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## XSIF—2010 Primer

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**Stock Fundamental**Analysis XSIF—2010 Primer**Valuation Approaches**• Valuation Approaches • Discounted CF: Value stock based on the PV of the expected CF: dividends, FCF, or FCFE. • Relative Valuation: P/E, P/BV, P/CF, or P/S. • Note: Both require estimating k and g.**Discounted Cash Flow**• Dividends: • Model • Gordon: • 2-stage or 3-stage growth model**Discounted Cash Flow**• Cash Flow Model: • Free cash flow to equity: Cash flow left after meeting obligations to capital suppliers: debt and preferred. • Model • Constant Growth: • where: g = growth in FCFE • 2-stage or 3-stage growth model**Relative Valuation**• P/E or Multiplier Approach: • Gordon P/E: • Example: Expected D/E = .5, k = .12, g = .08, then P/E = 12.5. • Note: Small changes in k or g have large impact on P/E.**Relative Valuation**• P/CF • Constant Growth: P/CF: • CF = EBDITDA (typically used)**Relative Valuation**• P/BV • P/S:**Points on Relative Valuation**• Comparative analysis: company to industry (or comparable companies) and to market • Comparative and time-series analysis: compare company, industry, and market over time.**g, k, and eps**• Both the Dividend Discounted Cash Flow and Relative Valuation Approaches depend on estimating g and k. • Both models also need to be compared to an estimated earnings or eps.**Estimating g**• In discounted dividend model and the P/E model, g is the growth rate in dividends. • The growth rate in dividends will equal the growth rate in EPS if the D/E is constant. • If D/E are increasing (decreasing) over time, then growth rate in DPS will be greater (less) than the growth rate in EPS.**Estimating g: Historical**• Historical Growth Rates: • Calculate historical growth rate in dividends or earnings. • Remember: More is better and recent is relevant.**Estimating g: Historical**• Historical: Geometrical: • Example:**Estimating g: Historical**• Linear Regression: • where: • Log linear form: • where:**Estimating g: Sustainable Growth**• Sustainable Growth Rate: • Estimate:**Estimating g: Sustainable Growth**• Estimating ROE: • Estimate ROE directly: • Historical Average • Regression • Use DuPont System (or Extended System):**Estimating g: Sustainable Growth**• Estimating ROE: • Comparative Analysis: Compare the ratios of the company, industry (or comparable companies), and market. • Set up Bloomberg table:**Estimating g: Sustainable Growth**• From your comparison, you can determine ROE to be above or below the industry or market. • By comparing ratio, you may get some insight on explain relative ROE. • Note: Bloomberg provides sustainable growth rates.**Estimating k**• Estimate k by examining fundamental risk factors • Fundamental risk factors: • Liquidity (Internal) Risk = LR • Business Risk = BR • Financial Risk = FR • Exchange-Rate Risk = ER • Market or External Liquidity Risk = ELR**Estimating k**• Methodology: • Conduct a relative analysis of each risk: Company, industry, and market. • Compare historical RP of company, industry, and market. • Based on analysis, determine if the company’s RP should be greater, equal or less than the industry and market.**Liquidity Risk**• Do a comparative analysis of liquidity ratios: • Liquidity Ratios:**Liquidity Risk**• Liquidity Ratios:**Liquidity Risk**• Comparative Analysis: Compare the ratios of the company, industry (or comparable companies), and market. • Set up Bloomberg Table. • Determine if the company has more or less liquidity risk than industry, and market.**Business Risk**• Measure: • Profitability Ratios: • Gross Profit Margin = Gross Profit/Sales • Operating Profit Margin = Operating Profit/Sales • Net Profit Margins = Net Income/Sales • Do a comparative analysis • Look at the variability of the margins.**Business Risk**• Measure • Coefficient of Variation (CV) in operating income: • CV = σ(operating income)/μ(operating income) • Coefficient of Variation (CV) in operating income: • CV = σ(Sales)/μ(Sales)**Business Risk**• Analysis of Business Risk – Points • Companies with a high operating leverage have high operating profit margins. As a result, their earnings vary more with sales – implies high unlevered beta. • High operating leverage companies tend to have higher earnings in economic expansion and lower in economic slowdowns. • Steel Companies have high operating leverages and operating margins. They should have higher CV • Retail Companies tend to have lower operating leverages and margins and therefore should have lower CV. • Sales of cyclical sectors – auto or steel – will be more volatile than noncyclicals – hospital services.**Business Risk**Operating Leverage: When a project has multiple methods of producing, the business risk of a capital budgeting project is determined in part by the project’s operating leverage. • Operating leverage relates to the mix of fixed (capital) and variable inputs (labor) used to produce the product. It exist whenever there are multiple methods of producing a product. This allows the firm a choice of spending more on fixed inputs and less on variable or vice versa. • When there is more fixed inputs relative to variable, then the project’s profit is more sensitive to sales and vice versa.