Transcript Valuing a Stock and a Bond - Oklahoma State University

Valuing a Stock and a
Bond
Stock Valuation is an Art not a
Science
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Economic drivers of stock value
Fundamental analysis based on
accounting information
Technical analysis based on price
patterns
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The Economics of Stock Value
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Ultimately, a stock’s value is a function
of its dividends and earnings.
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We say the stock’s value today is the “present
value of all future dividends, discounted at a rate
appropriate for its risk”.
This is called the “dividend discount model”, or
DDM.
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So, where do we get the numbers, and what
kind of numbers do we need?
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What information is important?
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Current and expected dividends
Expected long term growth rate in dividends
or earnings
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b = % earnings retained (retention ratio) and
r = “return on equity”
Cash flow per share
Book value per share
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Let’s try this with ConocoPhillips
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The Data:
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Current price is $64.
Last year’s dividend = $2.53,
Expected dividend next year = $2.74
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Dividend payout ratio = 28%
Retention ratio = 72%
Historic growth in earnings = 10%
I’ve estimated a required return of 14%
This data equates to a price of $68.50.
Morningstar shows:
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Fair value = $85
Consider buying at $68, and selling at $106
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Other Ways to Estimate Price
1.
2.
3.
4.
Price/Earnings Ratio
Price/Cash Flow Ratio
Price/Book Value
Price/Sales
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Some Selected P/Es
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P/Es on trailing year earnings:
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ConocoPhillips:
Proctor & Gamble
Intel
Apple
Johnson & Johnson
United Technologies
AEP/PSO
8.1
16.0
10.2
15.5
15.3
14.0
12.9
What do these tell us about the stock?
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Using the “P/E” (the price/earnings
ratio) to Determine a Fair Price.
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Today’s price divided by 12 months of
earnings. For COP the data is:
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Trailing P/E is 8.1 versus 13 for S&P 500
Forward P/E is 7.3 versus 12.5 for S&P 500
Five year average P/E is 8.0
So, if the normal P/E is 8.0X, and expected
earnings are $7.94 then next year’s price is
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Price = normal P/E times expected earnings,
which is = 8.0X $7.94 = $63.52.
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Using the Price/Cash Flow Ratio
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P/CF is today’s price divided by yearly cash
flow per share
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COP is 5.3X; S&P is 8.6X
So, if the expected FCF per share in 2012 is
$12.83, then today’s fair value price is:
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Price = FCF/share X expected cash flow
= $12.83 X 5.3 = $68
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Other Ratios
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Price/Book
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Tries to capture the amount of “premium”
that exists in a stock’s price over its
accounting value (book value).
The benchmark number is 1.0
Price/Sales
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Like P/CF, it estimates the fair price by
normal relationship between sales and
price.
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The P/E to Growth Measure: PEG
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The “PEG” ratio
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It’s the forward P/E ratio divided by the long term
rate of growth in earnings:
The benchmark value is 1.0.
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If a stock’s PEG > 1.0 its richly valued
If a stock’s PEG < 1.0 its cheap
However, you will find a majority of stocks with a
PEG>1.0
For ConocoPhillips its:
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PEG = 7.3/10 = .73
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So, let’s look at PEGs for some stocks
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P/Es and PEGs
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ConocoPhillips
Proctor & Gamble
Intel
Apple
Johnson & Johnson
United Technologies
AEP/PSO
P/E
PEG
8.1
16.0
10.2
15.5
15.3
14.0
12.9
.7
1.5
.8
.6
2.0
1.2
2.7
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How Wall Street Analysts
Value Stocks.
Technical Analysts or
Fundamental Analysts
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Technical Analysis
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Technicians believe that all information
about a security is reflected in its series
of previous prices.
They use past prices in an attempt to
predict future price movements in a
stock.
Analysis relies on charts, filters, moving
averages, etc.
Strictly Financials
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Support and Resistance Levels
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A support level is a price or level below which a stock or the
market as a whole is unlikely to go.
A resistance level is a price or level above which a stock or
the market as a whole is unlikely to rise.
Support and resistance levels are “psychological barriers:”
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bargain hunters help “support” the lower level.
profit takers “resist” the upper level.
A “breakout” occurs when a stock (or the market) passes
through either a support or a resistance level.
Charting: Open-High-LowClose (OHLC)
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Charting: Price Channels
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Charting: Head and Shoulders
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S&P 500 Pattern as of Friday*
*Source: Larry McMillan, “The Options Strategist”, Sept 30, 2011
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Charting: Moving Averages
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Moving average charts are average daily prices or index
levels, calculated using a fixed number of previous prices,
updated daily.
Because daily price fluctuations are “smoothed out,” these
charts are used to identify trends.
Example: Suppose the technical trader calculates a 15-day and
a 50-day moving average of a stock price.
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If the 15-day crosses the 50-day from above, it is a bearish
signal—time to sell.
If the 15-day crosses the 50-day from below, it is a bullish signal—
time to buy.
Fundamental Analysts
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Believe they can find undervalued
stocks by examining accounting data
and economic factors to calculate a
“true value” of a stock.
