Transcript Document

Equity Fundamentals
Econ 173A
Summer 2013
1
Financial Instruments

Money Market
 Certificates of Deposit
 U.S. Treasury Bills
 Money Market Funds

Bond Market

 Treasury Notes and Bonds
 Municipal Bonds
 Corporate Bonds
Equity Market
 Common Stock
 Preferred Stock

Derivative Market
 Options
 Futures
2
Risk and
Prices
andexpected
Coupon Return
Rates
Return
Risk
3
Equity Basics
 Equity Securities: Evidence of an ownership share in a
corporation.
Fixed Income Securities vs. Equity Securities
Fixed Claim
High Priority on cash flows
Tax Deductible
Fixed Maturity
No Management Control
Bonds
Residual Claim
Lowest Priority on cash flows
Not Tax Deductible
Infinite life
Management Control
Hybrids (Combinations
of debt and equity)
Common Stock
4
The Appeal of Common Stocks
 Residual Owners: stockholders of a firm are the
owners, who are entitled to dividend income and a
prorated share of the firm’s earnings only after all the
firm’s other obligations have been met
 Stocks allow investors to tailor investments to meet
individual needs and preferences.
 Stocks may provide a steady stream of current income
through dividends.
 Stocks may increase in value over time through
capital gains.
5
From Stock Prices to Stock Returns
 Stock Returns: take into account both price changes and
dividend income
 Over past 50 years, stock returns have ranged from +48.28%
in 1954 to -21.45% in 1974
 Stock returns over past 50 years have averaged around 11%
 From 1998 through mid-’03, DJIA averaged 1.7%
6
7
DJIA annual Returns since 2003
2003
8341.63
10453.92
2112.29
25.32%
2004
10453.92
10783.01
329.09
3.15%
2005
10783.01
10717.50
-65.51
-0.61%
2006
10717.50
12463.15
1745.65
16.29%
2007
12463.15
13264.82
801.67
6.43%
2008
13264.82
8776.39
-4488.43
-33.84%
2009
8776.39
10428.05
1651.66
18.82%
2010
10428.05
11577.51
1149.46
11.02%
2011
11577.51
12217.56
640.05
5.53%
2012
12217.56
13104.14
886.58
7.26%
Average
5.95%
Standard Deviation 16.02%
8
Current Income from Stocks versus Bonds
9
Equity Basics
 Equity can either be:
 Privately held
 Publicly held
 There are two types of equity:
 common stock
 preferred stock
10
Advantages of Stock Ownership

Higher returns than bonds.

Over past 50 years, stocks averaged 11% and high-grade
corporate bonds averaged 6%.

Inflation hedge – stock returns typically exceed the rate of
inflation.

Easy to buy and sell stocks.

Price and market information is easy to find in financial media.

Unit cost per share of stock is lower than for bonds.
11
Disadvantages of Stock Ownership
 Stocks are subject to many different kinds of risk:




Business risk
Financial risk
Market risk
Event risk
 Difficult to predict which stocks will go up in value due
to wide swings in profits and general stock market
performance
 Low current income compared to other
investment alternatives
12
Common Stock Values
 Par Value: the stated, or face, value of a stock
 Mainly an accounting term and not very useful
to investors
 Book Value: the amount of stockholders’ equity
 The difference between the company’s assets minus the
company’s liabilities and preferred stock
 Market Value: the current price of the stock in the
stock market
13
Common Stock Values
 Market Capitalization: the overall current value of the
company in the stock market
 Total number of shares outstanding multiplied by the market
value per share
 Investment Value: the amount that investors believe
the stock should be trading for, or what they think it’s
worth
 Probably the most important measure for a stockholder
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Shareholder Rights
 If a dividend is declared, the dividend each shareholder
receives must be in proportion to the shareholder’s
ownership interest in the firm.
 the right to vote – one vote for each share held


