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Chapter 17

Security Valuation and Selection

Fundamental Analysis versus Technical Analysis

Fundamental analysis the practice of evaluating the information

contained in financial statements, industry reports, and economic factors to determine the intrinsic value of a firm

Fundamental Analysis versus Technical Analysis

Intrinsic value the “true” or economic, value of a firm

Fundamental Analysis versus Technical Analysis

Fundamentalistsanalysts who utilize fundamental analysis in

an attempt to forecast future stock price movements

Fundamental Analysis versus Technical Analysis

Technical analysisexamination of supply and demand for

securities to determine trends in price movements of stocks or financial instruments

Fundamental Analysis versus Technical Analysis

Technicians the term given to analysts who examine

stocks and financial markets using technical analysis

Economic Analysis

Forecasting business cycles to determine when to expect changes in the

business cycle, or the direction in which aggregate economic activity is moving

Economic Analysis

Business cycle the movement in aggregate economic

activity as measured by the gross domestic product (GDP)

Economic Analysis

Expansion increasing economic activity

Economic Analysis

Contractiondecreasing economic activity

Economic Analysis

Gross Domestic Product (GDP)a measure of all of the goods and services

produced in the economy during a specified time period

Economic Analysis

Recession two consecutive quarters of economic

contraction, or decline, in the GDP

Recessions and Stock Price Movements 1975 - 2005

Economic Analysis

Economic indicatorsLeading economic indicators

economic measures that tend to move prior to, or precede, movements in the business cycle

Economic indicators

Lagging economic indicatorseconomic measures that tend to move

after, or follow, movements in the general economy (business cycles)

Economic indicators

Coincident indicatorseconomic measures that tend to

mirror, or move at the same time as, business cycles

Business Cycle Indicators

Business Cycles - Monetary Policy and Fiscal Policy

Monetary Policy the means by which the Federal Reserve

influences economic conditions by managing the nation’s money supply

Business Cycles - Monetary Policy and Fiscal Policy

Fiscal PolicyGovernment spending, which is primarily

supported by the government’s ability to tax individuals and businesses

Business Cycles - Monetary Policy and Fiscal Policy

Deficit spending situation that occurs when the government

spends more than it collects in taxes

Industry Analysis

Cyclical industries industries that tend to be directly related to

business cycles such that they perform best during expansions and worst during contractions

Industry Analysis

Defensive, or countercyclical, industries industries that tend to perform best when

the economy is in a contraction or recession, but are generally the poorest performers in expanding economies

Industry Analysis

Industry life cycle the various phases of an industry with

respect to its growth in sales and its competitive conditions

Industry Life Cycle

Industry Sales

Life-Cycle Stages

Introductory

Expansion (Growth)

Mature

Evaluating the Firm’s Financial Position

Financial statement analysis1. comparison to other similar firms

2. forecast direction for future

3. predict earnings and dividends

4. risk evaluation

Stock Valuation Techniques

Dividend discount models (DDM)a model that utilizes the discounted cash

flow principle to value common stock value is represented by the present value

of the dividends expected to be received from investing in the stock

Dividend discount models (DDM)

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Stock Valuation Techniques

Stock Valuation Techniques

Valuation using P/E ratios ratio computed by dividing the current

market price per share, P0, by the earnings per share, EPS0

used to estimate the value of a stock; P0 ≈ (P/E) x EPS0

Stock Valuation Techniques

Evaluation using the economic value added (EVA) approachmethod used to evaluate if the earnings

generated by a firm are sufficient to compensate the suppliers of funds - both the bondholders and the stockholders

Evaluation using the economic value added (EVA) approach

EVA IRR - WACC Invested

capital

EBIT 1- T WACC Invested

capital

Stock Valuation Techniques

Economic Value Added (EVA)

Changing the capital structure can change value because the WACC is affected

Increasing the efficiency of the firm through reductions in operating expenses or increases in revenue will increase operating income and thus increase value

Technical Analysis

Charting - using charts and graphs

Bar charta graph that indicates the high, low,

and closing price movements for a stock during a specified period

Technical Analysis

Charting - using charts and graphsTrend line

a line that indicates the direction of the stock price movements

it is drawn so that it touches either the high prices or the low prices for some of the trading days

Technical Analysis

Charting - using charts and graphsTrend line penetration

the point at which the trading line crosses the trend line

Trend Line Penetration

Technical Analysis

Measures and indicators used by technical analystsThe Dow Theory

a technique used to predict reversals in market patterns by examining the movements of the Dow Jones Industrial Average and the Dow Jones Transportation Average

Measures and indicators used by technical analysts

Moving averagesstock price averages for a fixed

time frame, say 100 days, computed for a particular period of time

Technical indicatorsmeasures used by technical

analysts to forecast future movements in stock prices

Measures and indicators used by technical analysts

Market breadth indicatorsmeasure the trading volume and

the range of trading that takes place in the market

Measures and indicators used by technical analysts

Advance/decline linea graph that depicts the results

computing the difference between the number of advancing stocks and the number of declining stocks over some time period

Measures and indicators used by technical analysts

Sentiment indicatorstechnical indicators that are used

to monitor the “mood” or psychology of the market

Measures and indicators used by technical analysts

Stock Selection Criteria

Growth stocks stocks of firms that have many positive net

present value opportunities in general, these firms exhibit sales and

earnings growth that significantly exceed the industry averages

Value stocks stocks of firms that are mispriced,

especially those that are undervalued

$1.99

Stock Selection Criteria

1. Be disciplined with your investment approach

2. Know the company in which you invest

3. Choose firms that are in strong financial positions

4. Stay with the investment until it no longer satisfies your investment goals

Investment Professionals’ Advice

Investment Selection in Efficient Markets

Abnormal returns returns that exceed the returns earned by

investments with similar risks

Weak form efficiency current market prices reflect all historical

information, including any information that might be provided by examining past price movements and trading volume data

Investment Selection in Efficient Markets

Semistrong form efficiency current market prices reflect all publicly

available information, including information contained in historical data and information contained in current financial statements

Strong form efficiency current market prices reflect all

information, whether it is public or private

Investment Selection in Efficient Markets

Even if we accept that abnormal returns cannot be earned on a consistent basis, we still need to evaluate the investments we select to ensure the risk position is appropriate and that our investment goals are being met

End of Chapter 17

Security Valuationand Selection