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Equity Fundamentals Econ 173A Summer 2013 1 Financial Instruments Money Market Certificates of Deposit U.S. Treasury Bills Money Market Funds Bond Market Treasury Notes and Bonds Municipal Bonds Corporate Bonds Equity Market Common Stock Preferred Stock Derivative Market Options Futures 2 Risk and Prices andexpected Coupon Return Rates Return Risk 3 Equity Basics Equity Securities: Evidence of an ownership share in a corporation. Fixed Income Securities vs. Equity Securities Fixed Claim High Priority on cash flows Tax Deductible Fixed Maturity No Management Control Bonds Residual Claim Lowest Priority on cash flows Not Tax Deductible Infinite life Management Control Hybrids (Combinations of debt and equity) Common Stock 4 The Appeal of Common Stocks Residual Owners: stockholders of a firm are the owners, who are entitled to dividend income and a prorated share of the firm’s earnings only after all the firm’s other obligations have been met Stocks allow investors to tailor investments to meet individual needs and preferences. Stocks may provide a steady stream of current income through dividends. Stocks may increase in value over time through capital gains. 5 From Stock Prices to Stock Returns Stock Returns: take into account both price changes and dividend income Over past 50 years, stock returns have ranged from +48.28% in 1954 to -21.45% in 1974 Stock returns over past 50 years have averaged around 11% From 1998 through mid-’03, DJIA averaged 1.7% 6 7 DJIA annual Returns since 2003 2003 8341.63 10453.92 2112.29 25.32% 2004 10453.92 10783.01 329.09 3.15% 2005 10783.01 10717.50 -65.51 -0.61% 2006 10717.50 12463.15 1745.65 16.29% 2007 12463.15 13264.82 801.67 6.43% 2008 13264.82 8776.39 -4488.43 -33.84% 2009 8776.39 10428.05 1651.66 18.82% 2010 10428.05 11577.51 1149.46 11.02% 2011 11577.51 12217.56 640.05 5.53% 2012 12217.56 13104.14 886.58 7.26% Average 5.95% Standard Deviation 16.02% 8 Current Income from Stocks versus Bonds 9 Equity Basics Equity can either be: Privately held Publicly held There are two types of equity: common stock preferred stock 10 Advantages of Stock Ownership Higher returns than bonds. Over past 50 years, stocks averaged 11% and high-grade corporate bonds averaged 6%. Inflation hedge – stock returns typically exceed the rate of inflation. Easy to buy and sell stocks. Price and market information is easy to find in financial media. Unit cost per share of stock is lower than for bonds. 11 Disadvantages of Stock Ownership Stocks are subject to many different kinds of risk: Business risk Financial risk Market risk Event risk Difficult to predict which stocks will go up in value due to wide swings in profits and general stock market performance Low current income compared to other investment alternatives 12 Common Stock Values Par Value: the stated, or face, value of a stock Mainly an accounting term and not very useful to investors Book Value: the amount of stockholders’ equity The difference between the company’s assets minus the company’s liabilities and preferred stock Market Value: the current price of the stock in the stock market 13 Common Stock Values Market Capitalization: the overall current value of the company in the stock market Total number of shares outstanding multiplied by the market value per share Investment Value: the amount that investors believe the stock should be trading for, or what they think it’s worth Probably the most important measure for a stockholder 14 Shareholder Rights If a dividend is declared, the dividend each shareholder receives must be in proportion to the shareholder’s ownership interest in the firm. the right to vote – one vote for each share held Attend annual meetings and vote in person. Sending in a proxy statement. the right to maintain ownership percentage rights offering. Preemptive right is sometimes waived in the corporate charter. 15 Stock Splits A stock split is an accounting decision to change the number of shares outstanding without selling any more to the public – a neutral occurrence. With a forward split, also called a regular way or direct split, shareholders end up with a greater number of shares than before the split. With a reverse split, the number of existing shares is reduced. 16 Stock Splits The value of a firm cannot be increased by splitting, or combining, its shares. Examples AT&T (Nov 2002) 1-for-5 split Netflix (Feb 2004) 2-for-1 split 17 Stock Splits The primary motivation for a stock split is usually a desire to reduce the share price – optimal trading range. People prefer to buy round lots. Large reverse splits often reduce the number of shareholders. The difference between a stock split and a stock dividend is purely an accounting phenomenon. With a stock split, the par value of the stock changes by the split factor. With a stock dividend, the par value is not affected. 18 The Financial Page Listing new 52-week high cc dd g n pf s wt x new 52-week low PE ratio > 100 loss in the most recent four quarters dividends and earnings in Canadian dollars newly issued in the past 52 weeks preferred stocks stock split/stock dividend > 10% in past 52 weeks warrant ex-dividend 19 Dividends Dividend income is one of the two basic sources of return to investors. Dividend income is more predictable than capital gains, so preferred by investors seeking lower risk. Dividends are taxed at maximum 15% tax rate, same as capital gains. Dividends tend to increase over time as companies’ earnings grow; increases average 3-5% per year. Dividends represent the return of part of the profit of the company to the owners, the stockholders. 