Attend annual meetings and vote in person.
Sending in a proxy statement.
 the right to maintain ownership percentage


rights offering.
Preemptive right is sometimes waived in the corporate charter.
15
Stock Splits
 A stock split is an accounting decision to change the
number of shares outstanding without selling any more to
the public – a neutral occurrence.
 With a forward split, also called a regular way or direct
split, shareholders end up with a greater number of shares
than before the split.
 With a reverse split, the number of existing shares is
reduced.
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Stock Splits
The value of a firm cannot be increased by
splitting, or combining, its shares.
Examples
AT&T (Nov 2002) 1-for-5 split
Netflix (Feb 2004) 2-for-1 split
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Stock Splits
 The primary motivation for a stock split is usually a desire
to reduce the share price – optimal trading range.
 People prefer to buy round lots.
 Large reverse splits often reduce the number of
shareholders.
 The difference between a stock split and a stock dividend is
purely an accounting phenomenon.
 With a stock split, the par value of the stock changes by the
split factor.
 With a stock dividend, the par value is not affected.
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The Financial Page Listing

new 52-week high

cc
dd
g
n
pf
s
wt
x
new 52-week low
PE ratio > 100
loss in the most recent four quarters
dividends and earnings in Canadian dollars
newly issued in the past 52 weeks
preferred stocks
stock split/stock dividend > 10% in past 52 weeks
warrant
ex-dividend
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Dividends

Dividend income is one of the two basic sources of return to
investors.

Dividend income is more predictable than capital gains, so
preferred by investors seeking lower risk.

Dividends are taxed at maximum 15% tax rate, same as capital
gains.

Dividends tend to increase over time as companies’ earnings
grow; increases average 3-5% per year.

Dividends represent the return of part of the profit of the
company to the owners, the stockholders.
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Dividends and Earnings Per Share
 Earnings Per Share: the amount of annual earnings
available to common stockholders, stated on a per-share
basis
 Earnings are important to stock price
 Earnings help determine dividend payouts
EPS 
Net profit
 Preferred dividends
after taxes
Number of shares of
common stock outstanding
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Dividends and Dividend Yield
 Dividend Yield: a measure to relate dividends to share
price on a percentage basis
 Indicates the rate of current income earned on the
investment dollar
 Convenient method to compare income return to other
investment alternatives
Annual dividends received per share
Dividend yield 
Current market price of the stock
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Dividends and Dividend Payout Ratio
 Dividend Payout Ratio: the portion of earnings per share
(EPS) that a firm pays out as dividends
 Companies are not required to pay dividends
 Some companies have high EPS, but reinvest all money
back into company
Dividends per share
Dividend payout ratio 
Earnings per share
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Dividends: Types of Dividends
 cash dividends
 paid in cash
 some firms have an optional dividend reinvestment plan
(DRIP).
 stock dividends
 paid in additional shares of stock
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Dividends: Special Distributions

spin-offs
 a parent firm divests itself of a subsidiary, and all the shares in the
subsidiary are distributed proportionally to the shareholders in the parent

split-offs
 a parent firm divests itself of a subsidiary, and the shareholders must
make a choice between keeping shares in the parent, or exchanging them
for shares in the separated subsidiary

tracking stock
 These shares track the performance of a subsidiary, and in many
respects, are just a new class of shares.
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The Dividend Payment Procedure
 A dividend paid in accordance with a previously announced
corporate policy is a regular dividend.
 Companies try to establish a regular pattern and usually
pay dividends quarterly.

