Investment Concepts PDF

Investments – Overview of Some basic concepts! The word “investment” is used in different contexts and in each context; it has a different meaning therefore, it is important to know what is meant by “investment” in this course. This course is about investment in securities market, or in other words,...

Investments – Overview of Some basic concepts! The word “investment” is used in different contexts and in each context; it has a different meaning therefore, it is important to know what is meant by “investment” in this course. This course is about investment in securities market, or in other words, investment in financial assets. This is not a course about investment in corporate assets such as NWC and FA; as typically these decisions are called investing decisions in corporate finance. This course is not about investment in an a country’s or province’s or city’s infrastructure such as roads, bridges, schools, hospitals, etc; as this is the meaning attached to the word investment by economists. This course is not about foreign direct investments as depicted by foreign entities building factories in this country. The course may have some relevance for foreign portfolio investment by foreigners who may be contemplating investing in securities markets in Pakistan. Both individual Investors as well as professional money managers in Pakistan working for institutional investors such as mutual funds, commercial banks, insurance companies, investment banks, pension funds, etc, are expected to benefit most from this course. THREE QUESTIONS FACED BY INVESTORS Any person or institution contemplating investments in securities markets must face three questions: 1. What to buy? 2. What combination to buy? 3. When to buy? Let us treat these questions in some detail in this lecturer; the rest of the course is also about the further details, derivations, and analytical skills needed to answer these 3 questions. Question One: What to Buy (or Sell): Common sense answer to the question “what to buy or what to sell” is: buy those securities that would make you wealthier. But more correctly the answer depends on your position in the market. If price of a share is likely to increase then take long position in a security that would give positive rate of return (ROR), and thus would increase your wealth. In other word buy those shares whose price is likely to increase in future so that when you sell it at higher price in future you become wealthier. On the other hand if price of a share is likely to decline then take short position in that 1 share, i.e., sell it now and buy it later when price has fallen. The short selling in such a share would give you positive rate of return and you would be wealthier. In any case you can become wealthier by taking appropriate long or short position depending if price is likely to increase or decrease in future respectively because as long as you earn positive ROR (percentage rate of return ) your wealth would increase. This can be written as: W1 = Wo (1 + ROR). Note: In the above expression , ROR (Rate of Return) is written in fraction. For example 10% ROR is written as 0.1; W0 is wealth now at time zero (at the beginning of a period) and W1 is wealth after one period. Wealth in this context means OE ( owners equity), that is your own funds, and does not include the borrowed funds used to make investment in securities. Selling is the flip side of buying; you are in the market as investor as long as you have bought some shares and have not sold them as yet. It is called having a long position in that security. And you would have this long position until you sell those shares though it may be after 10 years; so in that case you would have an open long position in that share for 10 years. On other hand if the shares you had bought earlier have now been sold then you have “closed your long position”, or simply you are out of the market. Also if you initiated your entry in the market by selling some shares first which you did not have but you had borrowed those shares from a broker to sell them, then it is called short selling , or simply you have short position in the market. You have an open short position as long as you do not close your short position by buying the same shares and returning them to the lending broker. It is necessary that short position is ultimately closed, closing of short position is called short covering, because the share you initially sold were not owned by you, in fact you had borrowed those shares from the broker and sold them in the market in the hope of making profit by buying these shares when share price would go down in future. So in short selling you borrow shares and sell them first and buy the same shares later when their price has fallen; and you have an open short position in the market until you buy the shorted shares and return them to the broker from whom you had borrowed them. On long position you earn positive ROR if price goes up in future, and on short position you earn positive rate of return if price goes down in future. 2 Example of Long Position For example you bought share of a company at Rs 100 and it is expected to give 5 rupees cash dividends and you estimate its price after one year would be 105 then your expected rate of return or expected Kc : Expected Kc =DPS1/P0 + (P1 - P0)/P0 Expected Kc = 5/100 + (105 - 100)/100 Expected Kc = 0.05 + 0.05 Expected Kc = 0.1 or 10% You expect to earn 10% ROR in one year so your wealth after one year is going to be: W1 = Wo (1 + ROR) W1 = 100 (1 + 0.1). Please note 10% ROR was written as 0.1 in decimal points. W1 = 110 Rs. In this case 10% positive ROR has increased your wealth from 100 to 110 Rs. Therefore you can take long position in this share. Similarly if current price is 100 and after one year expected price is 93, and expected cash dividends are zero then expected ROR = (Selling price – buying price)/ buying price = (93 - 100) / 100 = - 0.07 or - 7% As expected ROR from this share is negative 7% and if you took long position in it, then after one year your wealth would be: W1 = 100 ( 1 + - 0.07) W1 = 93 Rs. Therefore negative expected ROR would decrease your wealth from 100 to 93 Rs. It is advisable not to buy this share at 100 Rs, you should not take long position in this share. Example of Short Position It is possible to increase your wealth as investor by investing in a share whose price is likely to fall. It can be done by short selling such a share. In short selling you borrow the share and sell it in the market at current high price; and then hope its price would fall in future, and you would buy it at that low price and give it back to the person from whom you had borrowed it. So short selling, or taking short position, requires selling FIRST and buying LATER; while taking long position requires buying FIRST and selling LATER. 3 For example you borrowed a share from broker and sold it at 100 at its current price now and the waited for one year for its price to fall; and then bought it after one year at 93. Assuming no dividends were given by this share, your ROR on this short position would be: ROR = (Selling price - buying price ) / buying price ROR = (100 - 93) / 93 ROR = 0.075 = 7.5% And your wealth after 1 year from this short position would be: W1 = Wo(1 + ROR) = 93(1 + 0.075) = 100 Please note that if you had taken long position in this share you would have bought it at its current price 100, and sold it after one year at 93; then expected ROR from this share would have been negative 7% as shown below: ROR = (selling price - buying price ) / buying price ROR = (93 - 100) / 100 ROR = -0.07 = -7% This was example of a share whose price was expected to fall, but if you take short position in such shares now (sell it first by borrowing the share) you can still earn positive ROR of 7.5%. It happens , as shown above, by selling now at 100 now and buying later at 93. Therefore shares whose price is likely to fall should be short sold , that is, short position should be taken in such shares; and shares whose price is expected to rise, long position should be taken in such shares. In real life both types of shares, those whose price is expected rise and those whose price is expected to fall, are used by investors for investment purposes to increase their wealth. It is important to note that regulators from time to time impose restriction on short selling in a period when prices are falling; they do so to stabilize the market prices and to discourage speculative short selling which can further aggravate downward trend of prices and therefore cause panic in the stock market. How To Select Shares That Increase Your Wealth : 4 Broadly speaking this area of analysis is called security analysis. In other words, investors should do some kind of security analysis before deciding to invest. Two types security analyses are discussed below in some detail SECURITY ANALYSES To select securities or shares which are expected to increase your wealth, two types of analyses are done by security analysts: fundamental analysis and technical analysis. Security analysis is done to identify mispriced securities. Mispricing means that either a security is overvalued or undervalued at its current market price ( P0). It is assumed as common sense that price of overvalued stocks is likely to decline in future; whereas price of undervalued stocks is likely to increase in future. To earn positive ROR you should take short position in overvalued sharers, and long position in undervalued shares. In other words, buy those shares that are cheap and short sell those shares that are too expensive. Saying that a security is currently mispriced also implies that there is a fair or just or correct price of that security; and in future the price of a mispriced security would sooner or later tend to move toward its fair value. That means overvalued shares in future would experience a decline in their price and undervalued shares would experience an increase in their price. A finance theory called EMH (Efficient Market Hypothesis) says that as new information arrives, security prices adjust accordingly very quickly so that due to arrival of good information prices increase and due to arrival of bad information prices decrease very quickly; and therefore observed market price of any security on any day is very close to its fair price. This contention of EMH implies that attempt by investors to discover mispriced securities is fruitless because of market’s efficiency; and it means current prices reflect all the past and present , public and private, information; thus the current price of a share is very close to its fair price. Therefore if EMH is correct then any attempt to identify mispriced shares is just a waste of time. Further details of EMH identify three types of market efficiencies: 1) weak-form of efficiency; 2) semi-strong form of efficiency; 3) strong form of efficiency. Weak form of efficiency means all past information has been incorporated in the prices , therefore there is no use of analyzing past information to discover 5 whether a share is now overvalued or undervalued. It is so because share prices have already responded to past information and have already changed according to that past information, therefore you as analyst cannot discover anything new by analyzing past data of EPS, DPS, growth rate, NI, Sales, past patterns of price changes and volume of trading, etc of the companies about