20 Dividends and Earnings Per Share Earnings Per Share: the amount of annual earnings available to common stockholders, stated on a per-share basis Earnings are important to stock price Earnings help determine dividend payouts EPS Net profit Preferred dividends after taxes Number of shares of common stock outstanding 21 Dividends and Dividend Yield Dividend Yield: a measure to relate dividends to share price on a percentage basis Indicates the rate of current income earned on the investment dollar Convenient method to compare income return to other investment alternatives Annual dividends received per share Dividend yield Current market price of the stock 22 Dividends and Dividend Payout Ratio Dividend Payout Ratio: the portion of earnings per share (EPS) that a firm pays out as dividends Companies are not required to pay dividends Some companies have high EPS, but reinvest all money back into company Dividends per share Dividend payout ratio Earnings per share 23 Dividends: Types of Dividends cash dividends paid in cash some firms have an optional dividend reinvestment plan (DRIP). stock dividends paid in additional shares of stock 24 Dividends: Special Distributions spin-offs a parent firm divests itself of a subsidiary, and all the shares in the subsidiary are distributed proportionally to the shareholders in the parent split-offs a parent firm divests itself of a subsidiary, and the shareholders must make a choice between keeping shares in the parent, or exchanging them for shares in the separated subsidiary tracking stock These shares track the performance of a subsidiary, and in many respects, are just a new class of shares. 25 The Dividend Payment Procedure A dividend paid in accordance with a previously announced corporate policy is a regular dividend. Companies try to establish a regular pattern and usually pay dividends quarterly. A firm that wishes to make an extra distribution of cash to the shareholders does so through a special dividend, also called an extra or extraordinary dividend. 26 The Dividend Payment Procedure The Chronology of Events 1. date of declaration Ex-dividend date (2 business days prior to the date of record) 2. date of record 3. date of payment 27 Why Dividends Do Not Matter Paying dividends reduces the amount in a firm’s checking account, and hence the shares are worth less. On the ex-dividend date, share prices tend to fall by about the amount of the dividend. Dividends can provide insights to the company’s thoughts about the future. 28 Categories of Stock blue chip Income stocks are those that historically have a higher-thanaverage payout ratio. Cyclical stock is one whose fortune is directly tied to the state of the overall national economy. Defensive stock is largely immune to changes in the economy. 29 Categories of Stock Growth stocks reinvest most of their earnings rather than paying them out as dividends and may be good candidates for above-average returns. Speculative stock has a high probability of a loss and a small probability of a large profit. Penny stocks refer to unusually risky, especially inexpensive shares. Category overlap: The stock categories are not mutually exclusive. 30 Types of Stock Blue Chip Stocks: financially strong, high-quality stocks with long and stable records of earnings and dividends Companies are leaders in their industries Relatively lower risk due to financial stability of company Popular with investing public looking for steady growth potential, perhaps dividend income Provide shelter during unsettled markets Examples: Wal-Mart, Proctor & Gamble, Microsoft, United Parcel Service, Pfizer and 3M Company 31 Types of Stock (cont’d) Income Stocks: stocks with long and sustained records of paying higher-than average dividends Good for investors looking for relatively safe and high level of current income Dividends tend to increase over time (unlike interest payments on bonds) Some companies pay high dividends because they offer limited growth potential More subject to interest rate risk Examples: Verizon, Conagra Foods, Pitney Bowes, R.R. Donnelley, Bank of America and AmSouth Bancorp 32 Types of Stock (cont’d) Income Stocks: stocks with long and sustained records of paying higher-than average dividends Dividends tend to increase over time (unlike interest payments on bonds) Some companies pay high dividends because they offer limited growth potential Examples: Verizon, Conagra Foods, Pitney Bowes, Wrigley 33 Types of Stock (cont’d) Growth Stocks: stocks that experience high rates of growth in operations and earnings High rate of growth in earnings > market Higher price appreciation (due to increasing earnings) Riskier investment because price will fall if earnings growth cannot be maintained Typically pay little or no dividends Examples: Lowe’s, Harley-Davidson, Starbucks, Apple 34 Types of Stock (cont’d) Cyclical Stocks: stocks whose earnings and overall market performance are closely linked to the general state of the economy Stock price tends to move with the business cycle Tend to do well when economy is growing, poorly in slowing economy Best for investors willing to move in and out of market as economy changes Examples: Caterpillar, Maytag