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Financial Analysis > 03 Equity Investment > Flashcards

03 Equity Investment Flashcards

1
Q

Market

A

A market in general brings together buyers and sellers to transfer goods or services

  • A market need not to have a physical location
  • A good market should allow for cheap and smooth transfer
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2
Q

Asset Classes

  • Risk/Return Level
  • Liquidity Level
A

Equity Investments

  • Medium to high risk/return
  • Medium to high liquidity

Fixed income securities

  • Low to medium risk/return
  • High liquidity

Derivatives

  • High risk/return
  • Medium to high liquidity

Alternative investments (investment companies, real estate, low-liquidity investments)

  • Medium to high risk/return
  • Low to medium liquidity
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3
Q

Characteristics of well-functioning markets (4)

A
  • Timely and accurate information on price and volume of past transactions and on the supply and demand for current goods will be provided
  • Liquidity is the ability to buy and sell quickly
  • Internal efficiency -> Lowest possible transaction cost is provided
  • Informational (external) efficiency -> Prices will rapidly adjust to new information so the market price reflects all information available
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4
Q

Liquidity requires…

A
  • Marketability: The ability to sell the security quickly
  • Price continuity: Prices that don’t change much in the absence of new info
  • Depth: Numerous buyers & sellers willing to trade at prices above & below the current price
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5
Q

Primary Market

A
  • Securities are initially offered to the public in the primary market
  • Most issues on primary markets are distributed with the aid of an underwriter
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6
Q

Primary Market - Services provided by an underwriter (3)

A
  • Origination: Design, planning and registration of the issue
  • Risk bearing: Insures or guarantees the price by purchasing the securities
  • Distribution: Sells the issue
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7
Q

Primary Market: Corporate Bonds - Forms of selling

A

Corporate stocks or bonds are almost always sold with assistance of an investment bank. -> Three forms are common

  • Competitive bids: Include less advice and are common for utilities
  • Negotiation: Most common form
  • Best efforts: The underwriter doesn’t take price risk nor guarantees
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8
Q

Primary Market: New Equity Issues

A

New equity issues involve either shares of firm’s already traded (seasoned issues) or first time issues called initial public offering (IPO)

  • Seasoned issues should sell close to the current market price
  • IPOs are typically underwritten by a lead underwriter and a group of investment banks
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9
Q

Secondary market (incl. Functions)

A

Trading of existing securities occurs in the secondary market including two main functions

  • Liquidity enables investors to sell quickly. -> The greater the liquidity the more investors are willing to engage in these securities
  • Providing continuous information for investors about the market price of their investment
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10
Q

Secondary Market: Different Structures of Security Markets

A
  • Call Markets
  • Continuous Markets
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11
Q

Secondary Market: Different Structures of Security Markets - Call Markets

A
  • Stock is only traded at specific times, a market clearing price is set
  • Used in smaller markets and to determine an opening price
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12
Q

Secondary Market: Different Structures of Security Markets - Continuous Markets

A

Price is set by either the auction process or by dealer bid-ask quotes

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13
Q

Over the Counter Markets (OTC)

A

Include the trading of all securities not listed on one of the registered (national or regional) exchanges

  • Negotiated markets, where investors negotiate directly with dealers
  • Bid and ask quote are listed over the National association of Securities Dealers Automated Quotation (NASDAQ)
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14
Q

Third Market

A

Includes transactions in OTC markets including stocks listed at a registered exchange

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15
Q

Fourth Market

A

Fourth market transactions describe the direct exchange between investors without the use of brokers to save transaction costs

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16
Q

Trading Systems

A
  • Pure Auction Market
  • Dealer Market
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17
Q

Trading Systems - Pure Auction Market

A

Exchange system where buyers and sellers submit their bid and ask prices to a central location

  • Transactions are made by brokers (computer) who do not have position in the stock (price-driven market)
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18
Q

Trading Systems - Dealer Market

A

Buyers and sellers submit their order to dealers who either buy or sell the stock for their own inventory (order-driven market)

  • OTC markets are organized like this
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19
Q

Types of Orders (4)

A
  • Market Orders
  • Limit Orders
  • Short Sales Orders
  • Stop Loss Orders
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20
Q

Types of Orders - Market Orders

A

Buy or sale at the best price available

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21
Q

Types of Orders - Limit Orders

A

Orders to trade away from the current market price at a price defined in the order.

