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8/8/2019 Investment Analysis and Portfolio Management10_mba_kubs
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INVESTMENT ANALYSIS ANDPORTFOLIO MANAGEMENT
EQUITY VALUATIONHow to find your bearing
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EQUITY VALUATION: How to find your bearing
Equity Analyst employ two kinds of Analyses:
Fundamental Analysis
Fundamental Analysts assess the fair market value of equity sharesby examining the assets, earning prospects, cash flow projections
and dividend potential
Technical Analysis
Technical Analyst essential rely on price and volume trends and
other market indicators to identify trading opportunities
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EQUITY VALUATION: How to find your bearing
To determine the expected rates of return onalternative assets, it is necessary to estimate the futurevalue of the asset since a major component of the rateof return is the change in value for the asset over time.
Therefore, the crux of investments is valuation! The
value of any earning asset is the present value of theexpected cash flows generated by the asset.
Therefore, to estimate the value of an asset, you mustderive an estimate of
(1) the discount rate for the asset (your required rate of return) (2) its expected cash flows.
The point is, the main source of information that willhelp you make these two estimates is the financialstatements,
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EQUITY VALUATION: How to find your bearing
Financial statements are also the mainsource of information when deciding
whether to lend money to a firm (invest inits bonds) or to buy warrants or options on a
firms stock. We first look into corporations major
financial statements and discuss why and
how financial ratios are useful. We will see how can internal liquidity,
operating performance, risk analysis, andgrowth analysis can be assessed.
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EQUITY VALUATION: How to find your bearing
Financial statements are intended to provideinformation on the resources available tomanagement, how these resources were financed, andwhat the firm accomplished with them.
Corporate shareholder annual and quarterly reports
include three required financial statements:o the balance sheet,
o the income statement, and
o the statement of cash flows.
Information from the basic financial statements can beused to calculate financial ratios and to analyze theoperations of the firm to determine what factorsinfluence a firms earnings, cash flows, and riskcharacteristics.
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EQUITY VALUATION: How to find your bearing
The Balance Sheet Ratios
The debt figure includes all long-term fixed obligations,
including lease obligations and subordinated convertiblebonds.
The equity typically is the book value of equity and includespreferred stock, common stock, and retained earnings.
Some analysts prefer to exclude preferred stock and
consider only common equity. Total equity is preferable if you are examining an industry in
which some of the firms being analyzed have preferredstock.
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EQUITY VALUATION: How to find your bearing
The Balance Sheet Ratios
Book Value:
It is simply the net worth of the company (paid-upequity + reserves + surplus) divided by the number ofoutstanding equity shares.
Liquidation Value
It is value realized from liquidating all the assets of thefirm and subtracting from it amounts to be paid to allthe creditors and preference shareholders. Thus the
figure obtained divided by Number of outstandingequity shares provides the liquidation value.
Replacement Cost
It is obtained by estimating a replacement cost of asset
minus the liabilities.
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EQUITY VALUATION: How to find your bearing
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EQUITY VALUATION: How to find your bearing
Valuation of Stock:
All of these valuation techniques are based on thebasic valuation model, which asserts that the value ofan asset is the present value of its expected futurecash flows as follows:
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EQUITY VALUATION: How to find your bearing
Single Period Valuation Model:
To start it we assume that the investor is holding thestock for one year. Using the standard formula of stockvaluation we work it out as follows:
Vj = D1 P1-------- + --------(1+k) (1+k)
Where:D1 = Dividend expected in the forthcoming year
P1 = Price of the share at the end of year (investment)
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EQUITY VALUATION: How to find your bearing
Single Period Valuation Model:D1 P1
Vj = -------- + --------(1+k) (1+k)
Consider a stock which is expected to give a dividendof Rs.2 and the stock price is expected to increase toRs.25. If the required rate of return of the investor is12% -- what s the current price of the stock.
Vj =
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EQUITY VALUATION: How to find your bearing
Valuation of Stock:
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EQUITY VALUATION: How to find your bearing
Valuation of Stock:
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EQUITY VALUATION: How to find your bearing
Valuation of Stock:
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EQUITY VALUATION: How to find your bearing
Mult-period Valuation Model
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EQUITY VALUATION: How to find your bearing
Mult-period ValuationModel
The next estimate is the expected sale price (SP) forthe stock three years in the future. Assume anestimated sale price using the DDM of $34.
