Introduction to security valuation

1
Introduction to security valuation

• A summary

2
Reminder

• Valuation always precedes the investment
  decision.
• Always.

3
Objective

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

4
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

5
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

6
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.

7
Important

• Valuation philosophy determines what approach and
  technique to use

8
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

9
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

10
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

11
Macro technique

• Analyze macroeconomic indicators

12
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

13
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.

14
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

15
Coincident indicators

• Industrial production
• Employees payrolls
• Manufacturing sales
• Etc.

16
Lagging indicators

• Average UI duration
• Inventories
• Banks prime rate
• Etc.

17
Micro techniques

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

18
Micro techniques DCF method

• Require
• Expected growth rate in earnings/dividends/free
  cash flows
• Required rate of return

19
Estimating the markets required return SP 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

20
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

21
Industry analysis

• Objective
• Evaluate industry trends and structural changes
• Methods
• Cross sectional performance analysis
• Trend analysis
• Comparative analysis of firms within an industry

22
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

23
Industry trends and the business cycle

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

24
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

25
Structural changes

• Demographics
• Lifestyles
• Technology
• Politics and regulation

26
Individual company analysis and stock selection

• Objective
• Identify candidates for the investment decision
• Investment decision
• Buy Intrinsic value gt Market price

27
Individual company analysis and stock selection

• Company Overall Strategy
• Defensive vs. offensive
• Low cost vs. differentiation
• Etc.
• Management assessment
• Current rivalries
• Threat from new entrants
• Potential substitutes
• Barganning power of suppliers buyers
• Etc.

• Prospects and Challenges
• Swot analysis
• Financial Performance
• Valuation
• DCF
• Relative

28
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.