k Formation

8/11/2019 k Formation

1/63

CapitalFormation

Real Asset and Financial Assets


2/63

Business Valuation

The value of a company is equal to thevalue of its financial claims:

VA= VD+ VE


3/63

Valuation Example

A company which owns an existing oil well

was purchased for $50M.

The investment was financed by the acquiring

company

raising $25M in equity

borrowing $25M at 8% interest

Case: We want to determine the current value

of the acquiring company.


4/63

Valuation Value of Debt: Company borrowed $25M by issuing an 8% bond. Currently

the bond has a maturity of 10 years and is trading at an 8% YTM:

V Int

k

F

k

V M M

M

where

Int c F M M

k YTM Rate required by creditors

D

D

t

D

Mt

M

D tt

R

D

( ) ( )

$2

( . )

$25

( . )$25

:

(. )($25 ) $2

1 1

108 108

08

1

101

10


5/63

V D

k

where

D Total Dividends

k Rate required by equity investors

Per Share

V d

k

where

d D n

V V n

n number of shares

E

e

tt

e

e

e

tt

e E

( )

:

( )

:

/

/

1

1

1

1

Value of Equity

Model


6/63

Note

If D is fixed over time then as t becomes l e

V D

k

D

k

To estimate V one needs to estimate k and D

k can be estimated u g the CAPM

E

e

t

et

E e

e

:

, arg :

( )

.

sin

11

Value of Equity


7/63

CAPM: Relation

Security Market Line (SML): Depicts the

equilibrium relationship between any

investments equilibrium return and its beta.Ei

*

EM

Rf

i1

SML

E R E Ri fM

f i* [ ]


8/63

Required Return on Equity

Given

Market Risk premium E R

R

Then the required return on equity for a stock with

a would be

k R E R

k

M f

f

e f M f

e

:

.

.

. :

[ ]

. [. ]( ) .

10

04

2 24

04 10 2 24


9/63

EXPECTED EARNINGSE TR M

TOC M E EBIT M

Int M M

E EBT MTaxes M t

E EAT M

RE no growth firmE D M

n M

E d

( ) $20

( )

[(. )($25 )]

( )[ . ]

( )

[ ]( )

( ) $1.

812

2 08

104 4

6

06

5

20


10/63

Valuation:

V E D

k

MM

V M

V V V

V M M M

E

e

D

A E D

A

0

0

0 0 0

0

24

( ) $6

.$25

$25 .

$25 $25 $50


11/63

Alternative Valuation:V M M M

V

EAT Int

k

M M

M

where

k f k f k

k M M

M

V EBIT t

k

MM

where

k f t k f k

k M M

M

A

A

c

nt

c

nt

d D e e

c

nt

A

c

t

c

t

d D e e

c

nt

0

0

0

16

08 24 16

1 1 4

144

1

1 4 08 24 144

FHG IKJ FHG IKJ

F

HG I

KJ F

HG I

KJ

$25 $25 $50

$6 $2

. $50

:

$25$50

. $25$50

. .

( ) $12 ( . )

.$50

:

( )

$25

$50( . ).

$25

$50. . .


12/63

Empirical Approaches

Discounted Cash Flow Models

P/e (Multiplier) Model

Wells Fargo

Decision Tree and Monte Carlo Simulation

Models


13/63

Discounted Cash Flow Models

Gordon Model:

Assumption: Dividends will grow (g) at a

constant rate over time:

V D g

k

D

k g

Et

e

t

et

00 1

1

1

1

( )

( )

.


14/63

Discounted Cash Flow ModelsTwo-Period Growth Model:

Assumption: Assumes extraordinary growth rateof g1 for N years followed by a steady-state growth

rate of g2thereafter.

V d gk

d gk

d gk

Vk

where V d g

k g

d g g

k g

e

e e

N

e

NN

e

e

N

N

e N

e

N

e

00 1 0 1

2

20 1

2

2

0 1

2

2

11

11

11 1

1 1 1

( ) ( )( )

( )( ) ( )

,

: ( ) ( ) ( )

.

