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Introduction to security valuation

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Introduction to security valuation A summary Reminder Valuation always precedes the investment decision. Always. Objective Describe the principles and summarize the ... – PowerPoint PPT presentation

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Title: 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.
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