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EQUITY VALUATION: How to find your bearing
Valuation of Stock:
If you anticipate holding the stock for several yearsand then selling it, the valuation estimate is harder.
You must forecast several future dividend paymentsand estimate the sale price of the stock several yearsin the future.
The difficulty with estimating future dividend paymentsis that the future stream can have numerous forms.
The exact estimate of the future dividends depends on
two projections. The first is your outlook for earnings growth because
earnings are the source of dividends.
The second projection is the firms dividend policy,which can take several forms.
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EQUITY VALUATION: How to find your bearing
Valuation of Stock: The easiest dividend policy to analyze is
one where the firm enjoys a constantgrowth rate in earnings and maintains a
constant dividend payout. This set
of assumptions implies that the dividendstream will experience a constant growth
rate that is equal to the earnings growthrate.
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EQUITY VALUATION: How to find your bearing
Valuation of Stock: Multi-period Growth ModelThe easiest dividend policy to analyze is one where
the firm enjoys a constant growth rate in earnings andmaintains a constant dividend payout. This set of
assumptions implies that the dividend stream willexperience a constant growth rate that is equal to theearnings growth rate.
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EQUITY VALUATION: How to find your bearing
Valuation of Stock:
The infinite period constant growth ratemodel can be simplified to the followingexpression:
To use this model for valuation, youmust estimate:
the required rate of return (k) and
the expected constant growth rate of dividends
(g).
After estimating g, it is a simple matter toestimate D1, because it is the currentdividend (D
0
) times (1 + g).
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EQUITY VALUATION: How to find your bearing
Derivation of Constant Growth Dividend Discount
Model (DDM)
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EQUITY VALUATION: How to find your bearing
Derivation of Constant Growth Dividend Discount
Model (DDM)
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EQUITY VALUATION: How to find your bearing
Derivation of Constant Growth Dividend Discount
Model (DDM)
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EQUITY VALUATION: How to find your bearing
Valuation of Stock:Consider the example of a stock with a current dividend of $1 a
share, which you expect to rise to $1.09 next year. You believe that,over the long run, this companys earnings and dividends willcontinue to grow at 9 percent; therefore, your estimate ofgis 0.09.
For the long run, you expect the rate of inflation to decline, so youset your long-run required rate of return on this stock at 13 percent;your estimate ofkis 0.13.
To summarize the relevant estimates:
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EQUITY VALUATION: How to find your bearing
Valuation of Stock:
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EQUITY VALUATION: How to find your bearing
Valuation of Stock:
These examples show that as small a changeas 1 percent in eithergorkproduces a largedifference in the estimated value of the stock.
The crucial relationship that determines thevalue of the stock isthe spread between the required rate of return(k) and
the expected growth rate of dividends (g).
Anything that causes a decline in the spreadwill cause an increase in the computed value,whereas any increase in the spread willdecrease the computed value of the stock.
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EQUITY VALUATION: How to find your bearing
Valuation with Temporary Supernormal Growth As noted, the assumptions of the model make
it impossible to use the infinite period constantgrowth model to value true growth companies.
A company cannot permanently maintain a
growth rate higher than its required rate ofreturn because competition will eventuallyenter this apparently lucrative business, whichwill reduce the firms profit margins andtherefore its ROE and growth rate.
Therefore, after a few years of exceptionalgrowththat is, a period of temporarysupernormal growtha firms growth rate isexpected to decline.
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EQUITY VALUATION: How to find your bearing
Valuation with Temporary Supernormal Growth
To determine the value of a temporary supernormalgrowth company, you must combine the previousmodels.
In analyzing the initial years of exceptional growth, youexamine each year individually.
If the company is expected to have two or three stagesof supernormal growth, you must examine each yearduring these stages of growth.
When the firms growth rate stabilizes at a rate belowthe required rate of return, you can compute the
remaining value of the firm assuming constant growthusing the DDM and discount this lump-sum constantgrowth value back to the present.
The technique should become clear as you workthrough the following example.