V d g

k g

k g

k

V

k

e

e

e

N N

e

N

N

e

e

N00 1

1

11 1 1

1 1

HG KJ

( ) ( ) ( )

( ) ( )


15/63

Discounted Cash Flow ModelsThree-Period Growth Model:

Assumption: Assumes extraordinary growth rateof g1, a transitional period, followed by a steady-

state growth rate of g2thereafter.

g

g1

g2

Timet2t1


16/63

P/e (Multiplier) ApproachModel:

Estimation of P/e: Take the Gordon model and divide through

by e:

V P

eE ee0 1HGKJ ( )

Ve

Pe

d ek g

Estimate d e k and g

e

e

/

: / , , .


17/63

P/e (Multiplier) ApproachEstimation of P/e:

Use a cross-sectional regression model. Example: Regress the P/e ratios of 150 stocks against their

historical growth rate (Elton-Gruber):

Example: Regress the P/e ratios of 300 stocks against their

growth rate, betas, and dividend-payout ratio (d/e)

(Malkiel-Craig):

( / )

( / ) .

P e a b g

P e g Elton Gruber

i i

i i

4 2 3

( / ) ( ) (( / ) ) ( )P e c c g c d e ci i i i 0 1 2 3

Malkiel Craig found good correlations between

P e and the above lanatory iables but

found the relation was unstable over time

/ exp var ,

.


18/63

P/e (Multiplier) ApproachEstimation of P/e:

Use a cross-sectional regression model. Example: Regress the P/e ratios of 150 stocks against their

historical growth rate (Elton-Gruber):

Example: Regress the P/e ratios of 300 stocks against their

growth rate, betas, and dividend-payout ratio (d/e)

(Malkiel-Craig):

( / )

( / ) .

P e a b g

P e g Elton Gruber

i i

i i

4 2 3

( / ) ( ) (( / ) ) ( )P e c c g c d e ci i i i 0 1 2 3

Malkiel Craig found good correlations between

P e and the above lanatory iables but

found the relation was unstable over time

/ exp var ,

.


19/63

Forecasting the Market, Industry, and

Stock using the Multiplier Approach

Many analysts use the top-down, three-stepapproach in which they try to forecast the

future values and returns of a market series,

industries, and companies in industries. The multiplier approach can be used in such

forecast.


20/63

Stock Market Analysis and Forecast The objective of aggregate stock market

analysis is to forecast the future marketvalue and rate of return of a major market

series such as the S&P 400 or S&P 500.

The forecast can be made using thefollowing multiplier model:

V P

e

E eps

where V next period s value of the market index

P e next period s multipler for the market

E eps ected eps for the series

M

M

1 1

1

1

HGKJ

( )

: ' .

/ ' .

( ) exp .


21/63

Stock Market Analysis and ForecastEPS Forecast Model:

Regression estimate of % change in sales

per share, S, in terms of the % change in

GDP:

g S a b GDP

S S gt t

% (% )

( )

1 1


22/63


Estimate operating profit margin, m. This

margin tends to depend on labor and

production factors:

Given m and S, EBDIT is:

m EBDIT

Salesf labor t production capacity ( cos , )

EBDIT m St t


23/63


Estimate depreciation, interest, and the effectivetax rate:Depreciation enses have increased between

and over the last years Depreication

enses are at the high end when the economy is

at a high level of capacity utilization

Dep f K Capacity

exp

.

exp

.

( )

5% 8% 20

Interest enses depend on corporate

leverage and Interest rate

Int f r

exp

.

( , )

The effective tax rate depends on initiatives

at federal and state levels.


24/63

Stock Market Analysis and Forecast

EPS Forecast Model: Given forecast of depreciation, interest, and

the effective tax rate, eps is:

EPS EBDIT Dep Int tt t t t t [ ]( )1


25/63

Stock Market Analysis and ForecastP/e Forecast Model:

The market multiplier can be estimated by

directly estimating each parameter in the

Gordon model:

P

e

d e

k g

d e market series dividend earnings ratio

k required market rate of returng growth rate in eps for the market

/

/ ' .

..


26/63

Stock Market Analysis and ForecastP/e Forecast Model:

d/e: d/e for the market series tends to

fluctuate. If dividends are stable and the

economy is growing, d/e moves inversely

with the economy.