A firm that wishes to make an extra
 distribution of cash to the shareholders does
 so through a special dividend, also called an extra or
extraordinary dividend.
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The Dividend Payment Procedure
The Chronology of Events
1. date of declaration
Ex-dividend date
(2 business days prior
to the date of record)
2. date of record
3. date of payment
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Why Dividends Do Not Matter
 Paying dividends reduces the amount in a firm’s checking
account, and hence the shares are worth less.
 On the ex-dividend date, share prices tend to fall by about
the amount of the dividend.
 Dividends can provide insights to the company’s thoughts
about the future.
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Categories of Stock
 blue chip
 Income stocks are those that historically have a higher-thanaverage payout ratio.
 Cyclical stock is one whose fortune is directly tied to the
state of the overall national economy.
 Defensive stock is largely immune to changes in the
economy.
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Categories of Stock
 Growth stocks reinvest most of their earnings rather than
paying them out as dividends and may be good candidates
for above-average returns.
 Speculative stock has a high probability of a loss and a
small probability of a large profit.
 Penny stocks refer to unusually risky, especially
inexpensive shares.
 Category overlap: The stock categories are not mutually
exclusive.
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Types of Stock
 Blue Chip Stocks: financially strong, high-quality
stocks with long and stable records of earnings and
dividends
 Companies are leaders in their industries
 Relatively lower risk due to financial stability
of company
 Popular with investing public looking for steady growth
potential, perhaps dividend income
 Provide shelter during unsettled markets
 Examples: Wal-Mart, Proctor & Gamble, Microsoft, United
Parcel Service, Pfizer and 3M Company
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Types of Stock (cont’d)
 Income Stocks: stocks with long and sustained records
of paying higher-than average dividends
 Good for investors looking for relatively safe and high level
of current income
 Dividends tend to increase over time (unlike interest
payments on bonds)
 Some companies pay high dividends because they offer
limited growth potential
 More subject to interest rate risk
 Examples: Verizon, Conagra Foods, Pitney Bowes, R.R.
Donnelley, Bank of America and AmSouth Bancorp
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Types of Stock (cont’d)
 Income Stocks: stocks with long and sustained records
of paying higher-than average dividends
 Dividends tend to increase over time (unlike interest
payments on bonds)
 Some companies pay high dividends because they offer
limited growth potential
 Examples: Verizon, Conagra Foods, Pitney Bowes, Wrigley
33
Types of Stock (cont’d)
 Growth Stocks: stocks that experience high rates of
growth in operations and earnings
 High rate of growth in earnings > market
 Higher price appreciation (due to increasing earnings)
 Riskier investment because price will fall if earnings growth
cannot be maintained
 Typically pay little or no dividends
 Examples: Lowe’s, Harley-Davidson, Starbucks, Apple
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Types of Stock (cont’d)
 Cyclical Stocks: stocks whose earnings and overall
market performance are closely linked to the general
state of the economy
 Stock price tends to move with the business cycle
 Tend to do well when economy is growing, poorly in
slowing economy
 Best for investors willing to move in and out of market as
economy changes
 Examples: Caterpillar, Maytag Corp.
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Types of Stock (cont’d)
 Defensive Stocks: stocks that tend to hold their value,
and even do well, when the economy starts to falter
 Stock price remains stable or increases when general
economy is slowing
 Products are staples that people use in good times and bad
times, such as electricity, beverages, foods
and drugs
 Best for aggressive investors looking for “parking place”
during slow economy
 Examples: Proctor & Gamble, WD-40, Walmart
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Market Capitalization
 Small-Cap Stocks: under $1 billion
 Mid-Cap Stocks: $1 billion to $4 or
$5 billion
 Large-Cap Stocks: more than $4 or
$5 billion
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Types of Stock
 Small-Cap Stocks: small companies with market
capitalizations less than $1 billion
 Provide opportunity for above-average returns
(or losses)
 Short financial track record
 Erratic earnings
 Not widely-traded; liquidity is issue
38
Types of Stock (cont’d)
 Mid-Cap Stocks: medium-sized companies with
market capitalizations between $1 billion and $4 or $5
billion
 Provide opportunity for greater capital appreciation
than Large-Cap stocks, but less price volatility than SmallCap stocks
 Long-term track records for profits and stock valuation
 “Baby Blues” offer same characteristics of Blue Chip stocks
except size
 Examples: Wendy’s, Barnes & Noble, Petsmart, Cheesecake
Factory
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Types of Stock (cont’d)
 Large-Cap Stocks: large companies with market
capitalizations over $4 or $5 billion
 Number of companies is smaller, but account for 80% to
90% of the total market value of all U.S. equities
 Bigger is not necessarily better
 Tend to lag behind small-cap and mid-cap stocks, but
typically have less volatility
 Examples: AT&T, General Motors, Microsoft
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Investing in Foreign Stocks
 Globalization of financial markets is growing
 U.S. equity market is less than 50% of world
equity markets
 Six countries make up 80% of world equity market
 U.S. market remains largest and one of best
performing equity markets
 Much of performance of non-U.S. markets is due to changes
in currency exchange rates
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Stock Investment Strategies
 Buy-and-Hold
 Investors buy high-quality stocks and hold them for
extended time periods
 Goal may be current income and/or
capital gains
 Investors often add to existing stocks over time
 Very conservative approach; value-oriented
42
Stock Investment Strategies (cont’d)
 Current Income
 Investors buy stocks that have high dividend yields
 Safety of principal and stability of income are
primary goals
 May be preferable to bonds because dividends levels tend to
increase over time
 Often used to provide to supplement other income, such as
in retirement
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Stock Investment Strategies (cont’d)
 Quality Long-Term Growth
 Investors buy high-quality growth stocks, mid-cap stocks
and tech stocks
 Capital gains are primary goal
 Higher level of risk due to emphasis on capital gains
 Significant trading of stocks may occur over time
 Diversification is used to spread risk
 “Total Return Approach” is version that emphasizes both
capital gains and high income
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Stock Investment Strategies (cont’d)
 Aggressive Stock Management
 Investors buy high-quality growth stocks, blue chip stocks,
mid-cap stocks, tech stocks and cyclical stocks
 Capital gains are primary goal
 High level of risk due to emphasis on capital gains
 Investors aggressively trade in and out of stocks, often
holding for short periods
 Timing the market is key element
 Time consuming to manage
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Stock Investment Strategies (cont’d)
 Speculation and Short-Term Trading
 Also called “day trading”
 Investors buy speculative stocks, small-cap stocks and tech
stocks
 Capital gains are primary goal
 Highest level of risk due to emphasis on capital gains in
short time period
 Investors aggressively trade in and out of stocks, often
holding for extremely short periods
 Looking for “big score” on unknown stock
 Time consuming & high trading costs
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What is Security Analysis?
 “The process of gathering and organizing information and
then using it to determine the intrinsic value of a share of
common stock.”
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What is Intrinsic Value?
 Intrinsic Value
 The underlying or inherent value of a stock, as determined
through fundamental analysis
 A prudent investor will only buy a stock if its market price
does not exceed what the investor thinks the stock is worth.
 Intrinsic value depends upon several factors:



Estimates of future cash flows
Discount rate
Amount of risk
48
“Top Down” Approach to
Traditional Security Analysis
 Step 1: Economic Analysis
 State of overall economy
 Step 2: Industry Analysis
 Outlook for specific industry
 Level of competition in industry
 Step 3: Fundamental Analysis
 Financial condition of specific company
 Historical behavior of specific company’s stock
49
Efficient Market Hypothesis
 Efficient Market: the concept that the market is so
efficient in processing new information that securities
trade very close to or at their correct values at all times
 Efficient market advocates believe:
 Securities are rarely substantially mispriced in
the marketplace
 No security analysis is capable of finding mispriced
securities more frequently than using random chance
50
Who Needs Security Analysis
in an Efficient Market?
 Fundamental analysis is still important because:
 All of the people doing fundamental analysis is the reason
the market is efficient
 Financial markets may not be perfectly efficient
 Pricing errors are inevitable
7-51
51
Industry Analysis
 Evaluate the competitive position of a particular industry in
relation to
other industries
 Looking for new opportunities &
growth potential
 Identify companies within the industry that look promising
 Looking for strong market positions, pricing leadership,
economies of scale, etc.
52
Issues that Affect an Industry
 What is the nature of the industry?
 Is the industry regulated?
 What role does labor play in the industry?
 How important are technological developments?
 Which economic forces have the most impact on the
industry (e.g., interest rates, foreign trade)?
 What are the important financial and operating
considerations (e.g., access to capital)?
53
Concepts of Value
 Book Value
 Market value
 Liquidation Value
 Fair Market Value, Intrinsic Value
a) Value given a thorough appreciation of the Company,
its prospects, and the market
b) Look for mispricing
c) Alpha = E(HPR) less Market RRR
54
The Valuation Process


a)
b)


a)