  • Usually have a limit (instantaneous, day, week, month, GTC)
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22
Q

Types of Orders - Short Sale Orders

A

Orders where a trader borrows the stock, sells it, repurchases it later and returns a loan

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23
Q

Types of Orders - Stop Loss Orders

A

Used to prevent losses or protect profits

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24
Q

Market Making on Stock Markets - Basic functions of Market Makers

A

Market makers provide two basic functions to the exchange

  • They act like brokers handling the limit order book where limit and stop orders are maintained
  • They act as dealers buying and selling for their own accounts to maintain an orderly market and provide bridge liquidity if there is an inadequate order flow
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25
Q

Margin Purchases

A

Margin purchases involve buying securities with borrowed money

  • Lending rate is about 1.5% above the bank call money rate
  • Federal Reserve Board Regulations T demand an initial margin of 50% -> equity provided by the borrower
  • Maintenance margin is the minimum equity portion of an account, currently at 25%
    o If the customer’s balance falls below this value he will get a margin call -> Trigger price
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26
Q

Maintenance Margin

A

Maintenance margin is the minimum equity portion of an account, currently at 25%

  • If the customer’s balance falls below this value he will get a margin call -> Trigger price
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27
Q

Function of Security-Market Indices

A

Intended to represent the behavior of the market

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28
Q

Areas that Security-Market Indices are used in (4)

A
  • Measuring portfolio performance -> Since it takes no effort to earn the market return the portfolio performance is measured compared to the market
  • Evaluate the financial variables that influence overall security price movements
  • Investment decision in technical analysis
  • Calculate a firm’s beta indices used as proxy for the market portfolio
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29
Q

Indices (incl. factors to be considered)

A

Indices track performance of a predefined market segment.

Factors that must be considered:

  • The sample must be representative of the population to avoid bias -> Source, size and breadth must be defined
  • The individual items must be weighted either by price, value, or equal weighting system
  • The mathematical or computational procedure to combine the individual items into a whole index must be defined. Generally, arithmetic average or geometric average, or base period weighting of the average are used
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30
Q

Price-Weighted Indices

A

Price-weighted series adds together the market price of each stock in the index and then divides the total by the numbers of stock

  • Such an index assumes the purchase of an equal number of shares of each stock represented in the index
  • High price stocks will have relatively greater effect on the index
  • The index divisor (denumerator) must be adjusted for stock splits and other changes (e.g. exit entry of new stocks)
    -> This results in a downward bias as predominantly successful companies tend to split their stock and thus will lose weight within the index
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31
Q

Market Value-Weighted Indices

A

Market value-weighted series are calculated by summing the total value of all stocks in the index. The sum will then be divided by the sum of the base period and multiplied with the index’s base beginning value

  • Assumes an investment proportionate to the market value in each company
  • Firms with greater market capitalization have greater impact on the index
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32
Q

Unweighted Indices

A

Unweighted price indicator series place an equal weight on all stocks regardless of their price and market value.

  • These indices are working with percentage price changes
  • The value can be calculated using arithmetic or geometric average
  • The geometric mean causes downward bias in the index as it will always be lower than respectively maximal equal to the arithmetic mean
  • Assumes that the index portfolio makes and maintains an equal dollar investment in each stock
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33
Q

Style Indices

A
  • The major indices are supplemented by small- and mid-cap indices, mainly to evaluate the performance of money managers who concentrate on those size sectors
  • Further distinction includes type of stock, i.e. growth or value stocks
  • Latest index “innovation” created Indices to track socially responsible investments (SRI)
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34
Q

Style Indices - Value Stock

A

Value stocks usually have a low price-earnings or price-book value ratio

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35
Q

Style Indices - Growth Stock

A

A growth stock is specified as a stock of a company experiencing rapid growth of sales and earnings

