Investment Course - 2005

1. Investment Course - 2005 Day Two: Equity Analysis and Portfolio Strategies

2. Forming Equity Portfolios: An Overview • After an investor’s strategic asset allocation (i.e., the percentage allocations to the broad asset classes) has been established, the next step in the portfolio management process is to form asset class-specific portfolios that we think will align with our investment objectives and constraints. • Asset class-level (e.g., stock) portfolios can be formed by following one of two approaches: • Passive: Designed to match a broad equity index (e.g., S&P 500, Russell 1000, IPSA); implicitly assumes that equity markets are efficient • Active: Attempts to outperform a designated equity benchmark, usually through picking stocks perceived to have superior characteristics (e.g., valuation, style) • Generally speaking, active equity management can be approached in one of two ways: • Top-Down (i.e., Three-Step) Approach • Bottom-Up (i.e., Stock-Picking) Approach The difference between the two approaches is the perceived importance of macroeconomic and industry influences on individual firms and stocks

3. The Three-Step Valuation Process 1. General economic influences • Decide how to allocate investment funds among countries, and within countries to bonds, stocks, and cash 2. Industry influences • Determine which industries will prosper and which industries will suffer on a global basis and within countries 3. Company analysis • Determine which companies in the selected industries will prosper and which stocks are undervalued

4. Example of a Global Portfolio: Texas Teachers Retirement System - September 30, 2004

5. Example of a Global Portfolio (cont.): Texas Teachers Retirement System - September 30, 2004

6. Examples of Style-Based Equity Portfolios

7. General Approaches to Equity Valuation

8. Enterprise Value vs. Equity Value

9. The Foundations of Stock Valuation

10. The Foundations of Stock Valuation (cont.)

11. The Foundations of Stock Valuation (cont.)

12. Constant Growth Valuation Example: CSR

13. Constant Growth Valuation Example: CSR (cont.)

14. Constant Growth Valuation Example: CSR (cont.)

15. Constant Growth Valuation Example: CSR (cont.)

16. The Foundations of Stock Valuation (cont.)

17. The Foundations of Stock Valuation (cont.)

18. The Foundations of Stock Valuation (cont.)

19. Two-Stage Growth Valuation Example: Duo Growth Company • The Duo Growth Company just paid a dividend of $1 per share. The dividend is expected to grow at a rate of 25 percent per year for the next three years and then to level off to 5 percent per year forever. You think that the appropriate capitalization (i.e., discount) rate is 20 percent per year. • What is your estimate of the intrinsic value of a share of the stock? • If the market price of a share is equal to this intrinsic value, what is the expected dividend yield? • What do you expect its price to be in one year? Is the implied capital gain consistent with your estimate of the dividend yield and the discount rate? • Valuation formula for problem:

20. Duo Growth Valuation Example: Solution

21. Estimating Cash Flow Growth Rates

22. Applying the Stock Valuation Model • The discounted cash flow approach to security valuation is the most exhaustive method for establishing a stock’s intrinsic (i.e., fundamental) value. Depending on the level of confidence that the analyst has with regard to the myriad assumptions that he or she has made, the model implies the following trading strategy: • If (Value) > (Market Price)  Buy Stock • If (Value) < (Market Price)  Sell (or Short) Stock • The valuation model also gives considerable guidance to help analysts understand what corporate managers must do to increase firm value: • Increase the cash flows generated by assets in place currently • Increase the expected growth rate of earnings • Increase the length of the abnormal growth period • Reduce the cost of capital that is applied to discount the cash flows

23. Applying the Stock Valuation Model: CFA Exam Question

24. Applying the Stock Valuation Model: Solution to CFA Exam Question

25. Applying the Stock Valuation Model: Solution (cont.)

26. Applying the Stock Valuation Model:Market-Implied Growth Rates

27. Implied Growth Rate Example: Empresas COPEC - February 2005

28. COPEC Implied Growth Rate Example (cont.)

29. Model Output for COPEC Implied Growth Estimate

30. Defining Measures of Cash Flow

31. Defining Measures of Cash Flow (cont.)

32. Defining Measures of Cash Flow (cont.)

33. Equity Valuation Example: Southwest Airlines (LUV) – January 2003 • Positive analyst report in January 2003 by S&P Outlook • Basis for the opinion was the forecast of improved growth due to cost-cutting measures at the firm and the company’s position in the industry • DCF analysis based on both analyst forecasts and a market-implied scenario • Refer to Excel workbook “LUV DCF Model” for the details of the stock valuation

34. LUV Stock Valuation Example (cont.)

35. LUV DCF Valuation Model Output

36. LUV DCF Valuation Model Output (cont.)

37. LUV Stock Valuation Example (cont.)

38. Valuing Special Situations: No Current Earnings

39. Valuing Special Situations (cont.)

40. Valuing a Negative EPS Company: AMZN in January 2001

41. Valuing a Negative EPS Company: AMZN in January 2001 (cont.)

42. Overview of Comparable Multiples Approach to Valuation

43. Relationship Between DCF and Comparable Multiple Valuation Approaches

44. DCF and Comparable Multiple Valuation Approaches (cont.)

45. DCF and Comparable Multiple Valuation Approaches (cont.)

46. Using Comparable Multiples in Practice: CFA Exam Question

47. Solution to CFA Exam Question

48. Solution to CFA Exam Question (cont.)

49. Asset-based valuation multiples (i.e., those using book value) generally produce smaller valuation errors than those using sales (from Lie and Lie, Financial Analysts Journal, 2002) Using Comparable Multiples in Security Valuation

50. Comparable Multiple Valuation Example: LUV