K: Using the CAPM, next periods required

market return is equal to the risk-free rate

and market risk premium.k R E R R

where

f M f

[ ( ] ,

: .

1


27/63

Stock Market Analysis and ForecastP/e Forecast Model: K: A relation exist between RF rate and market RP: The

lower Rf the greater RP.

G: The growth rate in eps can be related to the retention

ratio (f) and the rate of return on investments:

The rate of return on investment, I, can be estimated using

ROE for market series:

g f i

ROE EPS

Equity Per Share

EPS

Sales Per Share

Sales

Assets

Assets

Equity

ROE Asset Turnover Ratio Asset Turnover Ratio Liquidity Ratio

HG KJHG KJHG KJ

.

( ) ( )( )


28/63

Stock Market Analysis and

ForecastValue and Expected Rate

V

P

e E eps

E d d e E eps

E r V E dV

tt

t

t t t

t t

:

( )

( ) ( ( / ) ) ( )

( ) ( )

F

HG

I

KJ

1

10


29/63

Stock Market Analysis and Forecast Example: Chapter 12 (Section 12.4) provides an example of

forecasting the S&P 400 series using the

preceding model. The example uses data fromStandard and Poors Analysts Handbook. The

information can be found in Stockch12.xls.


30/63

EXHIBIT12.4-2

FORECAST OF MARKET SERIES

(1) Variable

(Per Share) 1995 1996 REASON

(2) Sales (S) $655 $710 Projected % Change in GDP = 6%.

%Sales = 1.38 (% GDP)}

% Sales = 1.38(6%) = .083S96= (1 + .083)S95S96= (1 + .083)($655) = $710

(2) Operating Profit

Margin

(m = EBDIT/S)

15.8% 15% Operating profit margins will not increase

as a result of the high level of capital

capacity utilization (85%), but will

decrease slightly because of expected small

increase in unit labor cost.

(3) EBDIT $103.50 $106.50 EBDIT = m SEBDIT = (.15) ($710) = $106.50

(4) Depreciation

(D)

$31.60 $34.13 Because of the high level of capacity

utilization (85%), an 8% increase in

capital expenditures is expected.

(5) Interest

(I)

$12.50 $11.87 Projected 5% decrease in interest

expenses based on a lower interest rate

expectation.

(6) Tax Rate

(t)

(Taxes paid/EBT)

35% 35% Expect no change in the tax rate.

(7) EPS $38.35 $39.32 EPS = (EBDIT - D - I)(1 - t)

EPS = ($106.50-$34.13-$11.87)(1-.35)

EPS = $39.32


31/63

EXHIBIT 12.4-2

MARKET FORECAST CONTINUED

(8)Dividend/Earnings

(d/e)

.37 .40 The dividend to earnings ratio is expectedto increase slightly based on the

assumption of higher earnings in 1996

and stable dividends.

(9) Required Return(k)

9% Projected risk-free rate of 6%.Projected market risk premium of 3%.

(10) Net Profit

Margin

(EPS/Sales)

.04 .04 Expect no change in net profit margin,

given the assumption of only a slight

change in operating profit margin.

(11) Asset Turnover(Sales/Asset)

.95 .95 Expect no change in asset turnover ratio.

(12) Liquidity Ratio

(Asset/Equity)

3.4 3 Expect slight decrease in liquidity ratio.

(13) Return on

Equity

(ROE)

11% 11.4% ROE = EPS/Sales =

(EPS/S)(S/Assets)(Assets/Equity)

ROE = (.04) (.95) (3) = .114

(14) Growth Rate

(g)

6.8% g = (Retention Ratio)ROE

g = (1 - (d/e))ROE

g = (.6)(.114) = .068

(15) P/e 18.8 18.5 P/e = (d/e)/(k-g)

P/e = .4/(.09-.068) = 18.5

(16) Dividends(d)

$15.50 $15.73 d96= (d/e)EPS96d96= (.4)($39.32) = $17.73

(17) Index Value

(V)

721 727.42 V96= (P/e)EPS96V96= (18.5)(39.32) = 727.42

(18) Expected Rate 3% E(Rate) = [(727.42+15.73)/721] 1

E(Rate) = .03


32/63

Industry Analysis Industry analysis is the next step in the top-down, three-step approach to

fundamental stock analysis.