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36
Q

Bond-Market Indices - Difficulties

A
  • Bond universe is much broader than the universe of stocks
  • Bond universe is changing constantly due to new issues, maturities, call terms and bond sinking funds
  • Significant pricing problems as many bonds lack of continuous trade data like that found for exchange listed stocks
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37
Q

Basic Categories of Bond Indices (3)

A
  • Investment grade bond indices
  • High-yield bond indices
  • Global bond indices
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38
Q

Composite Stock-Bond Indices

A

Developed to measure the performance of all securities in a given country

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39
Q

Efficient Market - Definition

A

In an efficient market the current price of a security fully reflects all available information including risk

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40
Q

Information Efficient Market - Definition

A

In an information efficient market prices adjust rapidly to new information

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41
Q

Assumptions of Market Efficiency (4)

A
  • A large number of profit maximizing participants are analyzing and valuing securities independent of each other
  • New information occurs randomly and independent of each other
  • Investors adjust their estimate of security prices rapidly
  • Expected returns implicitly include risk in the price of the security

-> Should these assumptions not hold (like in emerging markets) excess returns may be possible

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42
Q

Efficient Markets Hypothesis (EMH): Weak-form EMH

A

Assumes that stock prices fully reflect all currently available (historical) security market information

  • Past price and volume information will not influence future prices
  • Technical analysis will not yield excess returns
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43
Q

Efficient Markets Hypothesis (EMH): Semistrong-form EMH

A
  • Holds that prices instantly adjust to the arrival of all new publicly available information
  • Investors cannot achieve excess returns using fundamental analysis
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44
Q

Efficient Markets Hypothesis (EMH): Strong-form EMH

A
  • Assumes all – market, nonmarket public, and private (inside) – information is reflected in the market price -> No group of investors should achieve superior returns
  • Assumes perfect markets in which all information is cost free and available to everyone
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45
Q

Efficient Capital Markets - Anomalies

A
  • If a mispricing is well known and persistent then it is referred to as an anomaly
  • Market anomalies are phenomena not explained by the efficient market hypothesis and possibly disprove EMH
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46
Q

Efficient Capital Markets - Anomalies: Time-Series Tests

A
  • Release of quarterly earnings surprises are not reflected in prices as fast as expected by semistrong EMH
  • January anomaly: Shows that tax-induced trading at year end increase prices in the short run -> An investor can earn excess returns by buying in December and selling in early January
  • Weekend effect: Shows that the average return for weekdays is positive but that there is a negative return associated with Fridays
  • Prices tend to rise on the last trade of the day
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47
Q

Efficient Capital Markets - Anomalies: Cross-Sectional Tests

A
  • Low price-earnings ratio (P/E) stocks experience superior results relative to the market
  • Small firm effect says that small and neglected firms (few analysts following them) experience significantly larger risk-adjusted return
  • The greater the ratio book to market value the greater the risk-adjusted return
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48
Q

Efficient Capital Markets - Anomalies: Event Studies (4)

A
  • Stock splits were found to have no long- or short-run impacts
  • IPOs are on average underpriced by 15%, the pricing adjustment occurs within the first trading day
  • The listing on a prestigious exchange or segment does not cause a permanent value increase, but researchers found short-run profit opportunities
  • Markets do react quickly and predictably accounting changes
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49
Q

Efficient Markets - Implications

A
  • Fundamental analysis has to be directed towards estimating variables that influence the long-run performance
  • Portfolio management should diversify on a global basis to eliminate unsystematic risk
  • Minimizing transaction costs is an important part of the investment managers job, i.e. taxes, trading turnover, liquidity
  • Performance measurement should compare investment professionals to a randomly selected buy-and-hold strategy
  • The investors job is to separate good money managers from the average and poor
  • Index funds are a cost-effective way to participate in the market’s performance, since EMH states that one cannot expect to outperform the market
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50
Q

