Equity Analysis: Key Concepts

Exam Details

• Topics 7, 8, and 9 will be tested.
• Material includes duration and convertible bonds.
• Knowledge of basic vs. diluted EPS is expected.
• Equity valuation ratios, such as P/E and P/S, are key.
• Calculating option payoffs and distinguishing between European and American options from Chapter 6 are required.
• Memorize formulas from various topics, beyond those on the formula sheet.

Industry Life Cycle (Chapter 2)

• Stage I (Pioneer/Early development): Characterized by modest sales growth and profit growth, with negative profits until breakeven. Profit margins are initially negative until breakeven, and there are unproven products/services.
• Stage II (Growth/Rapid expansion): Sales growth rate accelerates, profit growth is high once breakeven is achieved. Profit margins are positive and increase as volume exceeds the critical level, and there is product/service acceptance.
• Stage III (Mature): Sales growth rate is high but slowing. Earnings growth slows, profit margins decline, and industry growth is tied to general economic growth. Higher growth requires increased market share or acquisition.
• Stage IV (Decline): Sales growth rate is negative, earnings start to fall negatively, and profit margins are negative as losses increase. Shifting tastes/technologies lead to demand decline, and participants either consolidate, reinvent, or fail.

Business Cycle Reaction

• Growth industries have above-normal sales and profits occurring independently of the business cycle (e.g., computer software, pharmaceuticals).
• Defensive industries show stable performance during economic ups and downs (e.g., food & beverage, utilities).
• Cyclical industries' profitability tracks the business cycle (e.g., autos, heavy equipment).

Porter's Five Competitive Forces

• The strength of these five factors determines an industry's long-term average profitability
• These five forces' collective effect affects prices, costs, and required investments
• Intense competition results in unattractive returns for firms.
• Limitations exist, such as basing analysis on historical data that may not be accurate in fast-changing industries. Porter's 5 Forces may not consider factors like ESG or globalization. It may be impractical to analyze diverse companies with one model.

Generic Competitive Strategies

• A firm's competitive strategy determines its relative position in the industry.
• There are three competitive strategies:
• Cost leadership: being the low-cost producer.
• Differentiation: being different from others.
• Focus (cost or differentiation focus): exploiting a niche/advantage.

Earning Per Share (EPS)

• Basic EPS is calculated as (Net Income - Preferred dividends) / No. of ordinary shares outstanding.
• EPS indicates the earnings "owned’" by each ordinary shareholder.
• Preferred stock dividends are deducted if declared or cumulative as they are “owned” by shareholders
• Investors consider two EPS figures: basic and diluted.

Basic EPS

• Basic EPS is the total earnings per share based on the number of ordinary shares outstanding.
• Basic EPS is also known as “trailing EPS” since it is based on the firm's past reported earnings. Analysts and investors will also forecast a company's future earnings based on their EPS.

Diluted EPS

• Diluted EPS examines all the potentially dilutive securities a company has issued, like convertible preferred stock, bonds, and employee stock options. Despite their non-conversion at year-end, calculations show these shares' potential EPS impacts.
• The diluted EPS presentation is a "what-if" scenario, which might never occur.
• Diluted EPS indicates the potential dilution magnitude in the future.
• Basic EPS only accounts for common shares while Diluted EPS includes convertible securities, employee stock options, and secondary offerings.

Relative Valuation

• Summary of Stock Valuation Method Using Relative Valuation

Price/Earnings Ratio (P/E Ratio)

• Indicates what the market is willing to pay for each dollar of a company's earnings. Formula: Market price per share / Earnings per share
• Alternatively, it can be expressed as Dividend Payout Ratio / (Required rate of return - growth rate)
• Advantages: It is widely recognized and used, and is easy to calculate and understand.
• Disadvantages: It is affected by accounting standards that can vary and by the company's accounting policies, and cannot be used with no or negative earnings.

Price/Cashflow Ratio

• Indicates what the market is willing to pay for the cash flow generated by the company.
• Formula: Market price per share / Cash flow per share
• Advantages: Less subject to manipulation than earnings, and avoids the issue of differences in earnings quality between companies, cash flows are typically more stable than EPS.
• Disadvantages: It cannot be used if there are no cash flows or cash flows are negative. When estimates are used, items like working capital are ignored. More volatile flow measurements of FCFE (free cash flow to equity) should be used.

Price/Book Ratio (P/B Ratio)

• It is used to evaluate whether a company's stock is over or undervalued.
• Formula: Market price per share / Book value per share; Book value is the company’s equity in the balance sheet.
• Advantages: Book value is more stable than EPS & is generally positive (except for unsolvent companies). Appropriate for valuing companies with mainly liquid assets, & not those expected to continually operate.
• Disadvantages: Book value may not represent earning power or future growth potential. It is reported in historical costs. It can be affected by accounting standards with asset depreciation decisions, less applicable for servicing firms without significant fixed assets.

Price/Sales Ratio

• Indicates how much the market is willing to pay for a firm's sales revenues.
• Formula: Market price per share / Sales or revenue per share
• Advantages: Useful for young and high-growth potential companies or those in cyclical industries. Still meaningful for distressed companies. Sales figures contain less manipulation & the ratio is not easily influenced by PE. Drives earnings and cashflow.
• Disadvantages: The ratio can vary between industries. Not used for comparing different cost structures. Contains no knowledge about the debt of the company and is can generate positive sales without positive profits/cash flows.

Enterprise Ratio (EV/EBITDA)

• Used to compare the entire value of a business to its annual EBITDA
• Formula: Enterprise Value / EBITDA. EV can be estimated based on (Market cap + Total debt + Preferred stock ) - Cash & Investment
• Advantages: It offers a more holistic company picture unaffected by capital structure, tax and accounting estimates. Harder to manipulate, and might be useful with the company is loss making and has positive EBITDA
• Disadvantages: It is inappropriate for comparing industries due to differing expenditure requirements. It also ignores businesses/ business risk and operating leverage because of its ignorance towards many of the Real Costs of Doing Business