Topic 6 Security Analysis

Question 1

Book value

Answer 1

1. Net worth of a company as reported on its balance sheet
2. Book value of an asset equals the original cost of acquisition less some amount for depreciation. Depreciation allocates costs over several years but does not reflect loss of actual value

Question 2

Market value

Answer 2

MV of a firm’s equity investment equals the difference between current values of all assets and liabilities.
MV reflects value of the firm as a going concern (may include value of brand name or specialty expertise)

Question 3

Liquidation value

Answer 3

A measure of a floor for the stock price
Represents amount of money that could be realized by breaking up the firm, selling its assets, repaying the debt and distributing the remainder to shareholders

Question 4

Ways of valuing a company

Answer 4

1. Book value
2. Market value
3. Liquidation value
4. Replacement cost

Question 5

What is intrinsic value

Answer 5

Intrinsic value is the PV of all cash payments to the investor in the stock, incl divs and ultimate sale price, discounted at the appropriate discount rate.

Question 6

In market equilibrium the current market price reflects?

Answer 6

Reflects the intrinsic value estimates of all market participants

Question 7

What is the market capitalization rate

Answer 7

Market capitalization rate is the market consensus value of the required rate of return (k)

Question 8

Name issues with dividend discount models

1. No divs
2. Issues with constant growth DDM
3. Substantial change to the organization , eg mergers and acquisitions.

Answer 8

1. If no dividend is expected, then the model implies the stock has no value. Need to adjust
2. Constant growth DDM is valid only when g (growth) is less than the k (required rate of return). Otherwise value of stock is infinite
   Solution may be multistage DDM

Question 9

Constant growth DDM implies that a stock’s value is greater when:

Answer 9

1. The larger its expected dividend per share
2. The lower the market capitalization rate k
3. The higher the expected growth rate of dividends

Question 10

What is the plough back ratio

Answer 10

Plough back ratio is the fraction of earnings invested with the firm
Also known as the earnings retention ratio

Question 11

What is the dividend payout ratio

Answer 11

Div payout ratio is the fraction of earnings paid out as dividends

Question 12

Define present value of growth opportunities (PVGO)

Answer 12

Value of the firm rises by the NPV of the investment opportunities.

Question 13

Value of the firm =

Answer 13

No growth value of the firm plus the present value of growth opportunities (PVGO)

Question 14

Explain why growth per se is not what investors desire

Answer 14

1. Growth enhances company value only when achieved by investments in attractive opportunities ie ROE greater than k.

Question 15

When is a firm subject to takeover offer

Answer 15

A firm is subject to takeover offer when the PVGO is negative. That is, when the NPV of a firms projects is negative, the rate of return on those assets is less than the cost of capital. Another firm can therefore purchase and change the investment policy.

Question 16

Return on Assets measures…

Answer 16

ROA measures income per dollar of total assets, regardless of whether debt or equity is used

Question 17

Estimate market return (use as an input to CAPM)

Answer 17

Market return=risk free rate + market risk premium
CAPM = r(f) + B(E(rm) - rf)
= k

Issues:

1. Estimates of inputs. If wrong, estimate of intrinsic value can be altered substantially
2. Highlights the need for sensitivity analysis

Question 18

Multi stage DDM (define)

Answer 18

Multi stage DDM captures the way projected growth may change significantly of different stages of a company’s life.
Estimate shirt to medium term growth, then use constant growth DDM to estimate contribution to intrinsic value made by long term growth.

Question 19

Price Earnings Multiple (define) (aka PE ratio)

Answer 19

Ratio of price per share to earnings per share
May serve as useful indicator of expectations of future growth opportunities
High PE can indicate that a firm enjoys ample growth opportunity, rather than that a higher relative PE means a firm is overpriced.