whose shares you want to make a judgment about their overvaluation or undervaluation. Since past patterns of prices are studies by Technical Analysts, therefore if weak form of efficiency is a correct theory then technical analysis of securities is a waste of time. Semi-strong form of market efficiency means all public information, both past and present, have been incorporated in the current share prices and share prices have adjusted accordingly; therefore you as analyst cannot discover something new by analyzing past and present publically available information about a company in an effort to judge its share is now overvalued or undervalued. Since fundamental analysis of securities is done by using publically available past and present information about a company, such as DPS, EPS, growth rate, etc; therefore if semi- strong form of efficiency is correct then fundamental analysis of securities is also a waste of time. Strong form of market efficiency means all public and private information has been incorporated already in the share prices and share prices have already adjusted according to that information; therefore you as analyst cannot discover something new by analyzing private and public information about a co to judge its share as overvalued or undervalued. This form of efficiency implies that current share prices reflect all that is knowable about that company, and any search of internal policy decisions (private information) won’t give advantage to make a judgment about overvaluation or undervaluation of a share. This claim has not been supported by the research; as insiders who have private information about future plans of a company have been found making abnormal profits by trading on the basis of such private information about a company. Trading on the basis of access to inside information is illegal in almost all the countries. For example if some directors (insiders) sell part or all of their holding of the shares in that company then they have to make this action public so that general investing public also knows that some director (top executives) do not consider this share worth holding and so general public may have opportunity to off load such share as well. In USA people have gone 6 to jail for trading on the basis of insider information, though proving such crime is not easy; and one can assume a certain amount of trading in a share is based on leaks from insiders to their friends and family members. And such trading can give unfair advantage to those investors who have gained access to insider information about a company’s future plans, or current problems, etc. Though EMH says that searching for mispriced shares by using past and present information, by using public and private information, is useless activity and by implications any type of security analysis is a waste of time and money, yet in real life analysts still do security analysis to discover mispriced securities. Security analysts operate on the belief that buying undervalued securities would give positive ROR as price of such shares is expected to increase in future ( and if market is informational efficient such increase in price should take place very soon); and analysts also believe that shorting the overvalued securities would give positive ROR as their price is expected to fall in future. Analysts expectation about direction of price movement in future is based on the comparison of current market price with the fair value (or just price) of that share. Analysts assume that the price of undervalued security would tend to go up in future toward its fair or just vale; and price of overvalued security would tend to fall toward its fair value. In short, security analysis is aimed at identifying the mispriced securities, because if a share is rightly priced there is no incentive for investors to invest in it; and practically trading in that share should not take place because buyers won’t buy it if they do not view it as undervalued; and sellers won’t sell it if they do not view it as overvalued at its current market price. A share must be viewed as mispriced at its current market price to be attractive for the investors. To be traded a share should be viewed by some investors as underpriced so that by taking long position (buying) now they would expect to earn positive ROR ; and at the same time this share must be viewed as overpriced by some investors so that selling it would seem good idea to them. Fundamental Analysis of Securities 7 This type of security analysis aims at estimating a fair value of shares; and then by comparing it with the current market price of the share you decide whether at its current price a share is overvalued or undervalued. You have covered basics of fundamental analysis of securities in previous courses such as Corporate Finance. Fundamental analysis uses fundamental financial data from income statement and balance sheet of a company such as TA, sales, NI , ROE, EPS, DPS, variance of past RORs, beta of stock. Also, data from macro- economic variables such as variance of ROR of stock market, GDP growth rate, interest rate and inflation rate in the economy, etc., to identify mispriced securities. The methodology of discovering mispricing requires first estimating a fair value (also called justified value, intrinsic value, or theoretically correct price) for the share using fundamental data and then comparing it with the prevailing market price of the share. If current market price is higher than the estimated fair value, then security is considered overvalued; and if current market price of that share is less than the estimated theoretically correct price then that share is viewed as undervalued. Then you, as security analyst, make recommendation for investment decision as: 1. Buy undervalued share, or, take long position in undervalued share 2. Short sell over valued share, or, take short position in undervalued share. Theoretically Correct Price or Fair Value of a Share 1. Gordon’s Model (DDM) Crux of fundamental analysis is the estimation of a fair value for share. There are multiple methods to estimate fair value of a share; these include Gordon’s constant growth dividend discount model (DDM), equity cash flows model, free cash flows model, accounting valuation model, PE ratio, etc. The following is some detail of Gordon’s DDM. You know that Expected ROR on share is symbolized in different texts books as Ks or Kc; and is composed of two components namely expected dividend yield and expected capital gains yield. Kc = expected dividends yield + expected capital gains yield Kc = (DPS1/Po) + (P1 – Po)/Po If a company does not change 5 corporate finance policies – net profit margin (NI/Sales), total asset turnover (Sales / TA), equity multiplier ( TA/OE), dividend payout ratio ( DPS/EPS), and number of share outstanding- and keeps these policies 8 at the same level as they were last year then percentage growth in OE due to increase in retained earnings is: g = ROE (1 d ) and this growth rate ultimately translates into same percentage growth rate in its TA, TL, Sales, NI, EPS, DPS, and share price. Keeping 5 policies unchanged means managing a company as well (or as badly) as it was managed last year. With these policy restrictions, expected share price after one year (P1 ) is estimated as: P1 = Po (1 + g). Expected cash dividend per share next year (DPS1 ) is estimated as: DPS1 = DPS0(1 + g). Let us pay little more attention to the growth rate formula: g = ROE (1 - d). Please note that in previous courses you were taught to analyze ROE in different manners, such as: ROE = ROIC + (ROIC – Ki) Debt / Equity ratio. Whereas ROIC is return on invested capital and it is equal to: ROIC = EBIT (1 - T) / total capital invested and total capital invested can be calculated from LHS of balance sheet as NWC + FA , or from RHS of balance sheet as LTL + OE. In ROE equation Ki refers to after tax percentage cost of debt capital used in company; and it is equal to Kd (1 - T), whereas Kd refers to before tax percentage cost of debt capital (or simply interest rate per year on the debt capital), and T refers to corporate income tax rate. Another method of analyzing ROE was the DuPont formula that decomposes ROE into 3 components: ROE = NI/S * S/ TA * TA/OE In the growth rate formula: g = ROE (1 - d), the Dividends Payout ratio (d) refers to percentage of NI that given by a company as cash dividends, and it is equal to total cash dividend / NI, or on a per share basis, it is equal to DPS/EPS. Some text books use a variant that is called retention ratio and is symbolized as ‘b’; please note b = (1 - d) ; if a company pays out , say, 20% of its NI as cash dividends then the rest 100% - 20% = 80% of NI is retained and reinvested in the business, so retention ratio is 80% or you can write it as: b=1–d b = 1 – 0.2 b = 0.8 Deriving The Gordon’s Valuation Model (DDM) of fair value: It is a model for estimating fair value of shares, you can view it as theoretically correct value of a share. It is based on the idea that a share is valuable today because investor expect 9 future cash flows from owning this share; and therefore present value of expected future cash flows from a share is its intrinsic value. The Gordon model can be derived from expected ROR formula shown above. This expected ROR formula is: Kc = (DPS1/Po) + (P1 – Po)/Po. It can be rearranged as a pricing formula which is known as Gordon Model or as DDM (dividend discount model) with constant growth assumption. This transformation of Kc formula into a share pricing formula is shown below. Kc = DPS1/Po + (P1 – Po)/Po (P1 – Po) /Po is percentage growth rate of share price “g” in one year that is called capital gains yield. As discussed above, if 5 policies are constant this growth rate in share price is equal to ROE ( 1 - d). For example a share is bought at 100 and sold after one year at 120, then (P1 – Po)/Po = (120 - 100) / 100 = 0.2 = 20%. So expected ROR from investment in a share, Kc, can be written as: Kc = ( DPS1/Po) + g Kc – g = DPS1 /Po Po (Kc – g) =DPS1 Po = DPS1 / (Kc – g) Fair Value now = DPS1 / (Kc – g) Note P0 now is referring to current fair value not the current market price because this model is estimating fair share value as present value of all future dividends; whereas its current market price is observed in the stock exchange. According to this valuation formula current fair value at time zero is estimated by discounting next year dividends (DPS1), or in other wording, fair value today is estimated by finding PV of future cash dividends whereas dividends are expected to grow at constant growth rate every year till infinity. If dividends are not expected to grow then ‘g’ is zero in above equation and valuation formula becomes: Fair value now = DPS1 / Kc In the above expression constant cash dividends per share are discounted at investors expected ROR, and it is PV of a perpetuity. Judging the Mispricing by Using DDM According to this fundamental security analysis, a share is mispriced if its current market price is different from its estimated theoretical price from Gordon formula. 