Limitations to Efficient Markets

A

Prices can adjust to new information only with a time lag

  • Processing of information is costly
  • If the delay is short enough (a few minutes) markets are still considered efficient

Cost of trading incur by traders: Time for investment selection and brokerage cost

  • The greater the cost of trading the greater the mispricing
  • If short selling (selling a stock you do not own) is more difficult than buying long (buying a stock you do not own) then prices are likely to be biased upward

Limitations of arbitrage may occur if mispricing continues

  • New economy
  • Arbitrageurs are limited by the capital amount available, therefore they concentrate on the most egregious mispricing
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51
Q

Behavioral Finance

A

Considers how various psychological traits affect the ways that individuals or groups act as investors

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52
Q

Behavioral Finance - Overconfidence in Forecast

A

Bias which causes analysts to overestimate growth rates, emphasize good news, and ignore negative news from growth companies

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53
Q

Behavioral Finance - Following the Herd

A

Traders following the news – and they “following the herd” – are almost always wrong and contribute to excess volatility

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54
Q

Behavioral Finance - Fusion Investing

A

Fusion investing is the integration of two elements, the fundamental value and the investor sentiment

  • Measures for investor sentiment can be analyst recommendation, price momentum, and high trading turnover
  • Especially for short-term trading the market sentiment may be important as fundamental analysis takes about three years to assert itself
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55
Q

Survivorship Bias

A

Survivorship bias occurs whenever a result is only based on existing entities, e.g. mutual fund performance of IPO performance

56
Q

Small-Sample Bias

A

Refers to the period of observation, if the period is not long enough mispricing may occur by chance

57
Q

Selection Bias

A

The sample may be biased to find the desired result

58
Q

Is it possible to short-sell an IPO?

A

No

59
Q

Valuation Theory - Value of an Asset

A

Value of an asset = Present value of its expected returns (cash flow)

60
Q

Valuation Theory - Required Items for the process of valuation

A

Stream of expected returns and the required rate of return on investment

  • The estimate of the stream of expected return encompasses not only the size but the form, i.e. the time pattern, the growth rate, and the uncertainty
  • Required rate of return is determined by the economy’s real risk-free rate, the expected rate of inflation, and a risk premium derived from the uncertainty of returns
    o The nominal risk-free rate equals for all investments within an economy, therefore the risk premium is the only responsible for a variation in required date of return
61
Q

What do different valuation models primarily differ in?

A

Valuation models primarily differ in the definition of the underlying return stream

  • Earnings
  • Cash flows
  • Dividends and capital gains
  • Interest payments and debt repayments
62
Q

Investment Decision Process

A
  1. Estimate the USD/EUR amount of the expected cash flows -> CFT
  2. Determine the required rate of return based on the risk (uncertainty of the cash flows) -> r
  3. Calculate the present value by discounting the expected cash flows -> PV
  4. Compare the estimate to the current security’s market price -> PV <> MV
  5. Buy undervalued securities and sell, short sell, or don’t buy overvalued securities
63
Q

Equity Analysis: Top-Down Approach - Steps

A
  • Economic Analysis
  • Industry Analysis
  • Company analysis
64
Q

Equity Analysis: Macroeconomic Influences

A
  • Fiscal policy (taxes, government spending) has influence on consumer demand
  • Monetary policy (money supply) influences interest rates and inflation and hence, economic growth
  • Especially, on a global perspective industries might be impacted by political changes
65
Q

Equity Analysis: Industry Effects

A
  • Consider how these industries react to economic change
  • Consider global economic shifts
66
Q

Equity Analysis: Firm Analysis

A
  • Compare firms within an industry using financial ratios and cash flow analysis
  • Identify firms with clear upside potential (buy) and high downward risk (short sell)
  • Focus on the firms future prospects
67
Q

Most important step of investment decision

A

Asset allocation decision (i.e. asset type, country, industry)

68
Q

Classification of changes in the economy

A
  • Cyclical Changes
  • Structural Changes
69
Q

Classification of changes in the economy: Cyclical Changes

A

Cyclical Changes have a mid-term effect on companies. Especially consumer durables and capital goods respond to those trends

