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Security Valuation and Analysis
 Macroeconomic/Industry Analysis
 Security valuation
 Ratio analysis
MBA566: chapter 17-19
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Fundamental Analysis
Factors affecting firm valuation




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Global economic analysis
Domestic Macro-economy
Government Policies
Industry analysis
Company analysis

A top-down analysis
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Global Economic Considerations
 Performance in countries and regions is highly
variable.
 Political risk
 Exchange rate risk (Figure 17.1, page 550)



Sales
Profits
Stock returns (Table 17.1, page 549)
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Domestic Macroeconomy
 Gross domestic product
 Unemployment rates
 Interest rates & inflation
 Budget deficit
 Consumer sentiment
Check St. Louis Fed for this set of information
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The Effect of Government Policy
 Either affect the demand side (fiscal policy, monetary
policy) or the supply side (improving the incentive of
production) of goods and service
 Demand shock - an event that affects demand for goods
and services in the economy.


Tax rate cut
Increases in government spending
 Supply shock - an event that influences production capacity
or production costs.


Commodity price changes
Educational level of economic participants
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Government Policies
 Fiscal Policy - government spending and taxing actions.
 Monetary Policy - manipulation of the money supply to
influence economic activity.
 Open market operations
 Discount rate
 Reserve requirements
 Supply Side Policies
 Policies on employment
 Productivities
 Economic growth
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Business Cycle
 Peak
 Trough
 Cyclical industries
 Defensive industries
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Economic Indicators
Economic indicators
8
Useful Economic Indicators
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Industry Analysis
 Factors affecting sensitivity of earnings to business
cycles:

Sensitivity of sales of the firm’s product to the
business cycles



Typically varying across industries
Operating leverage
Financial leverage
 Industry life cycles
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Effect of Operating Leverage
 See example 17.1 on page 567
 Firms with lower operating leverage do better in
recessions
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Effect of Operating Leverage
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DOL
 Degree of operating leverage (DOL)
=% change in profit/ % change in sales
=1+Fixed costs / Profit
 Computing DOL for firms A and B
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Effect of Financial Leverage
 Financial Leverage
 Financial leverage hurts in bad years

See example 19.1 on page 639 (Table 19.4)
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Figure 17.6 Returns on Equity,
2005
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Figure 17.7 Rate of Return, 2009
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Industry Life Cycles
Slow growers
Stalwarts
Fast growers
Cyclicals
Turnarounds
Asset plays
(page 572)
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Industry Life Cycle
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Sector Rotation
 Portfolio is adjusted by selecting companies that
should perform well for the stage of the business
cycle




Peaks – natural resource extraction firms
Contraction – defensive industries such as
pharmaceuticals and food
Trough – capital goods industries
Expansion – cyclical industries such as consumer
durables
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Industry Structure and Performance
 Threat of entry
 Rivalry between existing competitors
 Pressure from substitute products
 Bargaining power of buyers
 Bargaining power of suppliers
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Equity Valuation Models
 Balance Sheet Models

Book Value
 Dividend Discount Models
 Price/Earning Ratios
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Limitations of Book Value
 Book value is an application of arbitrary
accounting rules
 Can book value represent a floor value?
 Better approaches


Liquidation value
Replacement cost
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Intrinsic Value and Market Price
 Intrinsic Value (page 606)
 Self assigned Value
 Variety of models are used for estimation
 Market Price
 Consensus value of all potential traders
 Trading Signal
 IV > MP Buy
 IV < MP Sell or Short Sell
 IV = MP Hold or Fairly Priced
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Value line investment survey report
 Figure 18.2, page 598
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Dividend Discount Models: General Model

Dt
Vo  
t
t  1 (1  k )
V0 = Value of Stock
Dt = Dividend
k = required return
25
No Growth Model
D
Vo 
k
Stocks that have earnings and dividends that are
expected to remain constant.
Preferred Stock
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No Growth Model: Example
D
Vo 
k
E1 = D1 = $5.00
k = .15
V0 =
27
Constant Growth Model
D1
Do(1  g )
Vo 

kg
kg
g = constant perpetual growth rate
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Constant Growth Model: Example
Do (1  g )
Vo 
kg
E1 = $5.00
(1-b) = 60%
V0 =
b = 40%
k = 15%
D1 = $3.00 g = 8%
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Estimating Dividend Growth Rates
g  ROE  b
g = growth rate in dividends
ROE = Return on Equity for the firm
b = plowback or retention percentage rate
(1- dividend payout percentage rate)
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Specified Holding Period Model
P
D
D
D

... 
V 
(1 k ) (1 k )
(1 k )
1
0
N
2
1
2
N
N
PN = the expected sales price for the stock at time N
N = the specified number of years the stock is
expected to be held
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Example
 Go through the example 18.1-18.3 from page 592
to 594
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P/E Ratio with Constant Growth
D1
E1(1  b)
P0 

k  g k  (b  ROE )
P0
1 b

E1 k  (b  ROE )
b = retention ratio
ROE = Return on Equity
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Numerical Example with Growth
Example 18.4 on page 598.
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Summary of Key Financial Ratios
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Table 19.10 Summary of Key Financial
Ratios
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Table 19.10 Summary of Key Financial
Ratios
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Table 19.10 Summary of Key Financial
Ratios
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Table 19.10 Summary of Key Financial
Ratios
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Figure 19.2 Comparative Accounting Rules
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