10 It is important to clarify the prevailing confusion as to the expected cash flows from a share. It is sometimes said that future cash flows expected from a share are of 2 types: expected cash dividends and expected selling price. But one should understand that expected future selling price itself is based on discounted value of expected cash dividends in subsequent years. For example someone buying a share now at Po expects DPS1 as well as P1 as two cash flows, but P1 itself is based upon discounted value (PV) of expected DPS2 and P2, and similarly P2 is based upon discounted value of DPS3 and P3. Therefore ultimately it is only the expected cash dividends in future years that are relevant cash flows and their discounted value gives value to shares today. To clarify it you can see from the expressions for estimating fair value in any future year depends on the subsequent year’s expected dividends: Po = DPS1 / (Kc – g) P1 = DPS2 / (Kc – g) P2 = DPS3 / (Kc - g) And so on. The same can be written as: P0 = DPS1/ (1 + Kc)1 + DPS2 / (1 + Kc)2 + …..+ DPSn/(1 + Kc)n P1 = DPS2/ (1 + Kc)1 + DPS3 / (1 + Kc)2 + …..+ DPSn/(1 + Kc)n P2 = DPS3/ (1 + Kc)1 + DPS4 / (1 + Kc)2 + …..+ DPSn/(1 + Kc)n Exercise of finding fair value A share is currently priced at 120 rupees in the stock market and last year its ROE was 24%, its dividend payout ratio was 25%, and it paid 5 rupees cash dividends per share. It is expected to give rate of return (Kc) 23.9%. You expect its dividend payout ratio to remain unchanged next year and also the other 4 policies are expected to 11 remain unchanged , namely profit margin, asset turnover, financial leverage, and number of shares outstanding. Please find: expected growth rate, expected DPS next year, expected price by next year, expected dividend yield, expected capital gains yield, expected rate of return, and its fair value today. Expected growth rate is: g = ROE (1 - d) g = 24% (1 - 0.25) g = 18% Expected dividends next year DPS1 = DPS0 (1 + g) = 5(1 + 0.18) = 5.9 rupees Expected price next year P1 = P0(1 + g) = 120 (1 + 0.18) = 141 rupees Expected dividend yield = DPS1/P0 = 5.9 /120 = 4.91% Expected capital gains yield = (P1 – P0)/P0 = (141 – 120) / 120 = 17.5% Expected rate of return = 4.91 + 17.5 = 22.4% Fair value = DPS1 / (Kc – g) Fair value = 5.9/ (0.239 - 0.18) = 5.9 / 0.059 = 100 rupees Decision Rule Its current market price in the market is 120, and you have estimated its fair value as 100 rupees; therefore as a fundamental analyst, you would conclude that it is overvalued at 120. You would further conclude that its price in the market should fall by 20 rupees to 100. And you would recommend to sell it and won’t advise to buy it at 120. Please remember it that in real life analysts do not agree on the same growth rate and therefore end up estimating different fair values. Let us assume three analysts agree about expected rate of return 23.9% but are estimating three different expected growth rates for this company; 10%; 20% ; and 22% ; and current market price of the share is 120 rupees. Then each of them would end up estimating a different fair value for this share as shown below. Fair value at 10% growth rate: DPS1 = DPS0 (1 + g)= 5(1 + 0.1) = 5.5 Fair value = DPS1 / (Kc – g) =5.5/ (0.239 - 0.10) = 39.5 rupees Decision: as market value 120 rupees is more than fair value 39.5 rupees therefore this share is overvalued at its current market price. You should recommend :”do not 12 buy it”, or if you have it already, then it should be sold at 120 because overvalued assets are sold when these are overvalued. If you do not have it, then you can short sell it at 120 and buy it later on when its price fells to your expected fair value of 39.5 rupees. Fair value at 20% growth rate DPS1 = DPS0(1 + g) = 5(1 + 0.2) = 6 Fair value = DPS1 / (Kc – g) =6/ (0.239 - 0.2) = 153.8 rupees Decision: as its market price 120 rupees is less than your estimated fair value of 153.8, therefore at its current price it is undervalued and you would recommend to buy it. Fair value at 22% growth rate DPS1 = DPS0(1 + g) = 5(1 + 0.22) = 6.1 rupees Fair value = DPS1 / (Kc – g) = 6.1/ (0.239 - 0.22) = 321.05 rupees Decision: Its current market price 120 rupees is less than your estimate of its fair value 321.05 rupees therefore it is undervalued at its current market price, and you would recommend to buy it. Herein lies the reason for daily trading in the shares; buyers believe a share is undervalued at its current market price and buy it assuming they are buying it cheap; while the sellers believe the opposite, that it is overvalued at its current market price and decide to sell it at its current price. The above example showed that for trading to take place, buyers and sellers must have opposite belief about the current market price of a share. The above example also showed as expected growth rate increased from 10% to 20% top 22% then fair value estimate also increased from 39 to 153 to 321 rupees. It means that fast growing companies are likely to have higher fair value; and if market is efficient then also higher share price in the market. Or in other words , growth prospects create value for shares. Companies expected to grow faster enjoy higher share price. 2. Use of Risk Adjusted Required Rate of Return vs Expected Rate of Return To Identify Mispriced Shares Another methodology used by fundamental analysts to identify mispriced stocks to make buy or sell decision is based on comparing the expected rate of return of a 13 share with its theoretically correct rate of return, that is also termed as Risk Adjusted Required Rate of Return, and is usually estimated using CAPM model. For example beta of a stock is 0.8, Rf is 10%, expected Rm is 20%, Expected price next year (P1) is 118, current price (P0) is 100, and it is expected to give during next year cash dividends (DPS1) of Rs 5.9 then according to CAPM, Risk Adjusted Required rate of return for this share is: Required Kc = Rf + (Rm - Rf) beta Required Kc = 10 + (20 - 10)0.8 Required Kc = 10 + (10 * 0.8) Required Kc = 10 + 18 Required Kc = 28% And according to expected ROR formula its expected ROR is Expected Kc = (P1 - P0)/P0 + DPS1 / P0 Expected Kc = (118 - 100) / 100 + 5.9 / 100 Expected Kc = 0.18 + 0.059 Expected Kc = 0.239 or 23.9 % Now comparing the required Kc with expected Kc you can say the share is mispriced in the market at its current price because the two rates of return are not equal. A P0 at which both RORs are equal is the fair value of this share. Since expected Kc is affected by P0, therefore lower expected Kc in this case means current P0 is too high, that is overvaluation. Decision rule: If expected Kc is less than required Kc, it is overvalued at its current market price and your recommendation would be “sell it”. On the other hand if expected Kc of a share is higher than its required Kc, it is undervalued at its current price , do not buy it or short sell it. But what is the fair value of this share? You can solve for fair value by equating required Kc with expected Kc and solving for P0. Because at the fair its risk adjusted required rate of return and expected rate of return would be same. Let us do it. Required Kc = Expected Kc Required Kc = (P1 - P0) / P0 + DPS1/P0 14 Required Kc = (118 – P0) / P0 + 5.9/P0 0.28 = (118 - P0 + 5.9) / P0 0.28P0 = 123.9 –P0 0.28P0 + P0 = 123.9 1.28P0 = 123.9 P0 = 123.9 / 1.28 P0 = 96.79 So, you have estimated its fair value as 96.79 rupees whereas its market price is 100 rupees, therefore you would conclude that it is overvalued at 100 rupees, and you would not buy it at 100 current price. You would wait for its market price to fall by almost 3.2 rupees before buying it. 3. Use of PE Ratio to Identify Mispriced Shares Fundamental analysts use price to earnings ratio (PE ratio) frequently to identify mispriced shares. This section shows there are 3 types of PE ratios: Trailing Actual PE, Leading Actual PE, and Leading Intrinsic PE Ratios. It further shows that Leading Intrinsic PE ratio can be bifurcated into 2 components: 1) Tangible PE and 2) Franchise PE. Then you would learn the use of PE ratio in identifying mispriced shares; and such identification would allow you to make a buy or not to buy decision. PE ratio (price of share / earnings per share) is also called earning multiplier, and it is commonly used to identify undervalued shares for buying or overvalued shares for short selling. It is therefore important to understand the PE ratio more thoroughly. Generally it is believed that relatively high PE ratio for a stock indicates high growth prospectus for that company, and low PE ratio indicates low growth prospects. Generally, but not always, growth in fundamental financial variables such as TA, Sales, NI, EPS, DPS in companies is expected to translate into growth in share price, that is , wealth creation for shareholders. But on the other hand high PE ratio may indicate overvalued stock and low PE ratio may indicate undervalued stock. Then the question arises if high PE ratio means expected high growth of share price and also over valuation at the current price then how come overvalued share is expected to grow in price because common sense tells us that overvalued shares should experience a fall in their price not a rise in their price. Therefore, this possible conflicting signal sent by PE ratio must be kept in mind while interpreting 15 PE ratio. Bifurcation of Leading Intrinsic PE ratio helps clarify this apparent conflict in interpreting the PE ratio, as you shall see in the following paragraphs. This conflict in interpretation of PE ratio is resolved by having clarity that Trailing Actual PE ratio is based upon actual or last year’s EPS ( EPS0 ) and current share price (P0). So, Trailing Actual PE ratio = P0 / EPS0. Analytically it is not very useful. Leading Actual PE ratio is estimated by using next year estimated EPS, that is EPS1. EPS1 is calculated by applying a growth rate on actual last year’s EPS; and Leading Actual PE Ratio = P0 / EPS1. While Leading Intrinsic PE ratio = d / (Kc – g); and it s calculated from fair value estimates of share price using Gordon model. Leading Intrinsic PE can be different from Leading Actual PE ratio. If leading actual PE ratio is smaller than the leading intrinsic PE ratio, then market price of share is less than the fair value of that share; and therefore the share is undervalued at its current market price. Since undervalued assets are the ones you like to buy, therefore, analysts make a BUY recommendation for such a share. On the other hand if leading actual PE ratio is greater than leading intrinsic PE ratio then its actual current market price is higher than its fair value; the share is overvalued at its current price, and analysts make a SELL recommendation for such shares. Exercise Three PE ratios: Trailing Actual PE ratio Leading Actual PE Ratio Leading Intrinsic PE ratio For Example Last year’s EPS of a Co was Rs 5, and currently its share price (P0 ) in the market is 100 Rs, and it is expected to have a growth rate 5% calculated as ROE (1 - d). Based on CAPM its Kc (risk adjusted required by investors) is 13%. It has paid 25% of its profits as cash dividends and that policy is likely to continue next year. So dividend payout ratio (d) is 25%. You can calculate 3 PE ratios: 1. Trailing Actual PE ratio is P0 / EPS0 = 100 / 5 = 20 times. 