Corp. 35 Types of Stock (cont’d) Defensive Stocks: stocks that tend to hold their value, and even do well, when the economy starts to falter Stock price remains stable or increases when general economy is slowing Products are staples that people use in good times and bad times, such as electricity, beverages, foods and drugs Best for aggressive investors looking for “parking place” during slow economy Examples: Proctor & Gamble, WD-40, Walmart 36 Market Capitalization Small-Cap Stocks: under $1 billion Mid-Cap Stocks: $1 billion to $4 or $5 billion Large-Cap Stocks: more than $4 or $5 billion 37 Types of Stock Small-Cap Stocks: small companies with market capitalizations less than $1 billion Provide opportunity for above-average returns (or losses) Short financial track record Erratic earnings Not widely-traded; liquidity is issue 38 Types of Stock (cont’d) Mid-Cap Stocks: medium-sized companies with market capitalizations between $1 billion and $4 or $5 billion Provide opportunity for greater capital appreciation than Large-Cap stocks, but less price volatility than SmallCap stocks Long-term track records for profits and stock valuation “Baby Blues” offer same characteristics of Blue Chip stocks except size Examples: Wendy’s, Barnes & Noble, Petsmart, Cheesecake Factory 39 Types of Stock (cont’d) Large-Cap Stocks: large companies with market capitalizations over $4 or $5 billion Number of companies is smaller, but account for 80% to 90% of the total market value of all U.S. equities Bigger is not necessarily better Tend to lag behind small-cap and mid-cap stocks, but typically have less volatility Examples: AT&T, General Motors, Microsoft 40 Investing in Foreign Stocks Globalization of financial markets is growing U.S. equity market is less than 50% of world equity markets Six countries make up 80% of world equity market U.S. market remains largest and one of best performing equity markets Much of performance of non-U.S. markets is due to changes in currency exchange rates 41 Stock Investment Strategies Buy-and-Hold Investors buy high-quality stocks and hold them for extended time periods Goal may be current income and/or capital gains Investors often add to existing stocks over time Very conservative approach; value-oriented 42 Stock Investment Strategies (cont’d) Current Income Investors buy stocks that have high dividend yields Safety of principal and stability of income are primary goals May be preferable to bonds because dividends levels tend to increase over time Often used to provide to supplement other income, such as in retirement 43 Stock Investment Strategies (cont’d) Quality Long-Term Growth Investors buy high-quality growth stocks, mid-cap stocks and tech stocks Capital gains are primary goal Higher level of risk due to emphasis on capital gains Significant trading of stocks may occur over time Diversification is used to spread risk “Total Return Approach” is version that emphasizes both capital gains and high income 44 Stock Investment Strategies (cont’d) Aggressive Stock Management Investors buy high-quality growth stocks, blue chip stocks, mid-cap stocks, tech stocks and cyclical stocks Capital gains are primary goal High level of risk due to emphasis on capital gains Investors aggressively trade in and out of stocks, often holding for short periods Timing the market is key element Time consuming to manage 45 Stock Investment Strategies (cont’d) Speculation and Short-Term Trading Also called “day trading” Investors buy speculative stocks, small-cap stocks and tech stocks Capital gains are primary goal Highest level of risk due to emphasis on capital gains in short time period Investors aggressively trade in and out of stocks, often holding for extremely short periods Looking for “big score” on unknown stock Time consuming & high trading costs 46 What is Security Analysis? “The process of gathering and organizing information and then using it to determine the intrinsic value of a share of common stock.” 47 What is Intrinsic Value? Intrinsic Value The underlying or inherent value of a stock, as determined through fundamental analysis A prudent investor will only buy a stock if its market price does not exceed what the investor thinks the stock is worth. Intrinsic value depends upon several factors: Estimates of future cash flows Discount rate Amount of risk 48 “Top Down” Approach to Traditional Security Analysis Step 1: Economic Analysis State of overall economy Step 2: Industry Analysis Outlook for specific industry Level of competition in industry Step 3: Fundamental Analysis Financial condition of specific company Historical behavior of specific company’s stock 49 Efficient Market Hypothesis Efficient Market: the concept that the market is so efficient in processing new information that securities trade very close to or at their correct values at all times Efficient market advocates believe: Securities are rarely substantially mispriced in the marketplace No security analysis is capable of finding mispriced securities more frequently than using random chance 50 Who Needs Security Analysis in an Efficient Market? Fundamental analysis is still important because: All of the people doing fundamental analysis is the reason the market is efficient Financial markets may not be perfectly efficient Pricing errors are inevitable 7-51 51 Industry Analysis Evaluate the competitive position of a particular industry in relation to other industries Looking for new opportunities & growth potential Identify companies within the industry that look promising Looking for strong market positions, pricing leadership, economies of scale, etc. 52 Issues that Affect an Industry What is the nature of the industry? Is the industry regulated? What role does labor play in the industry? How important are technological developments? Which economic forces have the most impact on the industry (e.g., interest rates, foreign trade)? What are the important financial and operating considerations (e.g., access to capital)? 