In evaluating industries, it is important to note that if there is little difference

in the performances among different industries, then there is no need to study

industries. If the aggregate stock market, for example, is expected to generate

a 12% rate of return, while the return amongst all industries only ranges

between 11% and 13%, then there would not be much purpose in conducting

an industry analysis: one could get a 12% expected return by just randomlyselecting industries. Studies of industrial performance, though, do show a

wide dispersion in the rates of return among industries. In 1995, for example,

the S&P 500 increased 37.6%, with the performances among industries

ranging from -15% (trucking industry) to 80% (biotech). This suggest

industry analysis is important and explains why many investment companies

maintain a staff of industry analysts. Ultimately, we want to be able to find the right stocks for investment. It is

easier, though, to find a good company and stock from a good industry, than to

find a good company and stock from a bad or declining industry.


33/63

Stages of Industrial Development

From an investment perspective, the identification of good

industries comes from finding those sectors whoseexpected returns exceed their require returns. As a starting

point, it is helpful to understand the nature of the industryin terms of its current stage of development.

Industrial organizational theory describes industries interms of the five stages of development that define thetypical industry's life cycle. These stages include: Pioneering,

Rapid Accelerating Growth,

Mature Growth, Stabilization,

Deceleration and Decline.


34/63

Pioneering

Pioneering Stage:This is the start-up stage of theindustry.

It is the stage in which firms in the industry are

just beginning to identify their markets.

The stage is characterized by high developmentcosts, small or modest sales, and small or negative

profit margins.

Examples of the pioneering stage would be thecar industry at the beginning of the century or the

computer industry in the 1950s.


35/63

Rapid Accelerating Growth

Rapid Accelerating Growth Stage: In this stage, the

market for the industry starts to develop. From a low salesbase, sales begin to increase at an increasing rate, oftenresulting in excess demand for the industry's product.

During this phase, firms in the industry respond to their

growing market by developing their production capacity. The Rapid Accelerating Growth Stage is characterized by

high profit margins, with profit increasing significant (asmuch as 100% in some years) from a low sales base.

The car industry in the 1950s, the computer industry in the

1970s, and the internet and biotech industries of the 1990swould be example of this second stage of industrydevelopment.


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Mature Growth Stage

Mature Growth Stage:This is a stage in which sales continue toincrease, but not at an accelerating rate.

From a relatively high sales base, sales growth tends to be above the

growth rate of the economy, but below the rates experienced in the

previous stage. For example, if the economy were growing at 5%, the

industry might be growing between 7% and 10% during this stage.

The Mature Growth Stage is the period when the industry's profit

attracts other firms into the industry. The increased competition

resulting from the entry of new firms often causes prices to decrease in

the industry during this time, lowering profit margins.

The greater competition also may lead to increases in advertising

expenditures and other costs related to differentiating a firm's product

or to constraining entry of new firms into the industry.


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Stabilization

Stabilization Stage: This is a stage where theindustry reaches an equilibrium in which the

number of firms in the industry is set, demand is

stable, and production capacity is at a level to

meet demand. In this stage, the industry growth rate matches the

economy's and profit margins are tight but stable.

For many industries, the stabilization stage is the

longest period in their life cycle.


38/63

Decleration and Declining Growth

Decleration and Declining Growth Stage:In this stage, the

industry's sales growth may increase at a decreasing rate or

decline.

It is a period in which there is a switch in demand brought

about by better substitutes

Examples:

Home computers and word processing software for typewriters

Cars for horses


39/63

Industry Life Cyclesalesingrowth%

Time

Pioneering

1Stage

GrowthRapid

2Stage

GrowthMature

3Stage

GrowthStable

4Stage

onDecelerati

5Stage


40/63

Note

Remember: Finding a good company in a good industry does

not necessarily mean that the stock of that

company is a good investment. For example, a

good company in a growing industry may be

experiencing high sales and profit margins, but it

could also be selling at a price that yields a return

below its required return; that is, the good

company's stock could be overpriced.