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EQUITY VALUATION: How to find your bearing
Valuation with Temporary Supernormal Growth
The XYZ Company has a current dividend (D0)of $ 2 a share. The following are the expectedannual growth rates for dividends.
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EQUITY VALUATION: How to find your bearing
Valuation with Temporary Supernormal Growth
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EQUITY VALUATION: How to find your bearing
Valuation with Temporary Supernormal Growth
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EQUITY VALUATION: How to find your bearing
Valuation of Stock: RELATIVEVALUATIONTECHNIQUES
The relative valuation techniques implicitly contendthat it is possible to determine the value of aneconomic entity (i.e., the market, an industry, or acompany) by comparing it to similar entities on thebasis of several relative ratios that compare its stockprice to relevant variables that affect a stocks value,such as
a. earnings,b. cash flow,c. book value; andd. sales.
Therefore, following relative valuation ratios:a. price/earnings (P/E),b. price/cash flow (P/CF),c. price/book value (P/BV); andd. price/sales (P/S).
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EQUITY VALUATION: How to find your bearing
Valuation of Stock: RELATIVEVALUATIONTECHNIQUES
We will discuss the P/Eratio, also referredto as the earnings multiplier model,because it is the most popular relative
valuation ratio. In addition, we will show that the P/Eratio
can be directly related to the DDM in a
manner that indicates the variables thataffect the P/Eratio
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EQUITY VALUATION: How to find your bearing
Valuation of Stock: RELATIVEVALUATIONTECHNIQUES
M
any investors prefer to estimate the value of common stock usingan earnings multiplier model. The reasoning for this approach recalls the basic concept that the
value of any investment is the present value of future returns. In the case of common stocks, the returns that investors are entitled
to receive are the net earnings of the firm. Therefore, one way investors can estimate value is by determining
how many dollars they are willing to pay for a Rupee of expectedearnings.
This computation of the current earnings multiplier (P/Eratio)indicates the prevailing attitude of investors toward a stocks value.
Investors must decide if they agree with the prevailing P/Eratio (thatis, is the earnings multiplier too high or too low?) based upon how itcompares to the P/Eratio for the aggregate market, for the firmsindustry, and for similar firms and stocks.
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EQUITY VALUATION: How to find your bearing
Valuation of Stock: RELATIVEVALUATIONTECHNIQUES
The infinite period dividend discount model canbe used to indicate the variables that shoulddetermine the value of the P/Eratio as follows:
If we divide both sides of the equation by E1(expected earnings during the next 12 months),
the result is
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EQUITY VALUATION: How to find your bearing
Valuation of Stock: RELATIVEVALUATIONTECHNIQUES
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EQUITY VALUATION: How to find your bearing
Valuation of Stock: RELATIVEVALUATIONTECHNIQUES After estimating the earnings multiple, you would apply it to your
estimate of earnings for the next year (E1) to arrive at an estimatedvalue.
In turn, E1 is based on the earnings for the current year (E0) and yourexpected growth rate of earnings.
Using these two estimates, you would compute an estimated value ofthe stock and compare this estimated value to its market price.
Consider the following estimates for an example firm:
D/E= 0.50 k= 0.12 g= 0.09 E0 = $2.00
Using these estimates, you would compute an earnings multiple of:
Given current earnings (E0) of $2.00 and a gof 9 percent, you wouldexpect E1 to be $2.18. Therefore, you would estimate the value (price)of the stock as V= 16.7 $2.18 = $36.41
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EQUITY VALUATION: How to find your bearing
Valuation of Stock: RELATIVEVALUATIONTECHNIQUESP
rice to Cash-Flow
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EQUITY VALUATION: How to find your bearing
Valuation of Stock: RELATIVEVALUATIONTECHNIQUESP
rice toB
ookValue
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EQUITY VALUATION: How to find your bearing
Valuation of Stock: RELATIVEVALUATIONTECHNIQUESP
rice toS
ales Turnover The advocates consider this ratio meaningful and useful for two
reasons.
First, they believe that strong and consistent sales growth is arequirement for a growth company. Although they note theimportance of an above-average profit margin, they contend that thegrowth process must begin with sales.