53 Concepts of Value Book Value Market value Liquidation Value Fair Market Value, Intrinsic Value a) Value given a thorough appreciation of the Company, its prospects, and the market b) Look for mispricing c) Alpha = E(HPR) less Market RRR 54 The Valuation Process a) b) a) a) b) The Economy, The Market, The Business Forecast Earnings and Cash Flows Growth rates Dividend payout rate Select Valuation Model Select the Discount Rate Exogenous or endogenous Conclusion & Recommendation Under or over Valued Buy, Sell, Hold 55 Economy, Sector, Market, Company Inherent sector and industry profitability Industry structure Company’s relative competitive position a) Market share b) Cost leadership c) Pricing power d) Product differentiation versus product focus 56 Forecasting Top-down forecast a) Economy-Sector-Industry-Company Financial forecast a) Financial Statement Analysis: revenues & expenses b) From profits to cash flows, esp. Free Cash Flows c) Costs, prices, and the Product life cycle 57 The Valuation Model Approach a) Cost b) Income c) Market Method a) De Novo or M&A b) Revenues, Earnings, Cash flows c) Comparables 58 Models Dividend Discount Model D.C.F. C.A.P.M. Fama & French 59 Discount Rates Build-up Method a) Risk-free Rate + b) Equity risk premium + c) Company risk premium P/E implied C.A.P.M. a) Risk-free Rate + b) Non-systematic risk premium 60 Growth Cycle Stages and Investments Growth Cycle reflects the vitality of an industry or a company over time. Initial development: industry is new and risks are very high Rapid expansion: product acceptance is growing and investors become very interested Mature growth: expansion comes from growth in the economy and returns are more predictable Stability or decline: demand for product is investors avoid this stage diminishing and 61 Fundamental Analysis Evaluate the financial condition and operating results of a specific company Competitive position Composition and growth in sales Profit margins and dynamics of earnings Asset mix (i.e. cash balance, inventory, accounts receivable, fixed assets) Financing mix ( i.e. debt, stock) The value of a stock is influenced by the financial performance of the company that issued the stock. 62 Where Do We Start? Interpreting Financial Statements Using Financial Ratios Fundamental analysis is often the most demanding and most time-consuming phase of stock selection. 63 Major Groups of Financial Ratios Liquidity Ratios: the company’s ability to meet day-to-day operating expenses and satisfy short-term obligations as they become due Activity Ratios: how well the company is managing its assets Leverage Ratios: amount of debt used by the company Profitability Ratios: measures how successful the company is at creating profits Common Stock Ratios: converts key financial information into per-share basis to simplify financial analysis 64 Common Stock Ratios Price/Equity Ratio: shows how the stock market is pricing the company’s common stock One of most widely used ratios in common stock selection Often used in stock valuation models P/E Market price of common stock EPS Net profit after taxes Preferred dividends EPS Number of common shares outstanding Higher ratio: more expensive Lower ratio: less expensive 65 Common Stock Ratios (cont'd) What is the P/E ratio for a company with profits of $139.7 million, 61,815,000 outstanding shares of common stock and a current market price of $41.50 per share? $139,700,000 EPS or $2.26 61,815,000 shares $41.50 Price/Earnings ratio or 18.4 $2.26 66 Common Stock Ratios (cont'd) Price/Earnings Growth Ratio (PEG): compares company’s P/E ratio to the rate of growth in earnings Stock’s P/E ratio PEG ratio= 3- to 5-year growth rate in earnings Ratio > 1: stock may be fully valued PEG = 1: stock price in line with earnings growth Ratio < 1: stock may be undervalued 67 Common Stock Ratios (cont'd) Payout Ratio: how much of its earnings a company pays out to stockholders in the form of dividends Traditional payout ratios have been 40% to 60% Recent trends have been lower payout ratios, with more tax efficient stock buyback programs used frequently High payout ratios may be difficult to maintain and the stock market does not like cuts in dividends Dividends per share Payout ratio Earnings per share 68 Common Stock Ratios (cont'd) Book Value per Share: difference between assets and liabilities (equity) per share Book value per share Common stockholders’ equity Number of common shares outstanding A company should be worth more than its book value. 69 Common Stock Ratios (cont'd) Price-to-Book Ratio: compares stock price to book value to see how aggressively the stock is being priced Market price of common stock Price-to-book-value Book value per share Higher ratio: stock is fully-priced or overpriced Lower ratio: stock may be fairly priced or underpriced 70