2. Leading Actual PE ratio is P0 / EPS1 Since EPS1= EPS0 (1 + g) = 5 (1+ 0.05) = 5.25 rupees, therefore Leading actual PE ratio = P0 / EPS1 16  = 100 / 5.25 = 19.04 3. Leading Intrinsic PE Ratio (Also called Justified PE ratio) Again given below is Gordon valuation formula for fair value of shares, it is also called intrinsic value of share: Po = DPS1 / (Kc – g) Dividing both sides of equation by expected earnings per share for next year , that is expected EPS1, symbolized here as E1, you get: Po / E1 = {DPS1 / (Kc – g)} / E1 Which can be written as : Po / E1 = {(DPS1 / E1)/ (Kc – g)}. But DPS1 / E1 is dividend payout ratio symbolized as ‘d1’ but as dividend payout ratio is assumed to remain unchanged therefore d1 for the next year is equal to the d0 of the last year and simply ,d, can be written. so Po / E1 = d / (Kc – g) Using the data from example above Po / E1 = 0.25 / (0.13 – 0.05) = 3.125 Note PE ratio of 3.125 times says if EPS next year is 1 Rupee then Share price now is 3.125 rupees, or, current share price is 3.125 times of expected EPS, or share is trading on a multiple of 3.125 of expected earnings of that company, or share’s earning multiple is 3.125. Decision rule to decide mispricing of a share is: if leading actual PE ratio > leading intrinsic PE ratio, share is overvalued. if leading actual PE < leading intrinsic PE, share is undervalued In this company leading actual PE ratio 19.04, and it is greater than its leading intrinsic PE of 3.125. So actual price is more than the fair value; and you decide that this share is overvalued in the market at its current price. Therefore it should not be bought, or it should be short sold. Decomposition of Leading Intrinsic PE ratio This formula: Po / E1 = {(DPS1 / E1)/ (Kc – g)} Says that leading Intrinsic PE ratio = dividend payout ratio / difference between required rate of return and growth rate ; and it is called leading Intrinsic PE ratio 17 because it is derived by using Gordon formula for intrinsic or fair value of a share. Leading Intrinsic PE ratio can be further broken down for analytical clarity. Such decomposition of the Leading Intrinsic PE ratio gives us insight about the reasons which are helping or hurting the leading Intrinsic PE ratio and thereby helping or hurting the fair value of a share. The Leading Intrinsic PE = Tangible PE + Franchise PE Leading Intrinsic PE ratio is sum of two components: 1) Tangible PE ratio : Tangible PE ratio refers to a situation where a company does not reinvest any of its profits in the business; gives out all its NI as cash dividends, and no increase in retained earnings (RE) takes place; and therefore no growth occurs in that company’s assets, production, sales, and profits due to reinvestment of profits. The resulting PE is based on perpetual use of existing assets which are non-growing because of no reinvestment of profits in the business. Therefore the resulting profits from the productive use of such non growing asset base are also non-growing year after year; and therefore are a perpetuity. It means same expected EPS each future year till infinity. If dividend payout rate is 1, then 100% of earning is given out as cash dividends and no portion of NI is reinvested in the business. Therefore there is no growth in co’s assets financed from internally generated equity funds, though such a co can still finance growth in its assets by raising external equity funds through issuance of more shares and/or by raising more debt capital from bond market or banks. It is important to understand the idea of growth rate in OE when 5 corporate policies are constant year after year. These 5 policies are: net profit margin, total assets turnover, financial leverage, dividends payout ratio, and number of shares outstanding. You know that NI or as it is called on Pakistan , PAT (profit after taxes), for a year can go to 2 places only: NI = Cash Dividends + increase in RE Or NI – cash dividends = increase in RE You know that: Percentage growth rate in OE = increase in OE/ beginning OE 18 But OE can grow either : 1) by issuing new shares 2) by increase in retained earnings If 5 corporate finance policies are kept constant then issuing shares is not a possibility as that is one of the 5 constant policies as stated above. Therefore only way OE of a company can grow is by increase in RE. Therefore: Percentage growth rate in OE = increase in OE/ beginning OE becomes Percentage growth rate in OE = increase in RE/ beginning OE As shown above: increase in RE = NI – cash dividends , therefore Percentage growth rate in OE = (NI – cash dividends) / beginning OE But cash dividends can be written as : Cash dividends = NI * d. (d = percentage of NI given as cash dividends, it is dividends payout ratio, and is equal to cash dividends / NI or on a per share basis DPS/EPS)) So Percentage growth rate in OE = (NI – NI*d) / beginning OE Percentage growth rate in OE =NI (1 – d) / beginning OE And this can be written as: Percentage growth rate in OE = NI/beg OE (1 – d) NI/ beg OE is ROE , so Percentage growth rate in OE = ROE(1 – d) Now, if a company gives all its NI as cash dividends and does not increase its RE, then its ‘d’ is 100% or 1. And growth rate in its OE, g, is: g = ROE (1 - d) = ROE ( 1 - 1) = ROE (0) = 0. In this case its intrinsic leading PE ratio is : Po / E1 = {(DPS1 / E1)/ (Kc – g)} Po / E1 = d / (Kc – g) =1 / (Kc – 0) =1 / Kc Let us see how this result is attained. Since DPS = EPS *d, and if all NI is given out as dividends then d = 1, therefore: DPS1 = EPS1 *d DPS1 = EPS1 *1 therefore Gordon valuation model becomes: Po = DPS1 / (Kc – g) 19 Po = EPS 1 / (Kc – 0) Po = EPS 1 / Kc Which means EPS is a perpetuity that is being discounted at discount rate Kc and PV of this perpetuity is the fair value of the share. It further means that leading Intrinsic PE ratio is derived by shifting EPS1 on the LHS of equation : Po / EPS1 = 1 / Kc And such PE ratio is called tangible PE because it is expected to be the PE if assets of co are not growing due to non retention of earnings. Therefore expected stream of EPS is constant or non growing in all future years due to a non growing asset base, and DPS is same as EPS. 2) Franchise PE: It has 2 components, namely Franchise Factor (FF) and Growth Factor (G). Franchise PE = Franchise Factor * Growth Factor Franchise PE = { 1 / Kc - 1 / ROE} * {g / (Kc – g)} Positive Franchise factor is experienced by a co if it is earning higher ROE than expected ROR of share holders (Kc) from those projects that were financed by retention of earnings. The growth factor is PV (present value) of constant growth rate (g) attained from reinvesting some NI into business and not giving out all of NI as dividends. Derivation of Leading Intrinsic PE Formula From Gordon’s DDM Formula As you know from corporate finance course that growth rate of a company’s OE can translate into growth rate of its Sales, TA, TL, NI, EPS, DPS, and ultimately growth rate of share price if 5 policies are same next year as they were last year. You also know that this growth rate can be quantified as: g = ROE * (1 – d). Thus Gordon formula for fair value of share : Po = DPS1 / (Kc – g) can be written as : Po = DPS1 / [Kc – ROE * (1- d)] And intrinsic leading PE ratio becomes: Po / E1 = (DPS1/E1) / [Kc – ROE (1 – d)] Po / E1 = d / [Kc – ROE (1 – d)] Now multiply RHS with Kc / Kc Po / E1 = ( Kc / Kc) [d / {Kc – ROE (1 – d)}] Po / E1 = (1/ Kc) * [(Kc*d) / {Kc – ROE (1 – d)}] Since (1 - d) is called retention ratio , let us show it with symbol ‘b’, and thus 20 d = (1 – b), now inserting this value, you get Po / E1 = (1/ Kc) [(Kc*(1 – b)) / {Kc – ROE * b}] Po / E1 = (1/ Kc) [(Kc – Kc*b) / {Kc – ROE* b}] Adding and subtracting ROE * b in numerator of RHS will give: Po / E1 = (1/ Kc) [(Kc – Kc*b + ROE*b – ROE*b) / {Kc – ROE* b}] and placing ROE* b closer to Kc gives: Po / E1 = (1/ Kc) [(Kc – ROE *b + ROE*b - Kc*b ) / {Kc – ROE* b}] Bringing divisor {Kc – ROE* b}] under both the terms of RHS Po / E1 = (1/ Kc) [{(Kc – ROE *b) /( Kc – ROE* b)} + { (ROE*b - Kc*b) / (Kc – ROE* b )}] Po / E1 = (1/ Kc) [1 + { (ROE*b - Kc*b) / (Kc – ROE* b )}] Taking ‘b’ as common Po / E1 = (1/ Kc) [1 + { b (ROE - Kc) / (Kc – ROE* b )}] Multiplying and dividing the term in large bracket after 1 with ROE we get Po / E1 = (1/ Kc) [1 + { ROE * b (ROE - Kc) /(ROE * (Kc – ROE* b ))}] Since ROE * (1 – d) = g, but (1 - d) = b, so you can write ROE * b = g. Now inserting this g in place of ROE*b you get Po / E1 = (1/ Kc) [1 + { g (ROE - Kc) /(ROE * (Kc – g)}] When 1 / Kc is brought inside the bracket, it multiplies with both 1 and with the term right of 1, and you get Po / E1 = [1/Kc + 1 /Kc { g (ROE - Kc) /(ROE * (Kc – g)}] Po / E1 = [1/Kc + { g (ROE - Kc) /(Kc* ROE * (Kc – g)}] Further simplification gives Po / E1 = [1/Kc + { (ROE - Kc) /(Kc* ROE)} * {g/ (Kc – g)}] Bringing denominator (Kc* ROE) under both terms of the numerator , that is under ROE as well as under Kc gives Po / E1 = [1/Kc + { (ROE / Kc*ROE) - (Kc /( Kc*ROE)} * {g/ (Kc – g)}] Po / E1 = 1/Kc + [( 1 / Kc - 1 / ROE) * {g / (Kc – g)}] In the above derivation Leading Intrinsic PE ratio is sum of Tangible PE ratio and Franchise PE ratio. tangible PE = 1/Kc it is due to 100% dividend payout and consequently zero growth. franchise factor = { 1 / Kc - 1 / ROE} growth factor = {g / (Kc – g)} Franchise PE= ( 1 / Kc - 1 / ROE} * {g / (Kc – g)} The product of Franchise Factor and Growth Factor is called Franchise PE ratio 21 { 1 / Kc - 1 / ROE} is Franchise Factor, it is positive if ROE earned by the co on its reinvested profits is greater than rate of return required by shareholders, Kc; that means retained earnings are invested in such projects by management that earn ROE greater than the cost of equity capital, Kc, which is also the expected ROR of shareholders. Positive franchise factor is an indication of competitive advantage of this company over its competitors in the products market. {g / (Kc – g) is growth factor, and it is positive only if cost of equity capital is greater than growth rate, and also if growth rate is itself positive which is the case only when co does not pay all its NI as dividends and reinvests some of its NI in the business. Franchise PE ratio = Franchise factor * Growth factor Tangible PE = 1 / Kc 3) Leading Intrinsic PE ratio = Tangible PE ratio + Franchise PE ratio As derived above, this bifurcation of Leading intrinsic PE into tangible PE (PE without growth) and Franchise PE (additional PE due to reinvesting profits in the business thus having growth in business) allows insight into a company’s future growth prospects and also likely impact of that growth on the fair value of its share. It is interesting to note that based on the above analytical break-up of leading intrinsic PE ratio, it is possible to identify that future growth is likely to be value creating in one company while value destroying in another company. Some companies would be far more valuable if they give all their income as cash dividends and do no reinvesting of their profits into business because these companies do not have profitable investment opportunities in terms of new products and markets, and are likely to end up having a negative franchise PE if they opted for growth. Such negative franchise PE is experienced by virtue of earning on investments in new ventures ROE that is lower than Kc required by their shareholders of that company. Therefore it is possible that growth factor is positive , thus indicating presence of growth opportunities in the product markets; but franchise factor is negative due to lack of competitive advantage in the products’ market. In such a company the result would be a negative Franchise PE, that would partially neutralize the tangible PE; and ultimately a lower Leading intrinsic PE and Lower fair value of the share would be the fate of such a company. Such a situation is termed “value destroying growth”. 