Second, given all the data in the balance sheet and incomestatement, sales information is subject to less manipulation than anyother data item. The specific P/Sratio is:
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INVESTMENT ANALYSIS ANDPORTFOLIO MANAGEMENT
MACROECONOMIC AND INDUSTRY ANALYSIS
Understanding the BroadPicture
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MACROECONOMIC AND INDUSTRY ANALYSIS
Understanding the BroadPicture
We analyze economies because of the strong link
between the overall economic environment in acountry and the performance of its security markets.
Security markets reflect what is expected to go on in
an economybecause the value of an investment is
determined by its expected cash flows and its futurerequired rate of return, and both of these factors areinfluenced by its expected aggregate economicenvironment.
Therefore, if you want to estimate cash flows, interestrates, and risk premiums for securities, you need toconsider aggregate economic analysis.
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MACROECONOMIC AND INDUSTRY ANALYSIS
Understanding the BroadPicture
Three major techniques are available for analyzing
securities markets. First, the macroeconomic approach attempts to project
the outlook for securities markets based on theunderlying relationship between the aggregate economyand the securities markets.
Second, the microanalysis approach involves using thepresent value of cash flows and the relative valuationratios to estimate a value for a countrys aggregate stockmarket.
Finally, the technical analysis approach assumes thatthe best way to determine future changes in securitymarket values is to examine past movements in interestrates, security prices, and other market variables.
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MACROECONOMIC AND INDUSTRY ANALYSIS
Understanding the BroadPicture
There are two possible reasons why stock prices lead the
economy. One is that stock prices reflect expectations of earnings,
dividends, and interest rates. As investors attempt toestimate these future variables, their stock price decisionsreflect expectations forfuture economic activity, not current
activity. A second possible reason is that the stock market reacts to
various leading indicator series, the most important beingcorporate earnings, corporate profit margins, interest rates,
and changes in the growth rate of the money supply. Because these series tend to lead the economy, when
investors adjust stock prices to reflect expectations forthese leading economic series, it makes stock prices aleading series as well.
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MACROECONOMIC AND INDUSTRY ANALYSIS
Understanding the BroadPicture
Government Policy:
Fiscal Policy: Fiscal policy is concerned with the spending and taxinitiatives of the government. It is perhaps the most direct tool tostimulate and dampen the economy. An increase to governmentspending stimulates the demand for goods and services.
Monetary Policy: Many academic and professional observershypothesize a close relationship between stock prices and various
monetary variables that are influenced by monetary policy.The best-known monetary variable in this regard is the moneysupply. The money supply can be measured in several ways,including currency plus demand deposits (referred to as the M1money supply) and the M1 money supply plus time deposits(referred to as the M2 money supply). There are other measures of
the money supply, but M1 and M2 are the best known. The Satebank of Pakistan controls the money supply through various tools,the most useful of which is open market operations.
Supply Side Policy: While the demand-siders focus on the impactof taxes on consumption demand, supply-siders look at the effect oftaxes on incentives to work and invest.
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MACROECONOMIC AND INDUSTRY ANALYSIS
Understanding the BroadPicture
Macroeconomic Analysis:
The key variables commonly used to describe the state of the macroeconomy are:
Growth in GDP
Industrial growth rate
Agriculture and rainfall
Savings and investments
Government budget and deficit
Price level and inflation
Interest rates
Balance of Payment, forex reserves, and exchange rate
Infrastructure facilities and arrangements
Sentiments
MACROECONOMIC AND INDUSTRY ANALYSIS
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MACROECONOMIC AND INDUSTRY ANALYSIS
Understanding the BroadPicture
Industry Analysis: Investment practitioners perform industry analysis because they believe it
helps them isolate investment opportunities that have favorable return-riskcharacteristics.
it is part of our three-step, top-down plan for valuing individual companiesand selecting stocks for inclusion in our portfolio.
What exactly do we learn from an industry analysis?
Can we spot trends in industries that make them good investments?
Are there unique patterns in the rates of return and risk measures over time indifferent industries?.