Most brokerage research analysts are
fundamental analysts.
Believe the market is extremely rational
and that value is derived from expected
earnings, dividends and cash flow.
Strictly Financials
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Other terms you might hear
analysts’ say*
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“Beta”
“Alpha”
*They come from using statistics to analyze stock price behavior
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Beta – It’s a risk measure of the stock’s
volatility relative to the market.
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The benchmark:
If beta = 1.0 the stock varies like the market.
 If beta < 1.0 the stock is less volatile than the
market.
 If beta > 1.0 the stock is more volatile than the
market.
“Beta” return, means the return you get in a stock
that’s provided by being exposed to the market in
general.
An index fund of the S&P 500 is all beta risk and beta
return.
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Alpha – a measure of the excess risk
adjusted return
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The benchmark
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Most stocks will have an “alpha” near 0.0
Alpha for an S&P 500 index fund should equal 0
If an investment manager is adding value
they should generate a “positive alpha”. This
is return greater than expected based on the
risk of the investment.
Managers that consistently produce “positive
alpha” are hard to find.
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What does all this mean?
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Stock Valuation is an art not a science.
Consistently identifying “under” or “over”
valued stocks is very difficult.
By understanding the factors that drive stock
value, you can better understand when the
market in general may be excessively high or
low.
You can now better judge the quality of the
services an investment advisor might be
offering you.
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What Determines Bond Prices?
The Bond’s properties is included in a
contract, the bond indenture, that specifies
the par value, coupon rate and
maturity date.
We need the “market interest rate” to
find the bond’s current value. This is the
bond’s “yield to maturity” (YTM).
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Treasury Yield Curve 9/30/2011*
*Source: WSJ, Oct 1, 2011
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Bond Yields and Prices
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A bond’s price is a function of the future cash flows it
will produce and a discount rate.
For a bond, there’s two cash flows:
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The discount rate to use can be determined by
looking at the market, but it’s a function of:
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The semiannual interest payments (if any)
The par value that will be returned at bond maturity.
The risk-free interest rate, + expected inflation rate,
+ liquidity (or maturity) premium + default premium.
Adding these together we get the “nominal” interest
rate, which is the one you observe in the market (our
YTM value).
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The Bond Pricing Process
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When a bond is sold, the issuer will set the coupon
rate at the current market rate of interest, today
about 2% for a 10 year U.S. Treasury Bond.
The rate of interest lenders are willing to take (yield
to maturity) fluctuates continuously as new
information about inflation, economic growth, credit
demand, etc. flow to the market.
Since par, coupon and maturity for any bond are set
by contract, the only thing that can vary to clear the
market is the current price of the bond.
Thus, bond prices vary continuously.
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How Bonds are quoted and traded
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Bond prices are typically quoted as a “% of
par” basis, eg. 100.00.
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A par bond is quoted at 100
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A premium bond is above 100
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Thus the coupon rate > market interest rate
A discount bond is below 100
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Thus the coupon rate = market interest rate.
Thus the coupon rate < market interest rate
Bonds that pay no annual interest are called
“zero coupon bonds” (or zeros).
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What do we know about how bond
prices behave?*
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Bond prices move inversely with interest
rates.
High coupon bonds are less volatile in price
than low coupon bonds.
Long maturity bonds vary more in price than
short maturity bonds.
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But higher coupon bonds tend to cushion this effect.
*There’s no magic, its all in the mathematics of bond prices.
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What are the risks in holding bonds?
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Interest rate risk – a bond’s price changes with
interest rates (but differently, see prior slide). It has
two offsetting components:
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Price Risk – the bond’s price will change inversely to
interest rate changes.
Reinvestment rate risk – because you are assuming
reinvestment of coupon payments at the market rate of
interest, changing interest rates will affect what you really
make from the bond.
Default risk – The chance that the issuer will go
bankrupt and not return the par value.
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Duration – The General Risk Measure
for a Bond
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Duration is the “time weighted” years to maturity of
a bond or a portfolio of bonds.1
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For example, a 5 year, 6% coupon bond, selling with a YTM
of 9%, has a duration of 4.2 years.
A 25 year, 6% coupon bond, selling at a YTM of 9% has a
duration of 10.6 years.
A 25 year, zero coupon bond, selling at a YTM of 9% has a
duration of 25 years. (There’s a pattern here.)
Think of duration as the measure that best describes
the risk of any particular bond (not including default
risk.)
Mathematically, it’s a derivative, ΔPrice/Δinterest rate
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Considerations about Bonds in
Today’s Markets
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U.S. Treasuries – The ultimate “non-correlated”
asset.
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They are not callable,
Have “no” default risk
Are the asset of choice in times of turmoil
Zero treasuries, “strips” have no reinvestment rate risk
High-Yield corporate bonds - For those willing to
take more risk in search of higher returns
Municipal bonds – For those seeking tax shelters
from U.S. (and often) state taxes.
But remember – all bonds will decline in value
if inflation expectations cause rising interest
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rates (except TIPS).