22 Therefore, a comparison of Leading Intrinsic PE ratio with the Leading Actual PE ratio allows you to make a decision about overvaluation or undervaluation of a share. For Example For a Co, ROE 15%, dividend payout ratio (d) is 70%, NI expected for next year 100 million rupees, market value of its equity is 600 million rupees. Shareholders require 20% risk adjusted ROR from share of this Co , that is, its required Kc. Please Find: growth rate ‘g’; tangible PE, franchise factor, growth factor, franchise PE, and Leading intrinsic PE, Leading Actual PE ratio, and give your verdict about over or under valuation of this share? Answers: g = ROE ( 1 - d) = 15% (1 - 0.7) = 4.5% Tangible PE ratio = 1 / Kc = 1 / 0.2 = 5 Franchise factor = 1/Kc – 1/ROE = 1/0.2 – 1/.15 = 5 – 6.67 = -1.67 Growth factor = g / (kc – g) = 0.045 / (0.2 – 0.045) = 0.045 /.155 = 0.29 Franchise PE ratio = franchise factor * growth factor = -1.67 * 0.29 = -0.48 Leading Intrinsic PE ratio = Tangible PE ratio + Franchise PE ratio =5 + -0.48 = 4.52 Double check by applying directly leading Intrinsic PE formula derived from Gordon model: Po / EPS1 = d / (Kc – g) = 0.7 / (0.2 - 0.045) = 0.7 / 0.155 = 4.52 So we get the same answer, but the former method of bifurcating into tangible PE and franchise PE provides additional insight. In this case growth factor (0.29) is very small; and franchise factor depicting the ability to earn ROE higher than Kc is negative ( - 1.67) implying poor competitive advantage of this company in the products market over its competitors. The overall contribution of franchise PE is negative towards intrinsic leading PE. Leading Actual PE ratio = P0 / EPS1 23 but since per share data is not given therefore you can use total amounts of expected NI of next year instead of EPS and total MV of equity instead of MV per share , that is P0. Leading Actual PE ratio = MV of equity / NI1 = 600 / 100 = 6 Decision Rule: Since for this share leading actual PE > leading Intrinsic PE 6 > 4.52 Therefore the share of this co is overvalued at its current price in the market and you should not invest in it; rather wait for fall in its price because overvalued assets are expected to experience decline in their market price: once that happens then it would be ok to buy it. Another possibility is to attempt to make profit by short selling this share in the hope of price fall in future. Please note that in this company ROE was less than Kc, so franchise factor , which is an evidence of competitive advantage of this co over its competitors, is negative in this company. Though this co has positive growth prospects, but due to its inability to earn ROE greater than Kc on reinvested earnings, the growth is going to be value destroying instead of value creating; and as a result of that its leading intrinsic PE would be less than its tangible PE. Or in other words, its PE without growth is more than its PE with growth. That means growth has negative impact on the fair value of its shares. On the other hand if a company has profitable investment opportunities in new projects where it earns ROE greater than Kc, then its PE with growth is more than their PE without growth. Such companies have positive franchise factor and therefore their franchise PE is positive resulting in their leading intrinsic PE being higher than their tangible PE. The lesson is so important that as an analyst you can not afford to ignore its ramifications. To be explicit, the lesson is: that it is not growth per se, but profitable growth, that creates value ; otherwise growth can turn into a value destroying phenomenon instead of being a value creating phenomenon. Summary of Fundamental Analysis 24 Preceding paragraphs discussed three techniques of fundamental security analysis that are used by the fundamental analysts to find mispriced shares. These techniques were: 1) Gordon model for fair value, also called DDM with constant growth assumption 2) comparison of risk adjusted required ROR with expected ROR 3) comparing actual leading PE ratio with intrinsic leading PE ratio. There are other methods of estimating fair value of a share while doing fundamental security analysis , such as, 4) fair value of share estimated using free cash flows model 5) fair value estimate using equity cash flows model 6) fair value estimate using accounting valuation model. All these methods require forecasting next few years income statements and balance sheets, and also require an estimate of Kc. You were exposed to these models in your Corporate Finance course. Moreover 7) if PB ratio is less than one then share is considered undervalued. PB ratio is also called MV to BV ratio and is calculated as P0/BV per share; whereas BV per share is OE / number of shares outstanding. To identify severely undervalued shares you can 8) compare P0 with NWC per share 9) P0 with Cash per share. If NWC per share or cash per share is more than current price of the share then the share is severely undervalued share. You can also 10) calculate organizational value per share as: Organizational value per share = P0 – break-up value per share If organizational value per share comes out negative then company is so undervalued in the market that it is worth more dead than alive. Break-up value per share is calculated by assuming that companies assets are liquidated (sold) in piece meal manner (one by one) and TL are paid from cash thus generated. The left over cash is break-up value of equity; dividing that by number of shares outstanding gives break-up value per share. For example break- up value per share for a company is 35 rupees and in the market its share is trading at 20 rupees, then its organizational value is -15 rupees. Therefore an investor can buy all its shares at 20 rupees per share, then after having gained total control of the company can liquidate its assets one by one, and from that amount pay its TL and still end up with 35 rupees per share cash. That means after recovering 20 25  rupees per share original investment, you would make a profit of 15 rupees per share. Therefore it is sensible to acquire such company, then kill it by liquidating its assets, and thereby make a quick profit of 15 rupees per share. Such companies have negative organizational value because as going concern the company had a value of 20 rupees per share but after breaking it up by liquidating its assets it gives 35 rupees per share cash. So breaking up this co would make shareholders wealthier than letting it continue to survive as a going concern. These are commonly used methods of identifying mispriced stocks while using fundamental analysis approach. This brief overview of fundamental analysis of shares was meant to refresh your memory, as you already know most of this material from other courses. Technical Analysis of Securities The focus of technical analysts is not on finding undervalued or overvalued shares, nor is the focus on expected ROR, rather it is focused on estimating the timing of change in the direction of share price trend. In a sense this method attempt to estimate direction of future price movement. Here it should be emphasized that expected ROR is also based on future expected price,P1 , therefore attempts to estimate future expected price of the stock next year is also required by fundamental analysts, but the difference lies in the methodology used by technical analysts and fundamental analysts. Technical analysts insist on using only that data that is generated in the stock market due to trading in a share, i.e. price of share and volume of its trading. They mostly use daily price data and graph it on a graph paper; sometime they also place daily volume of trading in that share also on the same graph. Similar exercise is also done with the index of stock prices as well to say something about the overall stock market. There is no fixed rule that a graph should be prepared using data of how many past days: 30, 60, 120, 360, or what ? This approach ignores fundamental financial data of the company such as sales, total assets, net income, EPS, DPS, growth rate, beta of share, etc. This approach also ignores fundamental economic data such as growth rate of GNP, inflation rate, interest rate, etc. 26 Technical analysts try to read past pattern of a share price over time; and claim to discover from these past price patterns future direction of price movement. Specifically, they claim to know when an upward trend in price would change into a down ward trend and vice a versa. The important word here is WHEN, which implies this type of security analysis is focused on discovering the timing of change in the direction of a share price or the change in direction prices of all the shares traded on stock exchange, that is change in the direction of the whole stock market index. Technical analysts are not interested in quantum of price change , and there for they are not interested estimating a future price and nor in estimating expected ROR. This approach has an underlying assumption that past is a good predictor of future, and past price trends are likely to repeat themselves in future. Past behavior of prices is a good indicator of their future behavior. For example, if in the past when ever price was lower than the 200 – day moving average price , and then on a certain day the price of share pierced the 200-day moving average price line from below then it is an indication that now a long term upward trend in the price of that share has set in; and in future days price would continue to move upward. But there is no rule that tells us for haw many days the expected upward trend would continue in the share price, nor is there a rule that can guide us about the amount of increase in price. Therefore, a lot of energy is spent on discovering the patterns of share price in the past periods; and then those patterns are taken as a guide for future price patterns. Practitioner of technical analysis claim to have the ability to time the exit (sell) and entry (buy) in the market correctly; that is, they claim to know when price would increase and therefore they can buy before increase in price, and also know when price would fall and thus can sell before price falls. If an investor can always buy shares before increase in price and sell share before decline in price, then she stands to make a very high ROR. It is interesting to note that mostly financial press reports about the performance of stock market using the jargon of technical analysis. The following paragraphs do not give exhaustive treatment to technical analysis; but the idea is to give you a taste of this method of security analysis: 1. Dow Theory identifies 3 types of trend in share prices. A) Primary Trend: It lasts for a long period such as a few years, and index of prices keeps either, a long 27  term, upward or down ward trend. B) Intermediate Trend: Within primary trend of prices, interruptions in the opposite direction that may last for a few weeks or months. C ) Daily Trend: Random movement of prices up or down around primary and secondary trend. 2. Bulls Market: When successive price ups (Peaks) are above the previous price peaks, and successive price low (troughs) are at higher price than the previous price low, then it is called bulls market. This behavior shows long term upward trend in the price of that share, or if you are considering the index then upward trend in whole stock market 3. Bears Market: When successive increases in price fails to cross the previous peak, and successive falls in price are lower than the previous trough (fall) in the price, then it is called bears market. This depicts a long term down ward trend in price. 