The industry analysis can be divided into three parts:
o The business cycle and industry sectors
o Industry life cycle analysis
o Study of the structure and characteristics of an industry
o Profit potential of industries
MACROECONOMIC AND INDUSTRY ANALYSIS
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MACROECONOMIC AND INDUSTRY ANALYSIS
Understanding the BroadPicture
Industry Analysis:
THESTOCKMARKETAND THEBUSINESSCYCLE
MACROECONOMIC AND INDUSTRY ANALYSIS
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MACROECONOMIC AND INDUSTRY ANALYSIS
Understanding the BroadPicture
Industry Analysis:
THESTOCKMARKETAND THEBUSINESSCYCLE
Toward the end of a recession, financial stocks rise invalue because investors anticipate that banks earningswill rise as both the economy and loan demand recover.
Brokerage houses become attractive investmentsbecause their sales and earnings are expected to rise asinvestors trade securities, businesses sell debt andequity, and there is an increase in mergers during theeconomic recovery.
These industry selections assume that when therecession ends there will be an increase in loan demand,housing construction, and security offerings.
MACROECONOMIC AND INDUSTRY ANALYSIS
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MACROECONOMIC AND INDUSTRY ANALYSIS
Understanding the BroadPicture
Industry Analysis:
THESTOCKMARKETAND THEBUSINESSCYCLE
Once the economy begins its recovery, consumerdurable firms that produce expensive consumer items,such as cars, personal computers, refrigerators, lawntractors, and snow blowers, become attractiveinvestments because a reviving economy will increaseconsumer confidence and personal income.
Once businesses recognize the economy is recovering,they begin to think about modernizing, renovating, or
purchasing new equipment to satisfy rising demand andreduce costs. Thus, capital goods industries such asheavy equipment manufacturers, machine tool makers,and airplane manufacturers become attractive.
MACROECONOMIC AND INDUSTRY ANALYSIS
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MACROECONOMIC AND INDUSTRY ANALYSIS
Understanding the BroadPicture
Industry Analysis:
THESTOCKMARKETAND THEBUSINESSCYCLE Cyclical industries whose sales rise and fall along with
general economic activity are attractive investments duringthe early stages of an economic recovery because of theirhigh degree of operating leverage, which means that they
benefit greatly from the sales increases during an economicexpansion. Industries with high financial leverage likewisebenefit from rising sales volume.
Traditionally, toward the business cycle peak, the rate ofinflation increases as demand starts to outstrip supply. Basic
materials industries such as oil, metals, and timber, whichtransform raw materials into finished products, becomeinvestor favorites. Because inflation has little influence on thecost of extracting these products and they can increase
prices, these industries experience higher profit margins.
MACROECONOMIC AND INDUSTRY ANALYSIS
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MACROECONOMIC AND INDUSTRY ANALYSIS
Understanding the BroadPicture
Industry Analysis:
THESTOCKMARKETAND THEBUSINESSCYCLE
During a recession, some industries do better thanothers. Consumer staples, such as pharmaceuticals,food, and beverages, outperform other sectors during arecession because, although overall spending maydecline, people still spend money on necessities sothese defensive industries generally maintain theirvalues.
Similarly, if a weak domestic economy causes a weak
currency, industries with large export components togrowing economies may benefit because their goodsbecome more cost competitive in overseas markets.
MACROECONOMIC AND INDUSTRY ANALYSIS
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MACROECONOMIC AND INDUSTRY ANALYSIS
Understanding the BroadPicture
Industry Analysis:
Industry Life Cycle Analysis:
The number of stages in this industry life cycleanalysis can vary based on how much detail
you want. A five-stage model would include: 1. Pioneering development 2. Rapid accelerating growth 3. Mature growth
4. Stabilization and market maturity 5. Deceleration of growth and decline
MACROECONOMIC AND INDUSTRY ANALYSIS
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MACROECONOMIC AND INDUSTRY ANALYSIS
Understanding the BroadPicture
Industry Analysis:
Industry Life Cycle Analysis:
MACROECONOMIC AND INDUSTRY ANALYSIS
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MACROECONOMIC AND INDUSTRY ANALYSIS
Understanding the BroadPicture
Industry Analysis:
Industry Life Cycle Analysis:
MACROECONOMIC AND INDUSTRY ANALYSIS
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MACROECONOMIC AND INDUSTRY ANALYSIS
Understanding the BroadPicture
Industry Analysis:
MACROECONOMIC AND INDUSTRY ANALYSIS
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MACROECONOMIC AND INDUSTRY ANALYSIS
Understanding the BroadPictureIndustry Analysis:Study of the structure and characteristics of an industry :
Structure of the Industry and Nature ofCompetition Nature and Prospects of Demand Cost Efficiency and Profitability Technology and Research
During any time period, the returns for different industries vary within a wide range,which means that industry analysis is an important part of the investment process.