Question 20

Plow back ratio and the PE ratio (3)

Answer 20

1. The higher the plough back rate, the higher the growth rate
2. BUT a higher plough back rate does not necessarily mean a higher PE ratio.
3. PE ratio increases only if investments undertaken offer a higher expected return than the market capitalization rate(otherwise more money goes to projects with inadequate rates of return)

Question 21

P/E ratios

Answer 21

1. Low PE ratios can represent good value as long as they are low relative to expected growth
2. DDM equation can imply that low PE ratio could reflect relatively high required return (k)
   - high required return correspond to high levels of systematic exposure (ie beta)
   - high returns observed on low PE stocks could be attributed to risk premium for the higher risks they represent

Question 22

Pitfalls of PE

Answer 22

1. Denominator is accounting earnings. These are influenced by historical cost in depreciation and inventory valuation. Inflation can distort
2. Earnings management (using accounting rules to improve apparent profitability of the firm)
3. Business cycle: model assumes a smooth trend line growth rate whereas reported earnings can fluctuate dramatically around a trend line. DDM looks at economic earnings, but reported earnings are computed based on generally accepted accounting principles.
4. Note PE ratios vary across industries. Those with lower PEs are generally more mature

Question 23

Comparative ratios

Answer 23

1. PE
2. PV
3. Price to Cash Flow (cashflows in and out of company less likely to be affected by accounting decisions. Can use operating cash flow, or free cash flow
4. Price to Sales (note profit margins vary widely, but can be useful for start ups)

Question 24

Name 2 factors that have substantial impact on stock prices

Answer 24

1. Interest rates

2. Corporate profits

Question 25

Steps to forecasting the stock market

Answer 25

1. Forecast corporate profits for coming period
2. Derive estimate of earnings multiplier, the aggregate PE ratio, based on a forecast of long term interest rates
3. Multiply the 2 forecasts

Question 26

Forecast P/E ratio

Answer 26

1. Plot earnings yield (EPS/Price per share, ie reciprocal of P/E ratio)

Question 27

What happens to PE when inflation rises?

Answer 27

PE tends to fall when inflation rises.

Question 28

Valuation methodologies summary (9)

Answer 28

1. Use ratios of price to company’s book value, either as it appears or as adjusted to reflect current replacement cost of assets or liquidation value
2. Focus on the present value of expected future cashflows. DDM suggests value of stock should equal PV of all future divs per share, discounted at a discounting rate commensurate with the risk of the stock
3. DDMs give estimates of intrinsic value of a stock.if price does not equal intrinsic value, actual expected return will differ from the equilibrium return based on the stock’s risk. Magnitude of actual expected return will depend on speed at which stock price is predicted to revert to its intrinsic value
4. Constant growth DDM assists that if dividends are expected to grow at a constant rate forever, then the intrinsic value of the stock is determined by (formula). Assumes constant growth rate g. Can use multi stage DDM instead. Can also infer market capitalization rate by inverting the formula.
5. Constant growth dividend discount mode, is best step to firms that are expected to have stable rates over foreseeable future. Consider however life cycle. Multi stage DDM well suited for this.
6. Expected future growth rate of earnings is related to both firm’s expected investment returns and the extent to which it reinvests earnings. G = ROE x (1-b)
7. DDM can reveal relationship between expected ROE and the company’s capitalization rate k. If ROE is higher than capitalisation rate, retaining earnings will increase intrinsic value
8. P/E ratio: reveal market’s assessment of firm growth opportunities,
   - cash cow: no growth opportunities therefore P/E is reciprocal of capitalisation rate k.
   - DDMs can compare P/E ratios and potential growth.
   - DDMs can also be used to argue that level of PE can be explained by implied risk exposure
9. Can estimate stock’s value or aggregate market value by multiplying forecast of EPS by expected PE multiple

Question 29

What does the balance sheet represent

Answer 29

Balance sheet represents the capital structure of the firm in terms of funding sources and deployment of resources as at a single point in time.

Question 30

Income statement represents…

Answer 30

Income statement represents the operating performance of the firm over a specified period.

Question 31

Accounting conventions to be aware of:

Answer 31

1. Matching principle (aka accrual accounting)
2. Historic cost convention
3. Going concern assumption
4. Consolidated financial reports

Question 32

Matching principle (accrual accounting)

• why necessary
• examples

Answer 32

Why necessary: trying to measure performance for a financial period, therefore allocate expenses to the period in which revenue is recognized, to ensure profit fairly reflects performance for the period.
Examples:
- depreciation (expense in calculating profit, even though cash was outplayed when asset was purchased)
- inventory (product may have been produced in a particular period, but not recognized as expense because revenue not yet earned, instead treated as asset until sold when charged as an expense)
- accruals and prepayments
The matching principle is one reason why cashflow will be different to profit

Question 33

Historic cost convention

• define
• exceptions

Answer 33

Define historic cost convention:
When calculating the balance sheet of an entity, asset items are recorded at original cost (minus accumulated depreciation) and liabilities recorded at face value.