4. Reversal: When in an upward (bullish) trend, the next peak in price is lower than the previous peak, and the next fall in prices is below the previous trough, then it is called reversal of the long term upward trend to the long term downward trend. If in the next upward price move, the peak is again below the previous peak, and trough is lower than the previous trough then it is taken as confirmation of change in long term trend from upward to downward in the price of that share or that index. 5. Confirmation: to confirm that upward market trend has changed to the downward trend in KSE-100 Index, the confirmation is found by looking at the similar price movement in another index, for example KSE-30 index, or SBP all share index. And if these indices also show similar price behavior then you say the reversal in price trend has been confirmed. 6. Correction and Consolidation: If an increase in price is partially off-set by subsequent decline in price, then such a decline is called correction. A period of no significant price change after the correction is called consolidation. 7. psychological price ceiling or Resistance Level: is that price above which price hesitates to go after repeatedly touching that level from below. It is assumed that at such a high price supply of share from investors in the form of sell orders is so big that price fails to go above that level. 8. psychological price floor or Support Level: is that price level below which price is hesitating to fall after repeatedly falling to that level. It is assumed that at such a low price the demand of shares becomes so high among investors that the 28  price does not fall below that level. To see that at certain level there is support present one should see that not once, but many times, price falls very close to that level but does not go below that level. 9. over-bought market depicting unjustified high prices, so it is time to sell 10. oversold market depicting unjustified low prices, so it is time to buy 11. profit taking by virtue of investors selling their already held shares a general decline in prices on that particular day was observed 12. short covering causing an increase in prices as short sellers are buying those shares that they had short sold in the past, and therefore on that specific day prices went up 13. market sentiments being bullish because generally share prices are increasing day after day; vice-a-versa is called bearish sentiments 14. advances to decline : A-D. It is a number calculated by subtracting the number of companies whose share has declined in price from the number of companies whose share has experienced an increase in price. For example, on a day shares of 180 companies saw increase in price and 160 companies experienced decline in price, then A – D = 180 -160 = 20. Daily this number daily is placed on the graph paper and the trend of the line is studied in comparison with the line of KSE-100 index. If both A-D line and index line are showing upward trend then technical analysts conclude that the market is technically strong, and if both lines have negative slope then market is technically weak. If index line is falling but A – D line is rising then this divergence in trend is taken as a signal of change in index (the market) trend from down to upward. If index line is upward but A-D line is falling then it indicates Weakening of the market implying that in future index would fall. A-D line is also an indicator of the breadth of the market. 15. Breadth of the market: higher A-D indicates higher breadth of market. Fifty weeks high and low price indicates breadth of the market, if large number of shares hit their 52 weeks high on a day then it is concluded that market was bullish on that day. If in an upward sloping index period a large number of shares hit their 52 week low price on a day then it is taken as a Sign of Trouble for the market index in future; and market is described as in troubled waters. 16. Volume of Trading: If volume of trading is high, it is considered that market is bullish; and if with high trading volume the prices are also increasing then market is considered very bullish on that day. For the technical analysts, it is a golden 29  rule to assume that high volume accompanies rising price, and low volume of trading accompanies falling price. 17. Short interest ratio: number of shares shorted on a day/average daily trading volume per month ratio. If the ratio is increasing, it is sign for the bearish sentiments about that share. Short interest ratio is compared every day with the historical range of this ratio, which is between 3 to 6 in New York. If on a given day, the ratio is above 6 then it is considered high and indicated pessimistic sentiments prevailing about that share on that day. 18. Contrary Opinion: When liquidity of mutual funds is low then it means they are fully invested in the market; and it happens close the peak of market prices of shares. Such view implies that now it is likely that prices have attained their peak and only direction they can take in future is downwards, therefore it is time to get out of the market, that is, time to sell. 19. Moving Average Line: Average price of a last few days, such as last 7 days, or last 30 days, or last 200 days is placed daily on the graph paper, the resulting line is moving average line. BUY SIGNAL: On a day when price of a share crosses the moving average line from below on high trading volume, then it is a buy signal for that share. SELL SIGNAL: on a day when share price falls below its moving average price on high trading volume, then it is a sell signal for that share. OTHER SELL SIGNALS: on a day when price of a share is below its moving average price line, and during the day price rises to come close to its moving average price but does not succeed to go higher than the moving average by crossing the line and turns downward , then it is sell signal generated on that day about that share. If moving average line has been rising and then flattens and then decline and the share price line crosses it from above then it is sell signal on that day for that share. If moving average price line is falling and the share price line crosses it from below then it is a sell signal for that share. 20. Abortive recovery: In an upward trend, if price falls and then increases but fails to surpass the previous peak price; and the next fall goes below the previous trough in price, then it indicates change in the primary price trend from upward to downward. If the subsequent price rally (peak) again fail to reach the previous peak and subsequent price fall again penetrates below the previous trough (low) then change of primary price trend from upward to downward is confirmed, and bear market has set in for that share. 30 21. momentum is said to be present in a share or in the market because after a rise in one period, in the next period again a rise is experienced in its price. But is not clear increase in which period length should be compared, that is, month to month, week to week, or what. 22. depth of market by virtue of no single investor being able to nudge the price in one or the other direction because of the huge size of any asset and huge quantum of funds needed to nudge the price of any asset in the desired direction 23. market being directionless because of no visible trend in prices 24. relative strength of a share because of faster increase in price of a share compared to index. Three types of relative strengths can be calculated: P MCB / KSE-100 index ratio: daily this ratio is calculated and placed on the graph, if the graph makes an upward sloping line then you conclude that MCB share has relative strength compared to the whole market. P MCB / Index of banking sector. Daily this ratio is calculated and placed on the graph. If the graph is upward then MCB is showing relative strength in the banking industry, meaning MCB share price is increasing faster than the index of the prices of banks’ shares. Index of banking industry / KSE-100 index: this ratio is calculated daily and placed on the graph, if the line is showing upward slope then banking industry stocks as a whole have relative strength compared to the overall stock market, meaning the prices of the shares of banks are rising faster than prices of all the shares in the market. Similarly if line of relative strength ratio is down ward sloping then it indicates relative weakness in the price of that share or in the shares of that industry. As a rule of thumb, if a share’s relative strength has been increasing for the last 4 month, then it is taken as a buy signal for that stock. Relative strength is also used to identify promising sectors of economy for the investment. For example if relative strength of textile is increasing (the graph is upward sloping) and of cement is deteriorating (graph is downward sloping) then investors should divest from cement and invest in textile shares. Be careful about interpreting the relative strength because it is possible that relative strength of a share is increasing over time simply because its share price is falling slower than fall in market index There is a lack of unanimity among those who use technical analysis about even their very basic calculations. For example what moving average of prices should be used: 7-days moving average, 30-days moving average, or 200-days moving average while 31 making the moving average graph. Therefore, usually business school professors do not teach this method of analysis. Final Word About Security Analyses The purpose of both types of security analyses is to identify those stocks that are promising to increase investors wealth. That is identifying undervalued shares so that long position can be taken in those shares; and identifying overvalued shares so that short position can be taken in those shares. Regardless of your preference for the use of fundament analysis or technical analysis as the guiding methodology for identifying good buys, your focus on expected ROR is only half the story. The remaining half of the story is Risk which must also be considered. Regrettably technical analysts use no measures of risk while fundamental analysts do try to incorporate relevant risk of share in the form of beta of that share while doing their analysis. Risk is uncertainty about expected ROR. Therefore decision to buy a specific share must be guided both by the consideration of its expected returns as well as its risk. In this course you shall learn in detail about the relationship of risk and return of securities, and how these are quantified and then used in decision making about buying shares. Question Two: What Combination to Buy Common sense answer is not to buy a single security. You know that risking everything on one endeavor is too risky; similarly putting all your money in one stock is too risky. If you put all your eggs in one basket and then basket of eggs is damaged due to an unexpected shock, then you stand to lose all your eggs; similarly if you invest in shares of one company only and then that Co faces bad times then you stand to lose big. Therefore it is advisable to buy a combination of securities, such combination of different shares or securities is called portfolio of securities. More importantly just any combination of securities won’t