**Business Risk**• Operating Leverage is characterized by the slope of profit/sales graph of the project. Consider a small wine seller who is evaluating two alternative processes for producing wine: Process A which would cost $120,000 to buy and install and would have a variable cost of $0.57/bottle; Process B which would cost $30,000 to buy and install and would have a variable cost of $0.72/bottle.**Financial Risk**• Financial risk is uncertainty due to debt. • Because of the fixed cost on debt, companies with high debt/equity ratios will find that in economic expansion, the net earnings available to shareholders will increase by a greater proportion and in economic downturns the proportion available will decrease by a larger proportion. • Plus, the higher the debt/equity ratio the greater the possibility of default and bankruptcy.**Financial Risk**Financial Leverage: When a firm has some debt financing, the debt portion of the financing cost are fixed rather than variable. • Shareholders’ variability in realized return will vary more, the greater the proportion of assets financed by debt. • Shareholders’ return, Re, in an all equity firm is the same as the firm’s realized return, RA. • Shareholders’ return in a leveraged firm is the return realized after the payment to bondholders.**Financial Risk**Financial Leverage: • Consider an investment valued at $100M that could be financed with all equity or leveraged with $50M in equity (E) financing and $50M in debt (L) financing. Assume no taxes and the firm pays kd = 10% on debt. • Given different possible returns from the project, RA, the Re for leverage financing will vary more than all-equity financing alternative. • This can be seen comparing the changes in Re for changes in RA for the two financing alternatives.**Financial Risk**Financial Leverage:**Financial Risk**• Measures of Financial Risk: • Balance-sheet ratio:**Financial Risk**• Measures of Financial Risk: • Coverage Ratios: • Note: Retail chains could have low L-T D/E, but because of leases and payables have high total D/A.**Financial Risk**• Bankruptcy Risk: • Determine ratio or set of ratios that provide the best prediction of bankruptcy. • Altman Z-Score: • Z = f(S/A, EBIT/A, Mkt. Value of Stock/BV of Debt, RE/A)**Exchange-Rate Risk**• ER risk depends on what proportion of sales and earnings are generated outside the U.S. and the variability of exchange rates. • Study the company’s hedging policy.**External Liquidity Risk**• External liquidity measure the marketability of the company’s stock. • Marketability: Ease of speed of trading a security with little change in price. • Measures: • Number of Shares • Market value of stock • Trading Volume • Trading Turnover**External Liquidity Risk**• External Liquidity Measures: • Number of Shares • Market value of stock • [(Hi price-low Price)/2](no. of shares) • Trading Volume • Trading Turnover = Proportion of outstanding shares traded during a period of time. • Example: 705 m shares traded in year; 1,020 shares outstanding; Turnover = 705/1020 = .70. • 70% annual turnover • Bid-Ask Spread • Institutional Ownership**External Liquidity Risk**• External Liquidity Points: • Foreign stocks may lack external liquidity. • Smaller Cap companies may lack external liquidity. • External liquidity information can be found in Bloomberg.**Fundamental Risk Analysis**• Compare the various ratios measuring for LR, BR, FR, ERR, ELR for the company, industry, and market. • Determine if the ratios are higher or lower than the norm or trend: • Below-Average or Above-Average LR • Below-Average or Above-Average BR • Below-Average or Above-Average FR • Below-Average or Above-Average ERR • Below-Average or Above-Average ELR • From fundamental risk comparison determine if • RP of Company >=< RP of Industry • RP of Company >=< RP of Market**Fundament Risk Analysis**• Range of market RP = 3%-8% • The company tends to have fundamental risk ratios that indicate it has less risk than the market. • Estimate the company’s RP to be between 2%-7%. • Note: The company’s beta should be less than 1.**Fundament Risk Analysis: k Estimate**• Range of market RP = 3%-8% • The company tends to have fundamental risk ratio that indicate it has less risk than the market. • Estimate the company’s RP to be between 2%-7%. • Note: The company’s beta should be less than 1. • If Rf = 4%, and market estimate is 5%, then the company would have k = Rf + RP = 4% + 4% = 8%**k Estimate: SML**• Market Model, SML: • Market RP = 3%-7% • Look at Relation between: • Rf and RP • Economy or market and RP**k Estimate: SML**• Example: • Current Market Risk Premium = 4% • Rf = 5% • Adjusted ß = .90**k Estimate: SML**• Estimate ß • Historical Regression • Poor regression results • Adjusted Beta: Vasicheck Technique • Adjust Beta up or down based on your fundament risk analysis.**Estimating Future EPS**EBIT Approach 1: From Bloomberg Data: • Operating Income = Rev. – Cost of Goods Sold – SGA • Pretax Income = Operating Income – Interest Exp. – Net Forn. EX Losses – Net Non-operating Losses • Income Before XO Items = Pretax Income – Income Tax • Net Income = Income before XO Item – Net XO Loss – Net Tax Effect of XO Loss – Minority Interest EBT EAT**Estimating Future EPS**Approach 1: Using Bloomberg Data; Estimation Model • Estimate the proportional changes in revenue (sales, S), cost of goods sold, SGA, interest expenses (Int), net FX losses, and income taxes. • S1 = (1+g)S0 • CGS1 = (1+g)CGS0 • Int1 = (1+g)Int0 • Etc.**Fundamental Stock Analysis**Oracle**Fundamental Stock Analysis**Oracle