70
Q

Classification of changes in the economy: Structural Changes

A

Structural Changes are permanent and long-term in nature. The business environment changes due to

  • Demographics, i.e. age, education, gender or ethnic composition
  • Technology changes “the way things are done” and results in different product and service demand
  • Politics influence the economy through reallocation and government funding
71
Q

Equity Analysis: Industry Analysis

A

Industry analysis is a major step in the three-part investment process to

  • isolate industry trends
  • study earnings cycles
  • study risk
  • study the individual position of firms within the industry
72
Q

Equity Analysis: Items of an industry analysis model (6)

A
  • Demand analysis
  • Supply analysis
  • External factor analysis
  • Profitability analysis
  • Industry classification
  • International competition and markets review
73
Q

What results do studies concerning industry analysis provide?

A
  • Performance and risk level varies widely across industries
  • Individual industries rate of return vary over time
  • Individual firms rate of return within an industry vary
  • Individual industries risk factors appear to be fairly constant over time
74
Q

Industry Analysis: External Factors and Structural Changes

A

Technology

  • Successful technological innovations
  • New technologies often lead mature companies to copy or acquire the competing solutions

Government

  • Regulation, taxes and subsidies influences almost every phase of industry

Social changes

  • Fashion changes (short-term and hard to predict)
  • Lifestyle changes (long-term and easier to predict)

Demography

  • Changes in the population’s vital statistics
  • Easy to predict, but implications difficult to forecast

Foreign influence

  • Threads and opportunities that my result in new markets, accelerating competition, or new positioning within the value chain
75
Q

Industry Classification - Industrial Life Cycle (Order of increasing time)

A
  • Pioneer
  • Growth
  • Mature
  • Decline
76
Q

Industry Classification - Industrial Life Cycle - Pioneer

A

Equity investors must be prepared to lose their entire investment

77
Q

Industry Classification - Industrial Life Cycle - Growth

A

Industry growth is faster than general economy, high profit margins

78
Q

Industry Classification - Industrial Life Cycle - Mature

A

Growth must come from increased market share or acquisition

79
Q

Industry Classification - Industrial Life Cycle - Decline

A

Participants have to reinvent themselves, or fail

80
Q

Industry Classification - Business Cycle Reaction

A
  • Growth stocks experience accelerating sales and profit margins during all phases
  • Defensive stocks are less cyclical than overall markets
  • Cyclical stocks tend to increase sales during expansion and peak phases but drop off significantly during recession phases
  • The stock’s classification change over time
81
Q

Industry Analysis - Porters Five Forces

A
  • Thread of new entrants
  • Thread of substitutes
  • Bargaining power of buyers
  • Bargaining power of suppliers
  • Rivalry among competitors
82
Q

Industry Concentration

A

One of the most important characteristics of an industry

Fragmented Industry:

  • Many firms compete
  • The theories of competition and product diversification are most applicable

Higher concentration:

  • Fewer firms
  • Oligopolistic competition and game theory become more important

Only one firm:
Theory of monopoly applies

83
Q

Industry Concentration - Approaches in analyzing firm fragmentation

A
  • N firm concentration ratio: Combines the market share of the N largest firms in the industry
  • Herfindahl index: Sums up the squared market shares of the firms in the industry
84
Q

Industry Concentration - Approaches in analyzing firm fragmentation: Regulators Rule of Tumb

A
  • Herfindahl index < 0,1 -> Unconcentrated industry
  • Herfindahl index up to 0,18 -> Moderate concentration
  • Herfindahl index > 0,18 -> High concentration
85
Q

Competitive Strategy

A

Competitive advantages allow for above average returns, but may be difficult to sustain

  • Cost Leadership
  • Differentiation
86
Q

Competitive Strategy - Cost Leadership

A
  • Economies of Scale
  • Technological Innovation
  • Special access to raw materials
  • Maintain differentiation parity
  • Fierce competition
87
Q

Competitive Strategy - Differentiation

A
  • Product itself
  • Delivery
  • Marketing approach
  • Maintain cost parity
  • Multiple differentiator possible
88
Q