a)
b)
The Economy, The Market, The Business
Forecast Earnings and Cash Flows
Growth rates
Dividend payout rate
Select Valuation Model
Select the Discount Rate
Exogenous or endogenous
Conclusion & Recommendation
Under or over Valued
Buy, Sell, Hold
55
Economy, Sector, Market, Company
 Inherent sector and industry profitability
 Industry structure
 Company’s relative competitive position
a) Market share
b) Cost leadership
c) Pricing power
d) Product differentiation versus product focus
56
Forecasting
 Top-down forecast
a) Economy-Sector-Industry-Company
 Financial forecast
a) Financial Statement Analysis: revenues & expenses
b) From profits to cash flows, esp. Free Cash Flows
c) Costs, prices, and the Product life cycle
57
The Valuation Model
 Approach
a) Cost
b) Income
c) Market
 Method
a) De Novo or M&A
b) Revenues, Earnings, Cash flows
c) Comparables
58
Models
 Dividend Discount Model
 D.C.F.
 C.A.P.M.
 Fama & French
59
Discount Rates
 Build-up Method
a) Risk-free Rate +
b) Equity risk premium +
c) Company risk premium
 P/E implied
 C.A.P.M.
a) Risk-free Rate +
b) Non-systematic risk premium
60
Growth Cycle Stages
and Investments

Growth Cycle reflects the vitality of an industry or a company
over time.

Initial development: industry is new and risks are
very high

Rapid expansion: product acceptance is growing and investors
become very interested

Mature growth: expansion comes from growth in the economy
and returns are more predictable

Stability or decline: demand for product is
investors avoid this stage
diminishing and
61
Fundamental Analysis
 Evaluate the financial condition and operating results of
a specific company




Competitive position
Composition and growth in sales
Profit margins and dynamics of earnings
Asset mix (i.e. cash balance, inventory, accounts receivable,
fixed assets)
 Financing mix ( i.e. debt, stock)
 The value of a stock is influenced by the financial
performance of the company that issued the stock.
62
Where Do We Start?
 Interpreting Financial Statements
 Using Financial Ratios
 Fundamental analysis is often the most demanding and
most time-consuming phase of stock selection.
63
Major Groups of Financial Ratios





Liquidity Ratios: the company’s ability to meet day-to-day
operating expenses and satisfy short-term obligations as they
become due
Activity Ratios: how well the company is managing
its assets
Leverage Ratios: amount of debt used by the company
Profitability Ratios: measures how successful the company is at
creating profits
Common Stock Ratios: converts key financial information into
per-share basis to simplify
financial analysis
64
Common Stock Ratios

Price/Equity Ratio: shows how the stock market is pricing the
company’s common stock
 One of most widely used ratios in common stock selection
 Often used in stock valuation models
P/E 
Market price of common stock
EPS
Net profit after taxes  Preferred dividends
EPS 
Number of common shares outstanding


Higher ratio: more expensive
Lower ratio: less expensive
65
Common Stock Ratios (cont'd)

What is the P/E ratio for a company with profits of $139.7
million, 61,815,000 outstanding shares of common stock and a
current market price of $41.50 per share?
$139,700,000
EPS 
or $2.26
61,815,000 shares
$41.50
Price/Earnings ratio 
or 18.4
$2.26
66
Common Stock Ratios (cont'd)
 Price/Earnings Growth Ratio (PEG): compares
company’s P/E ratio to the rate of growth
in earnings
Stock’s P/E ratio
PEG ratio=
3- to 5-year growth rate in earnings
 Ratio > 1: stock may be fully valued
 PEG = 1: stock price in line with
earnings growth
 Ratio < 1: stock may be undervalued
67
Common Stock Ratios (cont'd)
 Payout Ratio: how much of its earnings a company
pays out to stockholders in the form
of dividends
 Traditional payout ratios have been 40% to 60%
 Recent trends have been lower payout ratios, with more tax
efficient stock buyback programs used frequently
 High payout ratios may be difficult to maintain and the stock
market does not like cuts in dividends
Dividends per share
Payout ratio 
Earnings per share
68
Common Stock Ratios (cont'd)
 Book Value per Share: difference between assets and
liabilities (equity) per share
Book value per share 
Common stockholders’ equity
Number of common shares outstanding
 A company should be worth more than its
book value.
69
Common Stock Ratios (cont'd)
 Price-to-Book Ratio: compares stock price to book
value to see how aggressively the stock is being priced
Market price of common stock
Price-to-book-value 
Book value per share
 Higher ratio: stock is fully-priced or overpriced
 Lower ratio: stock may be fairly priced
or underpriced
70