SAA: the investment universe Flashcards
Fundamental analysis
According to fundamental analysis, a firm’s intrinsic value comes from its earnings prospects, which are determined by:
- The global economic environment
- Economic factors affecting the firm’s industry
- The position of the firm within its industry
The Global Economy
•International economy affects firm prospects.
•Performance in countries and regions can be highly variable.
–Eurozone, BRIC countries
•It is harder for businesses to succeed in a contracting economy than in an expanding one.
•Specific risks of international investment:
–Political risk – e.g., Greek economy or U.S. fiscal cliff
–Exchange rate risk – e.g., changes the prices of imports and exports
The Domestic Macroeconomy
•Stock prices rise with earnings (potential).
–P/E ratios are normally in the range of 12-25.
•The first step in forecasting the performance of the broad market is to assess the status of the economy as a whole.
Macroeconomic indicators
- Gross domestic product
- Unemployment rates
- Inflation
- Interest rates
- Budget deficit
- Consumer sentiment
- …and changes and growth of the above indicators
Business cycles
Cyclical Industries
- Above-average sensitivity to the state of the economy.
* Examples include producers of consumer durables (e.g.,
Business cycles
Defensive Industries
- Little sensitivity to the business cycle
- Examples include food producers and processors, pharmaceutical firms, and public utilities
- Low market betas
Sensitivity to the business cycle (1)
1.Sensitivity of sales:
•Necessities vs. discretionary goods
•Items that are not sensitive to income levels (such as tobacco and movies) vs. items that are (such as machine tools, steel, autos)
2.Operating leverage: the split between fixed and variable costs
3.Financial leverage: the use of borrowing
Sector rotation
Portfolio is shifted into industries or sectors that should outperform, according to the stage of the business cycle.
–Peaks – natural resource extraction firms, i.e. mining
–Contraction – defensive industries such as pharmaceuticals and food
–Trough – capital goods industries
–Expansion – cyclical industries such as consumer durables
Five Determinants of Competition
- Threat of entry
- Rivalry between existing competitors
- Pressure from substitute products
- Bargaining power of buyers
- Bargaining power of suppliers
Valuation by comparables
Compare valuation ratios of firm to industry averages or other firms in the industry.
•Ratios like price/sales are useful for valuing start-ups that have yet to generate positive earnings.
Limitations of book value
•Book values are based on historical cost, not actual market values.
–Book values are based on original cost of asset acquisition, thus cannot account for loss in actual value (even despite depreciation).
–Market value is the current value: going concern
–It is possible, but uncommon, for market value to be less than book value.
•Other “notable” values
–Liquidation value: floor or minimum value of the stock price
–Replacement cost: Tobin’s q = market price/replacement cost
Intrinsic value and market price
•The intrinsic value (IV) is the “true” value, according to a model.
–Typically it is the PV of all dividend payments and maybe the CF of the ultimate sale of the stock.
•The market value (MV) is the consensus value of all market participants
–Market consensus value = market capitalization rate ($)
Trading Signal:
–IV > MV: Buy
–IV < MV: Sell or Short Sell
–IV = MV: Hold or Fairly Priced
P/E and growth rate
•Wall Street’s rule of thumb:
The growth rate is roughly equal to the P/E ratio.
Pitfalls in P/E analysis
•Use of accounting earnings
–Earnings management
–Choices in accounting practices
- Inflation
- Reported earnings
Price-to-book ratio
–P/BV per share
–Proxies the market’s valuation of the firm
