Introduction to security valuation

A summary

Reminder

Valuation always precedes the investment decision. Always.

Objective

Describe the principles and summarize the process of security analysis & valuation.

Outline

Introduction to valuation principles, approach & techniques Discussion of approaches and techniques Analysis of alternative economies and security markets Industry analysis Individual company analysis and stock selection

Valuation philosophy, approaches, and techniques

Valuation philosophy Acknowledges the basic principles that are important in estimating intrinsic values
Valuation approach Pertains to the valuation process in general It spells out the steps of the selection process Valuation techniques/methods Refers to the quantitative methods used to estimate intrinsic values for individual securities, industries, and markets

Valuation philosophy
Fundamental analysis Investors have rational expectations. It is possible to forecast, hence to estimate intrinsic value as a function of risk and required return
Technical analysis Investors are biased, slow in responding to new information, and overreact There are recurrent price patterns to be exploited. It is more meaningful to find trends than to forecast sales, earnings, risk, return, etc.

Important

Valuation philosophy determines what approach and technique to use

Valuation approaches
Top-down (Three-step) Valuing and selecting securities while accounting for the more general economic context
Analysis of alternative economies and security markets Industry analysis Individual company analysis and stock selection

Bottom-up (Stock picking) Valuing and selecting securities without accounting for the more general economic conditions

Valuations techniques for markets, industries and securities

DCF techniques
Intinsic value = PV of future cash flow

Relative valuation techniques

Require the comparison of various market ratios

Both methods should be used in combination

Analysis of alternative economies and security markets

Objective: Estimate future macroeconomic performance Evaluate the trend in corporate earnings and security prices Prevailing view: General economic conditions are associated with firm performance Markets determine individual security returns How it is done in real life
Macro technique Micro technique: DCF & relative valuation Trend analysis & extrapolation

Macro technique

Analyze macroeconomic indicators

Macroeconomic indicators
Leading indicators Precede the economic cycle
Coincident indicators Synchronized with the economic cycle Lagging indicators Follow in the wake of the economic cycle

Leading indicators
Initial UI claims Construction of new houses Manufacturers new orders Stock market indices M2 Shifts in the money supply propagate through the bond market and stock market (liquidity transition) Consumer and business credit outstanding Consumer confidence Etc.
Most important indicators are bundled and used as indices: Unemployment Index, Inflation Index, Consumer confidence Index, etc.

Leading indicators
Are the most scrutinized Not always easy to interpret and use Ex:
Relationship between interest rates and bond prices: clear Relationship between interest rates and stock prices: murky

Higher interest rates:

Increase the cost of borrowing Signal increased demand, higher prices, and higher corporate earnings

Coincident indicators

Industrial production Employees payrolls Manufacturing sales Etc.

Lagging indicators

Average UI duration Inventories Banks prime rate Etc.

Micro techniques

Applied to the market as a whole Often looks at an index of the most representative securities

Micro techniques: DCF method

Require :
Expected growth rate in earnings/dividends/free cash flows

Required rate of return

Estimating the markets required return: S&P 500

Risk-free rate:
from T-bills to 30-year government bonds

Equity risk premium:

Arithmetic mean (Requities - RT-bill) = approx 9.2% over 75 years Geometric mean (Requities - RT-bill) = approx 7.6% over 75 years Rozeff: dividend yield = 1.5% (when above 6% is time to buy)

Bottom line:
According to different opinions, required return ranges from 6% to 12%

Micro techniques: Relative valuation

Estimating future earnings (EPS)
1. Forecast GDP 2. Project corporate sales as a function of GDP 3. Forecast operating profit:
Capacity utilization rate (+) Unit labor costs(+/-) Inflation (+/-) Foreign competition (-)

4. Forecast EPS

Estimating future earnings multipliers (P/E)

Changes in EPS are not always good predictors of returns Helps spotting bubbles

Industry analysis
Objective Evaluate industry trends and structural changes

Methods
Cross sectional performance analysis Trend analysis Comparative analysis of firms within an industry

Results of empirical studies

Returns vary across industries No patterns of return as a function of time Returns vary within each industry: differentiation Consistent pattern of risk differences among industries

Industry trends and the business cycle

Wide-held belief: Industry performance is related to business cycle.

Industry trends and the business cycle

End of recession
Finance companies do well: more loans, investments in anticipation, etc.

Rock bottom
Consumer durables improve: edging consumer confidence and expected income

Upward trend
Capital goods improve: expanding to meet demand

Peak
Oil, gold, timber, etc do well

Decline
Consumer staples do well: one has to eat and live nevertheless

Structural changes

Demographics Lifestyles Technology Politics and regulation

Individual company analysis and stock selection

Objective Identify candidates for the investment decision

Investment decision Buy: Intrinsic value > Market price

Individual company analysis and stock selection

Company Overall Strategy

Defensive vs. offensive Low cost vs. differentiation Etc.

Prospects and Challenges

Swot analysis

Management assessment
Current rivalries Threat from new entrants Potential substitutes Barganning power of suppliers & buyers Etc.

Financial Performance

Valuation
DCF Relative

Conclusions
Intrinsic value is a very elusive concept, subject to personal interpretation
Security valuation, although a very complex process, is not a science. The principles, approaches and techniques outlined above reflect the prevailing view among security analysts and portfolio managers.