The rates of return for individual industries vary over time, so we cannot simplyextrapolate past industry performance into the future.
The rates of return of firms within industries also vary, so analysis of individualcompanies in an industry is a necessary follow-up to industry analysis.
During any time period, different industries risk levels vary within wide ranges, so wemust examine and estimate the risk factors for alternative industries.
Risk measures for different industries remain fairly constant over time, so thehistorical risk analysis is useful when estimating future risk.
MACROECONOMIC AND INDUSTRY ANALYSIS
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MACROECONOMIC AND INDUSTRY ANALYSIS
Understanding the BroadPicture
Industry Analysis:
Threat of new entrants
Rivalry among the existing firms
Pressure from substitute products
Bargaining power of buyers
Bargaining power of sellers
MACROECONOMIC AND INDUSTRY ANALYSIS
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MACROECONOMIC AND INDUSTRY ANALYSIS
Understanding the BroadPicture
Industry Analysis:
MACROECONOMIC AND INDUSTRY ANALYSIS
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MACROECONOMIC AND INDUSTRY ANALYSIS
Understanding the BroadPicture
Industry Analysis:
MACROECONOMIC AND INDUSTRY ANALYSIS
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MACROECONOMIC AND INDUSTRY ANALYSIS
Understanding the BroadPicture
Industry Analysis:
MACROECONOMIC AND INDUSTRY ANALYSIS
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MACROECONOMIC AND INDUSTRY ANALYSIS
Understanding the BroadPicture
Industry Analysis:
Profit Potential of Industries:
Threat of new entrants
Rivalry among the existing firms
Pressure from substitute products
Bargaining power of buyers
Bargaining power of sellers
MACROECONOMIC AND INDUSTRY ANALYSIS
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MACROECONOMIC AND INDUSTRY ANALYSIS
Understanding the BroadPicture
Industry Analysis:
Profit Potential of Industries:
Threat of new entrants
Rivalry among the existing firms
Pressure from substitute products
Bargaining power of buyers
Bargaining power of sellers
MACROECONOMIC AND INDUSTRY ANALYSIS
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MACROECONOMIC AND INDUSTRY ANALYSIS
Understanding the BroadPicture
Industry Analysis:
Profit Potential of Industries:
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INVESTMENT ANALYSIS ANDPORTFOLIO MANAGEMENT
COMPANY ANALYSIS
Establishing the Value Benchmark
COMPANY ANALYSIS
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COMPANY ANALYSISEstablishing the Value Benchmark
Industry Analysis:
Profit Potential of Industries:
The basic SWOT analysis, is intended to
articulate a firms strengths, weaknesses,opportunities, and threats. These two analyses should provide a
complete understanding of a firms overall
strategicapproach. Given this background, we review the
financials
COMPANY ANALYSIS
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COMPANY ANALYSISEstablishing the Value Benchmark
Industry Analysis:
Profit Potential of Industries: Analysts use two general approaches to valuation. The techniques
that serve each of these approaches follow:
PresentValue ofCash Flows (PVCF)
1. Present value of dividends (DDM
)2. Present value of free cash flow to equity (FCFE)
3. Present value of free operating cash flow to the firm(FCFF)
Relative Valuation Techniques
1. Price/earnings ratio (P/E)2. Price/cash flow ratio (P/CF)
3. Price/book value ratio (P/BV)
4. Price/sales ratio (P/S)
COMPANY ANALYSIS
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CO S SEstablishing the Value Benchmark
Present Value of Dividends
For simplicity, we will initially discuss theconstant growth DDM. We saw that when
dividends grow at a constant rate, a stocks priceshould equal next years dividend, D1, divided bythe difference between investors required rateof return on the stock (k)and the dividend
growth rate (g)
COMPANY ANALYSIS
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Establishing the Value Benchmark
Present Value of Dividends
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Establishing the Value Benchmark
Present Value of Free Cash Flow
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Establishing the Value Benchmark
Present Value of Operating Free Cash Flow