Company Analysis and Valuation - Investment Returns

A
  • Outcome of economic and industry analysis: Securities with the most upside or clear downside potential should be identified -> Involves past performance and future prospects
  • Golden rule of valuation values an asset at its present value -> Future cash flows are discounted at the appropriate rate of return
89
Q

Investment Returns - Forms of cash flows

A
  • Current yield: Based on the actual cash received -> Typically composed of dividends and interest and stated as a percent of price
  • Capital gains yield (price change): Result from the percentage increase or decrease in the price and are realized when the asset is sold
90
Q

Preferred Stocks

A
  • Usually carry no voting rights and are senior to voting shares
  • The dividend payment is fixed
  • Preferred shares are often used to finance private or pre-public companies
  • Determining the required return rps is difficult, but should be above the firm’s bond rate rBond
91
Q

Preferred Stocks - Certificate of Designation

A

States the specific terms and may specify nearly any right conceivable

  • Almost all preferred stocks have fixed or floating (LIBOR) cumulative dividend obligations (perpetuities)
  • Special voting right may be assigned (e.g. issuance of new shares)
  • Series of preferred shares may have a senior, pari-passu or junior relationship with other series issued
  • May carry call provisions, enabling the issuing corporation to repurchase the share
  • Straight or convertible specification
  • Preferred yields are often below the firm’s highest grade bond yields (tax exempt)
92
Q

Dividend Discount Model (DDM)

A
  • The stocks intrinsic value is the PV of its future cash flows
  • Size and timing of the cash flows CFt are uncertain, hence the required rate of return rCS is higher than rPS (preferred stocks) or rBond (bonds)
  • The discount rate is estimated via CAPM (Formula 1)
  • The PV is the sum of the discounted dividends (Formula 2)
93
Q

Infinite Period DDM

A
  • The infinite period DDM assumes a stable growth rate g
  • Also known as constant growth or Gordon Growth Model
  • Long-term growth above GDPnom is unrealistic
94
Q

Two-Stage DDM

A
  • There are variations to the stable growth model
  • Short-term dividend can be predicted more reliable or show abnormal behavior. -> The model my distinguish two different phases
  • Long-term return, and derived dividends should be estimated according to the company’s industry
  • Short-term return can exceed the industries average returns (Competitive advantage period)
    -> Theory assumes that competitive advantage cannot be sustained forever
  • In the long-term a stable growth is assumed (Formula 1)
95
Q

Required Rate of Return

A

Risk free rate (RFRreal) + inflation premium (IP) + risk premium (RP)

96
Q

Applying Valuation Models for foreign securities - Further Risks to consider (5)

A
  • Business risk: Represents the country’s variability of economic activity along with the degree of operating leverage
  • Financial risk: Determined by the financial leverage
  • Liquidity risk: May increase investing in countries with small or inactive capital markets
  • Exchange rate risk: Must additionally be taken into account
  • Country risk: Arise from unexpected economic or political events
97
Q

Required Rate of Return - Types of Companies

A
  • Defensive Companies
  • Cyclical Companies
  • Speculative Companies
98
Q

Defensive Companies

A

Future earnings are likely to withstand an economic downturn

99
Q

Cyclical Companies

A

Sales and earnings will be heavily influenced by aggregated business activity

100
Q

Speculative Companies

A

Assets involve great risk but also has a possibility of high gains, e.g. oil exploration

101
Q

Growth Rate

A
  • The firms earnings growth rate is defined as the firm’s retention rate (or earnings plowback) times the return on equity
  • Assumption: Past investments are stable and the calculation allows for maintenance of the past earnings power
102
Q

Growth Rate - Implications

A
  • If profit margin increases, RoE will increase
  • If RoE increases, g will increase
  • If g increases, r-g will decrease
  • If r-g decreases, the stock price will increase
103
Q

Estimating EPS - Required Input variables (5)

A
  • Sales per share
  • Operating profit margin
  • Depreciation Expenses
  • Interest expenses
  • Corporate Tax
104
Q

How can Sales per Share be estimated?