Exceptions

• lower of cost or market
• Aus, value land and buildings to market value every 3 years
• certain financial institutions are able to value assets and liabilities at current market values.

Question 34

Balance sheet represents…(4)

Answer 34

1. B/S represents company’s financial position at a point in time by reporting assets, liabilities and shareholders equity. Snapshot of financial condition
2. Assets = liabilities + equity
3. Net assets = assets - liabilities = equity
4. Also, common size balance sheets divide each item by total assets

Question 35

Income statement reports….(6)

Answer 35

1. Income statement reports results of transactions arising from company’s operations over the reporting period.
2. Net Income = revenue - cost of sales - other operating costs - depreciation - finance costs - income tax expense
3. Capital transactions such as asset purchases or new borrowings are not included, but annual costs (representing depreciation and interest expense) are
4. Analysts generally focus on a particular earnings number
5. Analysts generally prepare a Common Size Income statement, in which all items are prepared as a fraction of total revenue.
6. Provides a measure of profitability over time

Question 36

Cash flow statement

Answer 36

1. Cash flow statement reports and analyses transactions that have an effect on the company’s cash balances. Therefore similar to profit and loss statement
2. Expected cashflow is the underlying driver of value
   Cashflow analysis is generally more objective, not impacted by accounting policies and non cash items
3. Cashflow from operations - cashflow from investing activities + cashflow inflow from financing = net change in cash and cash equivalents

Question 37

Contrast income statement and balance sheet with the statement of cashflows

Answer 37

The income statement and balance sheet are based on accrual methods of accounting, ie revenues and expenses are recognised at the time of sale even of no cash has changed hands; the cashflow statement tracks the implications of cash transactions. Cashflow statement will not show cash from a sale until the cash is paid.

Question 38

Cashflow statement, evidence of financial well being….

Answer 38

If the company cannot pay dividends and maintain the productivity of capital stock out of cashflow from operations, it must resort to borrowing to meet these needs. This is a serious warning.

Question 39

Accounting vs. economic earnings

Answer 39

Economic earnings: the sustainable cashflow that can be paid out to stockholders without impairing the productive capacity of the firm.
Accounting earnings: affected by several conventions regarding the valuation of assets such as inventories (LIFO/FIFO), and the way expenditure is recognized over time (eg depreciation)

Question 40

Liquidity ratios (3)

Answer 40

1. Current ratio
   - current assets / current liabilities
   - ability of firm to pay off current liabilities by liquidating its current assets, ability to avoid insolvency
2. Quick ratio (acid test ratio)
   - (cash + marketable securities + receivables)/current liabilities
   - better measure of liq for those firms where inventory is not readily converted to cash.
3. Cash ratio
   - cash ratio = (cash +marketable securities)/current liabilities.

Question 41

Summary, accounting statements (4)

Answer 41

1. Accounting statements can represent a model of the firm structure (ie balance sheet) and performance (ie income statement) that is useful for understanding the likely growth in a company’s earnings
2. Primary focus for a security analyst should be firm’s real economic earnings rather than reported accounting earnings
3. Firm’s ROE is key determinant of growth rate in earnings. ROE is affected profoundly by firm’s degree of financial leverage. Increase in D:E will raise its ROE and hence it’s growth rate only is the interest rate on debt is less than firm’s ROA
4. Can be helpful to decompose firms ROE ratio into product of several accounting ratios and to analyze their separate behavior over time. Consider DuPont system.

Question 42

If PVGO is negative, how can intrinsic value be increased for shareholders

Answer 42

1. increase dividen payout ratio

2. buy back shares

Question 43

A high asset turnover relative to industry average implies that the firm…
(asset turnover is Sales/Assets)

Answer 43

is utilising assets more efficiently than other firms in the industry

Question 44

Tobin’s Q =

Answer 44

Tobin’s Q = total market value of the firm’s common stock divided by the replacedment cost of the firm’s assets less liabilities.

Question 45

Low PE ratios can represent good value as long as …

Answer 45

Low PE ratios can represent good value as long as they are low relative to expected growth.

Question 46

Low PE ratio can be associated with a high….

Answer 46

A low PE ratio can be associated with a required rate of return (k)
Assuming high required rates of return are associated with a higher beta, stains means high returns on low PE stocks could be attributed to risk premium for the higher risks they represent.