do; Modern Portfolio Theory (MPT) has proven that you should preferably buy an efficient combination of securities, or in other words you should try to build an efficient portfolio. The following questions are relevant in this regard. What is meant by an efficient portfolio? How to build an efficient portfolio of securities? Which securities are included in it, and which are not? And those included, what proportion of your own money (OE) is invested in each of those securities, it is called weight of a security in your portfolio and is denoted with symbol ‘x’ ? In an efficient portfolio which 32 securities have positive weight ( that is you have long position in those securities, i.e. you buy those), and which securities have negative weight (short position , short sell those)? What is Expected ROR of a portfolio and what is its total risk ? Can total risk of portfolio be divided into components such as diversifiable risk and non diversifiable risk? For an investor, which risk is relevant while making investment decision? It is hoped that this course would help you answer these questions in detail and with mathematical precision. Such precision is the result of theoretical developments in the Modern Portfolio Theory (MTP) during 1950s and 1960s due to contribution of Markowitz, Sharpe, Lintner, and Mossin. The application of MPT in real life took off during 1970s due to the availability of computing power to the investors. A new set of industries based on the application of MPT emerged such as mutual funds industry, pension funds industry, hedge funds industry. In short the whole area of professional money management really became an industry after the wide spread availability of computers made it possible even for small investors to do the calculation required by MPT. Question Three: When to Buy or Sell This is a question about correctly timing your “entry in” and the “exit from” the market. Common sense answer is: buy a stock when its price is low and sell it when its price is high. But in real life how can one know that today’s price is the lowest, and it won’t go down further and therefore today is the best time to buy. Or today’s price is the highest and therefore today is the correct time to sell; and tomorrow or in future price won’t go up further. Is it not possible that price may go down further tomorrow? And if that happens then you would regret that you should have waited one more day so you could have bought even cheaper that particular stock? This dilemma leads to an interesting question: can anyone correctly time the market exit and entry? This question also can be posed as: If anyone has the ability to beat the market consistently? Beating the market means being able to always buy a stock before its price goes up; and always selling it before its price falls; thus resulting ROR would be higher than ROR on overall market portfolio comprising of all the stocks. Numerous research studies have shown that no portfolio manager has shown such ability consistently. Showing this ability once or twice is not the issue; ability to always buy at the lowest price and sell at the highest price in any given time period 33 is the issue. It means correctly timing your entry and exit from the market. No investor has shown such ability: be they individual investors, or professional money managers (portfolio managers) working for financial institutions which have huge research and computational resources at their disposal. Those who do Technical Analysis claim to be able to correctly judge if price is now too high and therefore it is time to sell (Over Bought Market); or price is now too low and therefore it is time to buy (Over Sold Market). But empirical testing of their proposed trading strategies (called technical trading systems) have shown conclusively that no system of trading based on technical rules was found capable of generating correct buy and sell signals for their users on a consistent basis. Though some research studies have found support for the “momentum based trading strategies” where a winner stock in past period seems to be a winner in the next period, and a looser in past period was found to be a likely looser in the next period as well. But even in this case a universal agreement about acceptable length of period for such comparison is non- existent because one analyst can use a one week period and the other analyst can use a one month or one year period, or a one day period to classify winners and losers. Generally the issue of timing is more relevant for the short term traders who frequently buy and sell almost on daily basis. Presently, due to ease in order execution as a result of information technology revolution, even frequent intra-day trading is becoming easier and popular. There is strong support in research literature for the “Buy and Hold” strategy over a reasonably long period of time. Such long term investors are more likely to be better- off in terms of increase in their wealth than the short term traders. It must be clearly understood that the nature of corporate shares is such that these are securities with no maturity , that is, theoretically their maturity is infinitely long period of time. Therefore holding period envisioned by investors should be a very long period. But unfortunately even the professional money managers working for mutual funds, pension funds, treasury departments of banks, etc, are evaluated on quarterly basis. This short term performance evaluation culture results in a bias in favor of showing good results every quarter; and therefore leads to excessive attention to market timing. All this results in more frequent trading than is warranted by common sense. 34 Probably the only beneficiary are brokerage-houses, because by virtue of frequent trading activity by investors brokerage houses stand to earn commission fee for executing the order of the investor on the exchange floor. Please understand that an investor pays commission to the broker both ways, i.e., when a share is bought as well as when a share is sold. Therefore brokers as a community has an inherent interest in seeing that investors do frequent trading, and do not opt for the “Buy and Hold Strategy”. Therefore if time horizon for investing in shares is very long then the question “when to buy” has a common sense answer: today. Because it does not matter much that you wait a few more days in the hope of buying at lower price if your investment horizon (expected holding period) is next 20 years. Similarly, after holding a share for 15 years ,if a long term investor has decided to liquidate her holding due to certain personal circumstances, then it is not a matter of great importance to wait for a few more days before selling her shares in the hope of getting higher selling price: “today” also is the right answer for her. Just looking at the value of major stock indices such as KSE-100 index (Pakistan) or Dow Jones 30 index (USA)or S&P 500 index (USA) over the last 50 years gives very strong evidence in favor of “buy and hold” strategy while doing investment in corporate shares. Compound annual growth rate of all these indices has been in double digits for more than the last half a century; and no other security or investment instrument has give such high rate of return over such a long period of time. Therefore commonly held belief that investing in corporate shares can make you very wealthy is correct; but for that to happen investor should have the patience of holding her investment for a long period: you should buy shares not for yourself but for your grand children. Now this approach to investing in shares is not stated in such stark terms by text book authors, nor is it promoted by professional investment advisers, probably for good reasons of self interest as their bread and butter is linked with investors indulging in frequent buying and selling of shares. Remember as soon as you get into a mindset of becoming rich overnight; and chose shares as the vehicle to attain that goal you are in the arena of gambling and out of arena of professional investing. Then the only relevant question is why select share market to satisfy your urge to gamble? There are available better, easier, and cheaper modes of doing gamble or playing games of chance than the share market. 35  What This Course Aims to Teach This course is aimed at learning the answers to the first two questions: 1) What to buy, and 2) what combination to buy; because these are answerable questions. The third question ( when to buy?) is a question about the market timing and that is not answerable; therefore this course won’t pretend to teach the answer to the third question. RATE OF RETURNS In this course the word rate of return (ROR) would be used frequently. It is important to be very clear about various types of rate of returns on shares Actual ROR , Historic ROR, Realized ROR, Ex-post facto ROR These are all various terms used for the past ROR that has actually been earned , usually during the last one year. On shares of companies, actual percentage rate of return (ROR) for one period (usually one year) investment is: Actual ROR = Realized capital gains yield + Realized dividend yield realized capital gains yield is: (selling price - buying price ) / buying price; and realized dividend yield is: cash dividend per share received / buying price. This actual ROR needs no theory, it is a historical fact, and it is actually available for past periods for all the shares, so there is no argument about it. Example: Realized ROR For example if you bought on January 1 a share of MCB at 200 and received during the year DPS of Rs 5, and sold the share after one year on December 31 for Rs 250. Then your actual, or realized, historic, or ex-post facto ROR is: Realized Capital Gains Yield = (250 - 200) / 200 = 25% Realized Dividend Yield = 5 / 200 = 2.5% Realized ROR = 25% + 2.5% = 27.5% per year. Since all of this has HAPPENED, it is a fact, there is no ambiguity about it, and this information is available to all investors, therefore actual or realized RORs are not the issue. And more importantly these RORs are no guarantee, or even a good reliable guide, for future ROR from the same share for the next period or next year. Having said that, it must be acknowledged that the tendency to project the past into future and making expectation about future ROR of a stock based upon its past RORs is wide spread. Probably it is a reflection of human inclination, as depicted in many other spheres of life, to believe that the patterns of past would continue to survive 36 in future. It is likely that abhorrence to change and a fear of unknown is the basis of such thought patterns. In any case there is no reason to believe that a share which has given 60% ROR last year would give close to 60% ROR next year as well; rather it has happened many times that a share giving very high ROR in one year, went bankrupt the next year. Expected ROR , Future ROR, Ex-ante ROR Investors making investment decision today are interested in expected ROR , or ex- ante ROR, which they hope to earn after completion of a holding period, usually one year. There are theories about expected ROR, and since it is a future oriented number therefore it has to be estimated by investors before making the investment decision. And there can be a disagreement among the analysts about the expected ROR from a share. Usually such estimation is done for one period which is usually next one year. The