I d t A l i d F t


41/63

Industry Analysis and Forecast

Like the market series, the value and rate of return for an industry can

be estimated using the multiplier approach

.V

P

eE eps

EBDIT m S or EBDIT a b EBDIT

EPS EBDIT Dep Int tP

e

d e

k g

d e and g can be estimated similar to market series

or each can related to the marketE d d e E eps

E r V E d

V

t

I

t

I

t

I

I M

t t t

t t

HGKJ

( )

[ ]( )/

/

.( ) ( ( / ) ) ( )

( ) ( )

1

1

10


42/63

Industry Analysis and Forecast

Example: Chapter 12 (Section 12.4) provides an example of

forecasting the return from the retail drug industry

using the preceding model. The example usesdata from Standard and Poors Analysts

Handbook. The information can be found in

Stockch12.xls.


43/63

EXHIBIT 12.4-4FORECAST OF INDUSTRY SERIES

RETAIL DRUG STORE INDUSTRY (RDS)

Variable

(Per Share) 1994 1995 REASON

(1) Sales (S) $361.71 $386.26 Projected % Change in PERSONAL

CONSUMPTION EXPENDITURE-MEDICAL (PCE-MC) = 6.7%.

%Sales = .92(%PCEMC)%Sales = .92(.067) = .062S95= (1 + .062)S94S95= (1 + .062)($361.71) = $386.26

(2) Operating ProfitMargin

(m = EBDIT/S)

6.42% 6.375% Operating profit margins will not increaseas a result of the high level of capital

capacity utilization (85%), but willdecrease slightly because of expected smallincrease in unit labor cost.

(3) EBDIT $23.26 $24.62 EBDIT = m S

EBDIT = (.06375) ($386.26) = $24.62

(4) Depreciation

(D)

$5.32 $5.50 A slight increase in capital expenditures is

expected because of the level of industrycapacity utilization.

(5) Interest

(I)

$1.10 $1.00 Projected small decrease in interest

expenses based on a lower interest rateexpectation.

(6) Tax Rate

(t)(Taxes paid/EBT)

38% 36% Industry is expected to move toward the

35% tax rate for the market.

(7) EPS $10.51 $11.60 EPS = (EBDIT - D - I)(1 - t)EPS = ($24.62-$5.50-$1.00)(1-.36)EPS = $11.60


44/63

EXHIBIT 12.4-4

INDUSTRY FORECAST CONTINUED

(8) P/e 15.48 17.32 Historically, the industry P/e has been

slightly higher than the market P/e, but

lower in recent years. Based on a micro

analysis, the industry is expected to have a

lower k than the market and a higher g.The higher g is based on a projected high

asset turnover ratio for the industry. The

industry P/e is projected to be 5% higher

than the projected P/e for the market:

P/eI= (1.05) (16.5) = 17.32

where: E(P/e)M= 16.5

(9) Dividends

(d)

4.64 d95= (d/e)eps95d95= (.4)($11.60)

Project increase in d/e from .34 to .4.

(10) Index Value

(V)

162.71 200.97 V95= (P/e) (EPS95)

V95= (17.32) (11.60) = 200.97

(11) Expected Rate 26.36%

E(Rate) = [(200.97+4.64)/162.71] 1

E(Rate) = .2636.

(12) Beta .5 .5 Project no change in systematic risk.

(13) Required

Return

(k)

7.5% SML: k = Rf + [RM - Rf]

K = .06 + [.03](.5) = .075.

RECOMMENDATION: ALLOCATE MORE INVESTMENT FUNDS TO RDS

C A l i d F t


45/63

Company Analysis and Forecast

Like the market and industry series, the value

and rate of return for a company can beestimated using the multiplier approach.

In analyzing a company, the parameters can be

estimated using a microeconomic analysis or by

comparing the companys performance with the

industry and market.

An example of forecasting the return for the

Walgreen company is presented in Section 12.4.Data for the analysis is in Stockch12.xls.

EXHIBIT 12.4-5


46/63

EXHIBIT 12.4 5

FORECAST OF COMPANY

WALGREEN

Variable 1995 1996 REASON

(1) Sales (S) $10.395B $11.44b Based on a microeconomic analysis of

projected new stores, a 10% increase in

sales is projected.

