and accelerated sales, survived the pioneering phase and are beginning to recognize sales growth.
3) Mature Growth Phase
Characteristics: above average growth, but no longer accelerating growth, face increasing competition, profit margins begin to erode.
4) Stabilization/Maturity Phase
Characteristics: average growth, face significant competition and the return on equity is now more normalized, typically longest phase an industry will go through.
5) Deceleration/Decline Phase
Characteristics: declining growth as demand shifts to other substitute (new) products
Example industries
· Consumer staples: ( neccessities- Pharma, food, etc.) outperform in recession.
· Consumer durables: (DVDs, cars) outperform as the economy is pulling out of recession.
· Capital goods: (Heavy goods, chemicals, etc.) outperform further on in recovery as business is more likely to renovate, modernize and purchase equipment.
· Financial stocks- near end of recession(bottom of trough), increase as anticipation of economy recovery)
· Basic industries: (Mining, oil, etc.) outperform best at the top of the GDP cycle.
Characteristics: low demand for the industry’s product, large upstart costs.
2) Growth Phase
Characteristics: little competition and accelerated sales, survived the pioneering phase and are beginning to recognize sales growth.
3) Mature Growth Phase
Characteristics: above average growth, but no longer accelerating growth, face increasing competition, profit margins begin to erode.
4) Stabilization/Maturity Phase
Characteristics: average growth, face significant competition and the return on equity is now more normalized, typically longest phase an industry will go through.
5) Deceleration/Decline Phase
Characteristics: declining growth as demand shifts to other substitute (new) products
Example industries
· Consumer staples: ( neccessities- Pharma, food, etc.) outperform in recession.
· Consumer durables: (DVDs, cars) outperform as the economy is pulling out of recession.
· Capital goods: (Heavy goods, chemicals, etc.) outperform further on in recovery as business is more likely to renovate, modernize and purchase equipment.
· Financial stocks- near end of recession(bottom of trough), increase as anticipation of economy recovery)
· Basic industries: (Mining, oil, etc.) outperform best at the top of the GDP cycle.
Key elements related to return expectations
Demand
Based on worldwide demand, include an analysis of substitutes for the company’s product.
Value Creation
Focus on the sources of value that can be extracted through the value chain, which consists of suppliers of raw materials, but also the delivery firms
Industry Life Cycle
Important to understand an industry’s growth prospects to determine an appropriate growth rate.
Competition
Much more complicated as the analysis is done with global industries and laws in mind.
Based on worldwide demand, include an analysis of substitutes for the company’s product.
Value Creation
Focus on the sources of value that can be extracted through the value chain, which consists of suppliers of raw materials, but also the delivery firms
Industry Life Cycle
Important to understand an industry’s growth prospects to determine an appropriate growth rate.
Competition
Much more complicated as the analysis is done with global industries and laws in mind.
Business Cycle
Phases of Business Cycle
· Recession
· Recovery
· Early Expansion
· Late Expansion
· Slowing into Recession
Recession
The bottom stage of the cycle, the stage ahead of recovery.
Attractive investment opportunities: commodities and stocks.
Recovery
The stage after recovery, start to “recover” after the recession
Attractive investment opportunities: cyclical investments and commodities
Early Expansion
A continuation of the recovery stage, where the recovery begins to gain momentum.
Attractive investment opportunities: overall stock market and real estate.
Late Expansion
After the early expansion stage, the expansion momentum continues and investor confidence is strong.
Attractive investment opportunities: bonds and interest sensitive investments.
Slowing into Recession
After the expansion phase, where the economy begins to show signs of slowing down and even turning negative.
Attractive investment opportunities: bonds and interest sensitive investments.
· Recession
· Recovery
· Early Expansion
· Late Expansion
· Slowing into Recession
Recession
The bottom stage of the cycle, the stage ahead of recovery.
Attractive investment opportunities: commodities and stocks.
Recovery
The stage after recovery, start to “recover” after the recession
Attractive investment opportunities: cyclical investments and commodities
Early Expansion
A continuation of the recovery stage, where the recovery begins to gain momentum.
Attractive investment opportunities: overall stock market and real estate.
Late Expansion
After the early expansion stage, the expansion momentum continues and investor confidence is strong.
Attractive investment opportunities: bonds and interest sensitive investments.
Slowing into Recession
After the expansion phase, where the economy begins to show signs of slowing down and even turning negative.
Attractive investment opportunities: bonds and interest sensitive investments.
Industry Analysis
Analyst can analyse the industry by analyzing the changes in:
· Demographics
· psychographics (lifestyle)
· technology
· regulation and politics
· Demographics
· psychographics (lifestyle)
· technology
· regulation and politics
Top-down approach vs. Bottom up approach
Top-down approach to valuation:
· Valuation process
· macroeconomic analysis - Fiscal, monetary policy, political changes
· industry analysis - cyclical, counter-cyclical, non-cyclical)
· stock analysis - identity company with most upside potential, not only examine past performance but future prospect).
This method is supported by AMIR.
Rationale for top-down approach:
Performance of individual firms is largely explained by economic and industry trends. Studies show that asset allocation is far more important than election of individual securities.
Bottom up, stock picking approach
Select underpriced stocks without considering the direction of economy and state of the industry
Valuation process:
1. Forecast expected cash flows
2. Determine required rate of return
3. Discount the cash flows
4. Make investment decision
· Valuation process
· macroeconomic analysis - Fiscal, monetary policy, political changes
· industry analysis - cyclical, counter-cyclical, non-cyclical)
· stock analysis - identity company with most upside potential, not only examine past performance but future prospect).
This method is supported by AMIR.
Rationale for top-down approach:
Performance of individual firms is largely explained by economic and industry trends. Studies show that asset allocation is far more important than election of individual securities.
Bottom up, stock picking approach
Select underpriced stocks without considering the direction of economy and state of the industry
Valuation process:
1. Forecast expected cash flows
2. Determine required rate of return
3. Discount the cash flows
4. Make investment decision
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