skill of security analyst lies in correctly estimating expected ROR for the next year, and this skill of a security analyst is judged by the accuracy of her estimated expected ROR when it is compared after one year with the actually realized ROR from that particular stock. Formula for expected ROR is very similar to formula for actual ROR: Expected ROR = expected Kc = Expected dividend yield + expected capital gains yield Expected dividend yield = Expected dividend per share next year / current price Expected dividend yield = DPS 1 / P0 Expected capital gains yield = (expected price next year – current price )/ current price Expected capital gains yield = (P1 - P0) / P0 Note that estimating the ROR for next year requires estimating 2 items: a) P 1 , that is price of the share after one year. b) DPS1, that is expected cash dividend per share that stock is likely to give to the stockholders during next year. Since both these items are estimated for the next year therefore expected ROR is as good as these estimates are. Expected ROR = ( DPS 1 / Po ) + (P 1 - Po)/ Po In this expression Po refers to current price of share which is available and needs no estimation. Please note that estimating DPS for next year requires estimating EPS for the next year, which in turn requires estimating NI for the next year, which ultimately requires 37 estimating income statement for the next year. As Income statement for the next year cannot be estimated without an estimate of an asset base, therefore it inevitably requires estimation of balance sheet for the next year as well. These forecasting exercises you have done in your previous courses such as Corporate Finance. Estimating P1 (expected price after one year) is more tricky. If you decide to apply a growth rate on current price then it gives P1 = Po (1 + g); in this formulation the dispute is about the right methodology for estimating growth rate of share price. Mostly analysts do not seem to agree one on growth rate for a company and their individual growth rate forecasts tend to vary greatly. Remember under assumption of 5 major policies remaining unchanged next year, this growth rate can be ROE (1 - d). But this condition of no-change in 5 policies is rather restrictive and therefore unrealistic in most cases because keeping the management performance un-changed in 5 major areas of performance is a tall order. To be specific, for ROE (1 - d) to be the growth rate in share price, performance in the following 5 areas should be same as last year’s performance , i.e., no change in 1) net profit margin ,NI/S, meaning ability to extract profit from sales revenues is constant; if last year it was 3% of sale , next year it should also be 3% of sales. 2) total assets turnover, S/TA, meaning productivity of assets in generating sales should be constant, if last year 1 rupee of asset was helping generate 2 rupees of sales then next year it should remain the same. 3) financial leverage, TA/OE, it means capital structure, and therefore financial risk, remains unchanged; if last year it was 5, then next year it should be 5 as well. 4) dividend payout ratio (d) , DPS / EPS, percentage of NI given out as cash dividend is constant; if last year a co gave 30% of its NI as cash dividend then next year also it should give 30% of NI as cash dividend. 5) number of shares outstanding remains unchanged; meaning no new share offering as bonus shares or stock dividends, no new share offering as right offering to existing shareholders to raise equity funds for co, no new share floatation as a seasoned offering to general public to raise equity funds; it also means no share repurchase next year by the co so that number of shares outstanding remain the same next year as they were last year. Please note keeping these 5 policies constant also means ROE next year would be same as last year because ROE = NI/S * S/TA * TA / OE. As these 3 ratios are assumed constant than by implication ROE is assumed constant year after year. 38 For example, last year the 3 component ratios of ROE were: NI/S = 3%; S/TA = 2 times; TA/OE = 5 times. Then last year’s ROE was: ROE = 3% * 2 * 5 = 30% Since 3 component of ROE would be same next year under policy constancy assumption therefore ROE next year would also be 30% as it was last year. But you must be clear about the fact that EPS won’t be same next year as it was last year because EPS = NI/S * S/TA * TA / OE * OE / # shares as S , TA , and OE cancel out, and you are left with: NI /# shares, and this is EPS. Since OE/# shares is BV per share, therefore you can write: EPS = ROE * OE/# shares EPS = ROE * BV per share and since BV of OE in balance sheet would increase next year due to profits or OE would decrease due to losses, therefore BV per share would be different next year as compared to the previous year. Also DPS next year won’t be the same as DPS last year because DPS = EPS * d. Though ‘d’, dividend payout ratio, is constant, but as EPS next year would be different than last year’s EPS , therefore DPS next year would come out different than the DPS of the previous year. With these 5 policies constancy restrictions in place, you can estimate: g = ROE (1 - d) P1 = Po (1 + g) DPS 1 = DPS o (1 + g), Example: Expected ROR For example current price of a company’s shares is Rs 50, Its ROE last year was 10% and its dividend payout ratio (d ) was 50%, and it had paid Rs 2 DPS last year. Then you would conclude that: growth rate of its OE is= ROE (1 - d) = 10% (1 - 0.5) = 5%. It has paid Rs 2 DPS in the most recent year, i.e. DPS o , therefore you would estimate its next year DPs as : DPS1 = DPSo (1 + g) = 2(1 + 0.05) = 2.1 Rs. And estimate for its next year’s share price is:P1 = Po (1 + g) = 50 (1 + 0.05) = 52. 5 Rs And based on these estimates you would estimate expected ROR for the next year : Kc = (DPS 1 / Po ) + (P1 – Po ) / Po Kc = ( 2.1 / 50) + (52.5 - 50) / 50 Kc = 0.042 + 0.05 39 Kc = 0.092 or 9.2% per year This is your estimate for the expected ROR from this share for the next year if you bought it at today’s price of Rs 50. Please note very carefully that this expected ROR may not be realized actually by the end of one year and therefore it has risk. One approach used to estimate P1 is estimating next year’s EPS and multiplying it with current PE ratio of the Company. Another approach of estimating P1 is to estimate next year’s BV per share (OE / number of shares) and multiplying it with current MV to BV ratio of the Company. If you want to use growth rate and do not want to make restrictive assumption of the constancy of 5 policies, and want to use such growth rate to estimate P1 , one approach to estimating growth rate is to use GNP growth rate as proxy for the growth rate of share price, such GNP growth rate estimates are easily available for any country. It is important to note that there is no single correct answer or a single approach available to estimate the requisite inputs for estimating expected ROR of a share for the next year. Therefore different analysts estimate different expected ROR for a share; and mostly this difference in opinion is due to estimating different growth rate for that company based on their own analysis of the prospects of that company. Actual (and also expected) ROR per year for multi-period holding period For example, you bought on January 1 , 2005 a share of MCB at 100, and in 2005 it gave you cash dividends of Rs 4, in 2006 cash dividends of Rs 6, in 2007 cash dividends of RS 3, in 2008 cash dividends of Rs 8, in 2009 cash dividends of Rs 7. At the end of 2009 you sold the share on December 31 for Rs 250. What was your realized annual ROR from this investment ? First put the Cash flows on time line: Time 0 - 100 Time 1 4 Time 2 6 Time 3 3 Time 4 8 Time 5 7 + 250 = 257, assuming dividends are given by the co at the end of each year. 40 Use CASH mode of FC -100 and enter in data editor all these cash flows , and solve IRR. You get 23.93% per year. Note: underlying assumption in this solution, like all IRR calculations, is that interim cash flows were reinvested at IRR; it means DPS of 4, 3, 6, and 8 were reinvested to earn 23.93% per year; and it must be stated that such assumptions , at best, are unrealistic in real life. One can apply this methodology for a future holding period of next 5 years as well if DPS for each of the next 5 years is estimated and an estimate of P5 (price after 5 years) is also made. But making such precise forecasts for extended periods in future is not realistic and practically not useable in real life. In practice the whole exercise boils down to an attempt to estimate DPS1 and P1 and based on these numbers estimating an expected Kc for the next year. Generic ROR on Various Investments For one year investment, ROR on any instrument has 2 component, namely, an income yield and a capital gains yield. Income yield is due to cash paid by that instrument (security or asset) to the investor. For shares this cash payment is called cash dividends, for bonds it is called interest payment, on commercial or residential rental property it is called rent income; but for investment in paintings, or plots of land, or jewelry there is no cash income. The second component of ROR , namely, capital gains yield is due to the increase in price of that investment since you bought it, it may be a capital loss also if price has declined since you bought that investment. In case of investment in plots of land, jewelry, antique furniture, and paintings all the ROR is from capital gains yield as there is no income yield from these assets. But in case of investments in share, bonds, and residential or commercial rental property cash income in the form of dividends, interest, or rent gives rise to an income yield. In case of investment foreign currencies, if you kept it in a bank deposit account you may earn interest as well (your interest yield) along with increase in value of foreign currency against local currency ( your capital gains yield in local currency). The following are examples of Realized ROR on different assets. For example realized ROR on one year’s investment in shares is: (selling price – purchase price) / purchase price + cash dividends received / purchase price. ROR on one year’s investment in bonds is: (Selling price – purchase price) / purchase price + interest received / purchase price ROR on one year’s investment in residential or commercial rental property is: (Selling price – purchase price) / purchase price + rental income / purchase price ROR on one year’s investment in a plot of land is: 41 (Selling price - purchase price) / purchase price ROR on one year’s investment in Paintings: (Selling price - purchase price) / purchase price ROR on one year’s investment in jewelry is: (Selling price - purchase price) / purchase price Note: Selling price does not mean you have to actually sell the asset, it means if you had sold it at the end of the year then at this price you would have sold it because it was the prevailing price at the end of the year. But ROR is still there and can be calculated even though you decided not to sell your investment. Expected ROR on the above stated assets is also calculated in the same manner by changing selling price with expected next year’s price P1); and dividends received or interest received, or rental income received is changed with the expected dividends, expected interest income, and expected rental income. Purchase price is changed with current price (P0). 42