S96= (1 + .10)S95S95= (1 + .10)($10.395B) = $11.44B

(2) Net Profit

Margin(m = EAT/S)

3.09% 3.2% Walgreen's net profit margins have been

increasing more than the industry's due toits marketing innovations. An increase in

margins is projected.

(3) EAT $318M $366M EAT96= m S96EAT96= (.032) ($11.44B) = $366M

(4) Number ofShares

(n)

246.14M 246.14M No change projected.

(5) EPS $1.29 $1.49 EPS96= EAT96/n

EPS96= $366M/246.14M = $1.49.


47/63


48/63

TECHNICAL ANALYSIS

Theory of Contrary Opinion

Follow the Smart Money

Diffusion Index

Dow Theory

Moving Averages

Charting


49/63

THEORY OF CONTRARY

OPINION

FIND OUT WHAT CERTAIN

GROUPS OF INVESTORS ARE

DOING, THEN DO THE

OPPOSITE.


50/63

Contrarian Indicators

Odd Lot Trades

Mutual Fund Cash Position

Credit Balances in Brokerage Accounts

Investment Advisory Opinions

Put/Call Ratio

Short Interest Ratio


51/63

FOLLOW THE LEADER

Rule: Find out what the leaders are doing,

then follow their lead.

Confidence Index

Spreads

Short Sales by Specialists

Debit Balance at Broker Firms


52/63

DIFFUSION INDICATORS

Diffusion Indicators are used to determine thepervasiveness of a market trend.

Advances Minus Declines: Number of stocks thathave advanced (A) minus the number of stocksthat have declined (D).

Breadth of the Market = Sum of (A - D).

Diffusion Index = A + .5(no change)/T. If indexis near 60%, market is overbought; if index is near40%, market is oversold.


53/63

SIGNS THE MARKET IS

NEAR A PEAK Stock Index Increasing

A-D decreasing

BOM stable

Diffusion Index near 60%


54/63

SINGS THE MARKET IS

NEAR A TROUGH Market Index is decreasing

A-D is increasing

BOM stable

Diffusion Index is near 40%


55/63

DOW THEORY

Primary Trend: Long-term trend that carries

the market; rooted in fundamentals; may

last for years. Secondary Trend: Reflects resistance levels

to the primary trend.

Minor Trend: Random movements; day-to-day fluctuations; ignore.


56/63

BULL TREND

Each successive peak is higher than the

previous peak.

Stock prices increase on heavy volume. Stock prices decrease on light volume.


57/63

BEAR TREND

Each successive trough is lower than the

previous trough.

Stock prices decrease on heavy volume. Stock prices increase on light volume.


58/63

EFFICIENT MARKET

THEORY LECTURE MATERIAL COMES FROM

CHAPTER 13.

MOST EXTENSIVELY RESEARCHEDAREA IN FINANCE.

METHODOLOGY IS MOREIMPORTANT THAN THE FINDINGS.

YOU DONT HAVE TO AGREE WITHEMH; RESPECT IT.


59/63

PROPOSITIONS

PROPOSITIONS

Market consist of

fundamentalist. Information is

disseminated

efficiently.

News is random.

IMPLICATIONS

Stocks Market price

(P) is equal to theintrinsic value of the

stock (V).

P = V at all times.

P = V fluctuates

randomly.


60/63

EMPIRICAL TESTS

WEAK-FORM TEST

SEMISTRONG-FORM TEST

STRONG-FORM TEST


61/63

WEAK-FORM TEST

Test of whether information contained inhistorical prices is reflected in current

prices. Ho: Investors cannot earn abnormal returnsfrom strategies based on historical trends.

Tests

Time Pattern Tests

Return Predictability Tests


62/63

SEMISTRONG-FORM TEST

Test of whether publicly available information is

fully reflected in current prices.

Ho: Investors, on average, cannot earn abnormalreturns from trading strategies based on publicly

available information.

Tests

Cross-Sectional Test

Event Studies


63/63

STRONG-FORM TESTS

Test of whether all information - public and

private - is fully reflected in security prices.

Tests to determine if those close to firm who have

privileged information can earn abnormal returns.

Two Null Hypotheses:

Ho: Investors cannot earn abnormal returns from

private information. Ho: Investment analysts cannot earn abnormal return

from their information.

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