A
  • Sales per share might be estimated according to GNP growth for the next year
  • For a stock market series regression analysis might be applied
105
Q

How can the operating profit margin be estimated?

A

Operating profit margin can be estimated (i) based on recent trends or (ii) estimate the operating profit margin defined as EBITDA/Sales

  • Second is appealing because it is not influenced by change in tax, interest, depreciation or amortization
  • EBITDA is influenced by (i) capacity utilization, (ii) unit labor cost, (iii) inflation, and (iv) foreign competition
106
Q

How can Depreciation expenses be assessed?

A

Depreciation expenses can be assessed using past depreciation including current capital expenditure -> If Capex is high, depreciation is expected to grow

107
Q

Interest Expenses

A

Interest expenses are a function of outstanding debt and expected interest rates

108
Q

What does the corporate tax depend on?

A

Corporate tax depends on the tax rate which might be treated stable depending on the political environment

109
Q

Cash Flow Definition of Company Valuation - What definitions of cash flow can be used for valuation? (3)

A
  • Dividends
  • Free cash flow
  • Residual income

-> All variations should theoretically result in the same value

110
Q

Cash Flow Definition of Company Valuation - Dividends

A
  • Theoretically justified (flow-to-equity)
  • Less volatile than other measures (earning and free cash flow)
  • Perspective of minority stakeholder (no influence on dividend policy)
111
Q

Cash Flow Definition of Company Valuation - Free Cash Flow

A
  • Cash flow generated by the firm’s operations that is not required to be reinvested to continue operations at its current level
  • Required rate of return is the WACC
  • Suited for private firms
  • Perspective of a controlling shareholder
112
Q

Cash Flow Definition of Company Valuation - Residual Income

A
  • The amount of earnings that exceed the investors’ required return
  • In-depth analysis of the firm’s accounting accruals
113
Q

Company vs. Stock Analysis

A
  • Identifying the best firms does not necessarily mean identifying the best investment -> A good company might be overpriced while a weaker company is underpriced
  • The analysts major task is to identify good investments where the expectations are not reflected in the current market price
114
Q

Company vs. Stock Analysis - Methods for making the investment decision

A

Compare the PV of the firm with the current market price

  • If V > Pmkt the stock is underpriced and should be acquired

Compare the expected rate or return with the required rate of return calculated

  • If rexp < rreq sell short or don’t buy the stock because it is overpriced
115
Q

How do relative valuation techniques work?

A

In contrast to DCF valuation, relative valuation techniques use multiples to value companies

116
Q

Multiples

A
  • Multiples are ratios of market price (as a proxy for the firm’s value) and some fundamental variable (e.g. EBITDA, book value, or non-financials)
  • Multiples imply that it is possible to determine a value of an economic entity by comparing it to similar entities on a basis of several relative ratios
  • Multiples are used in public and private company valuation and for comparison within an industry
  • They can be based on historic or forecasted fundamentals
  • They are usually calculated as an average multiple of the peer group (industry multiple)
  • Relative valuation techniques heavily depend on the quality of the peer group, i.e. are the companies comparable
117
Q

Earnings Multiplier - Price to earnings (P/E) ratio

A
  • P/E ratio is the most commonly used ratio as earnings power (EPS) is the primary determinant of investment value
  • Research shows that differences in P/E is significantly related to long-run average stock returns
118
Q

Price-to-earnings ratio - Shortcomings

A
  • Negative earnings produce useless P/E ratio
  • Volatile earnings make the interpretation difficult
  • High influence of management discretion lessens the comparability
119
Q

Versions of the P/E Ratio

A

Trailing and leading version of P/E ratio

  • Commonly used trailing P/E ratio uses earnings over the most recent 12 months
  • Leading (forward or prospective) P/E ratio uses next year expected earnings
120
Q

P/E is determined by (according to formula)

A
  • The expected dividend payout ratio (D/E)
  • The estimated required rate of return on the stock (r)
  • The expected growth rate of dividends from the stock (g)
121
Q

Main determinant of P/E ratio

A

The spread between r and g is the main determinant of the P/E ratio

122
Q

Price/Book Value Ratio

A
  • Book value is typically positive, even when a loss is reported
  • Book value is more stable then EPS -> Might be used when earnings are particularly high, low, or volatile
  • Might be useful for valuation where going concern is difficult
  • Appropriate measures of net asset value for firms that primarily hold liquid assets, i.e. banks, insurance, investment and finance
123
Q

Price/Book Value Ratio - Shortcomings

A
  • The value of non-physical assets is not recognized
  • Can be misleading where significant differences in asset size exist
  • Influence of accounting conventions (e.g. R&D, FIFO vs. LIFO inventory accounting)
  • Inflation and technological change cause the book / market value of assets to differ
124
Q

Book Value - Formula and Variations

A
  • BV = common shareholder’s equity = total assets – total liabilities – preferred stock
  • Adjustments (tangible BV) = BV – intangible assets (e.g. goodwill, patent, off balance sheet assets / liabilities)
125
Q

Price to Sales (P/S) ratio

A
  • The ratio is meaningful even for distressed firms as sales are always positive
  • Less distortion or manipulation from accounting conventions
  • Less volatile than earnings multiples -> Appropriate for mature, cyclical, and start-up businesses
  • P/S are significantly related to long-term average stock returns
126
Q

Price to Sales (P/S) ratio - Drawbacks

A
  • Growth in sales does not necessarily indicate growth in operating profits, which are discounted in DCF analysis. -> Top line growth (sales) might not proxy bottom line (earnings) development
  • P/S ratios do not capture differences in cost structures across companies
  • Be aware of the revenue recognition method applied, which might accelerate sales into an earlier period
127
Q

Price/Cash Flow Ratio

A
  • Cash flow is harder to manipulate by management than earnings
  • Price to cash flow is more stable than price to earnings
  • The problem of earnings quality is avoided
128
Q

Price/Cash Flow Ratio - Drawbacks

A

Different definitions of cash flows are used

  • Earnings plus non-cash charges
  • Adjusted CFO for after tax interest costs
  • Free cash flow to equity (FCFE) is theoretically correct
  • Earnings before interest, tax, depreciation and amortization (EBITDA)

Cash flow is more difficult to calculate than earnings

129
Q

How do multiples derive a value?

A

Multiples derive a value via comparison

130
Q

Predicted P/E

A

Predicted P/E ratio is estimated from linear regression of historical P/Es on the company’s fundamentals including expected growth and risk

  • Predictive power is uncertain
  • The relationship is likely to change over time
  • Multicollinearity makes it difficult to interpret individual regression coefficients
131
Q

Comparables - Function and Steps

A

Comparables are used to determine over-/undervaluation

Steps

  1. Select and calculate the multiple to be used
  2. Select a benchmark stock (portfolio) and calculate mean (impact of outliers) or median
  • Similar industry
  • Equity index
  • Historical average (inflation)
  1. Compare and examine whether the observed differences are explained by the underlying determinants of the multiple
132
Q

Purpose of Financial Ratio Analysis

A

Financial ratio analysis is used to identify a reliable peer group

  • P/E ratios differ significantly over capitalization size
  • Based on market data but mispricing errors in peer will transfer to value
133
Q

Multiple Models

A
  • Fed Model
  • Yardeni Model
134
Q

Multiple Models - Fed Model

A

Suggests interest rate to be the key factor influencing the market’s P/E ratio:

  • Overvalued when current earnings yield less than 10-year treasury bond
135
Q

Multiple Models - Yardeni Model

A

Relates market’s P/E to current A-rated corporate bonds and consensus 5-years earnings growth rate

The growth rate is one of the fundamental factors affecting P/E -> PEG (P/E-to-growth-ratio) “standardizes” for expected growth rates

  • The relationship between P/E and g is not linear
  • PEG ratio still does not account for risk
  • PEG assumes single stage model

Financial Analysis (5 decks)

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