Security Analysis MIDTERM LECTURE PDF

MACROECONOMIC AND INDUSTRY ANALYSIS - Global Economy - Domestic Economy - Fiscal, Monetary and Supply - Side Policies - Business Cycle - Industry Analysis - Industry Life Cycle - Industry Structure and Performance Global Economy: The system of industry and trade around the world that has developed...

MACROECONOMIC AND INDUSTRY ANALYSIS - Global Economy - Domestic Economy - Fiscal, Monetary and Supply - Side Policies - Business Cycle - Industry Analysis - Industry Life Cycle - Industry Structure and Performance Global Economy: The system of industry and trade around the world that has developed as the result of globalization. Refers to the interconnected economic activities and systems of all the countries in the world. It encompasses the production, consumption, and trade of goods and services across international borders. Refers to the economic system, which remains interconnected given the growing relationship between countries across the world. It emphasizes how countries, businesses, and individuals interact across borders and the economic relationships that develop as a result. It also checks how these interactions affect global economic growth, development, and stability. Deals with all the economic activities that are conducted within or between multiple nations. Challenges the global economy faces include: economic inequality, environmental threats, technological shifts, adverse effects of globalization, and political instability due to wealth gaps, resource use Indicators of global economy include: GDP, unemployment rate, inflation rate, trade balance, and current account balance, which measure various elements like production, unemployment, inflation, trade balance, financial transactions, Gross Domestic Product (GDP): reflects the total value of the goods & services produced annually in a country. It is the most prominent measure of economic activity. Hence, it is a key indicator of a country's economic health. Unemployment Rate: This represents the proportion of unemployed individuals looking for jobs in a country. Inflation Rate: It gauges inflation levels, typically using the Consumer Price Index (CPI). Trade Balance: It measures a country's imports and exports, highlighting surplus or deficit based on their volumes. Current Account Balance: It is part of the balance of payments of a country and records trade transactions and capital transfers. It shows the inflow and outflow of funds. Importance of global economy 1  The global economy offers several prospects despite the difficulties. Certain opportunities available to countries worldwide are listed below: Economies of Scale: It gives access to expanded markets and enables efficient and cost-effective production. Increased Investment: It boosts economies as global connectivity attracts investment. Capital Flows: It drives economic growth as access to diverse capital sources. Technological Advancements: It fosters innovation and progress as globalization provides access to technology. Affordable Imports: Global trade enables goods and services to reach every corner of the world easily and affordably. Expanded Export Markets: It creates opportunities for export-driven growth as markets broaden. Specialization Benefits: It leads to cost-effective outcomes and lower prices due to production specialization. Development Opportunities: It nurtures sustainability along with progress, helping developing nations advance economically due to greater incoming investments from multinational companies. Domestic Economy: Domestic economic policies are strategies and actions taken by a government to manage and influence its country’s economy. Types of domestic economic policies: 1. Fiscal Policy: This involves government spending and taxation. By adjusting these, the government can influence economic activity. For example, increasing public spending can stimulate growth, while raising taxes can help control inflation1. 2. Monetary Policy: Managed by a country’s central bank, this policy controls the money supply and interest rates. Lowering interest rates can encourage borrowing and investment, while raising them can help control inflation 1. 3. Regulatory Policy: These are rules and regulations that govern business practices. Effective regulation can ensure fair competition, protect consumers, and promote economic stability2. 4. Trade Policy: This includes tariffs, trade agreements, and import/export regulations. Trade policies can protect domestic industries and promote exports2. 5. Labor Policy: Policies related to employment, wages, and working conditions. These can influence the labor market and overall economic productivity2. 6. Industrial Policy: Strategies to promote specific industries or sectors within the economy. This can include subsidies, tax incentives, and support for research and development 7. Supply Side Policy (SSP) refers to measures governments take to increase the availability or affordability of goods and services, along with generous tax reform, which refers to tax cuts and changes in tax laws that may encourage or discourage productive behavior. Examples of supply side policies: include reducing taxes on businesses and individuals, reducing regulation and bureaucracy, investing in education and 2  training, promoting free trade, and encouraging research and development. Business Cycle: The business cycle, also known as the economic cycle, consists of four main stages: 1. Expansion: This phase is characterized by increasing economic activity. Indicators such as GDP, employment, and income rise. Businesses invest more, consumer spending increases, and overall economic confidence is high 1. 2. Peak: The peak is the point at which the economy reaches its maximum output. Economic indicators are at their highest, but growth starts to slow down. This stage marks the transition from expansion to contraction1. 3. Contraction: During this phase, economic activity begins to decline. GDP decreases, unemployment rises, and consumer spending falls. If the contraction is severe and prolonged, it can lead to a recession 1. 4. Trough: The trough is the lowest point of the business cycle, where economic activity bottoms out. This stage is followed by a recovery as the economy begins to expand again Industry Analysis: Industry analysis is a crucial tool for businesses and investors to understand the competitive dynamics, opportunities, and threats within a specific industry. Here are some key methods and components of industry analysis: Key Methods 1. Porter’s Five Forces: This model, developed by Michael Porter, analyzes five key forces that determine the competitive intensity and attractiveness of an industry: o Competitive Rivalry: The intensity of competition among existing firms. o Threat of New Entrants: The ease with which new competitors can enter the market. o Bargaining Power of Suppliers: The power suppliers have over the price and quality of materials. o Bargaining Power of Buyers: The influence customers have on pricing and quality. o Threat of Substitutes: The likelihood of customers finding a different way of doing what you do1. 2. PEST Analysis: This framework examines the external macro-environmental factors affecting an industry: o Political: Government policies, regulations, and legal issues. o Economic: Economic growth, exchange rates, inflation rates, and economic cycles. o Social: Cultural trends, demographics, and consumer behaviors. o Technological: Technological advancements and innovations2. 3. SWOT Analysis: This method evaluates the internal and external factors affecting a business: o Strengths: Internal attributes that are helpful to achieving the objective. o Weaknesses: Internal attributes that are harmful to achieving the objective. o Opportunities: External factors the company can exploit to its advantage. o Threats: External factors that could cause trouble for the business 3. 3 Key Components 1. Market Size and Growth: Assessing the overall size of the market and its growth potential. 2. Competitive Landscape: Identifying key competitors and their market share, strengths, and weaknesses. 3. Customer Behavior and Preferences: Understanding consumer needs, preferences, and purchasing patterns. 4. Regulatory and Legal Environment: Evaluating the impact of regulations and legal requirements. 5. Technological Trends: Keeping up with technological advancements that could impact the industry. 6. Economic Factors: Considering economic conditions that influence the industry’s performance. 7. Social and Cultural Trends: Examining societal shifts that affect demand and preferences. 8. Environmental and Sustainability Factors: Addressing environmental concerns and sustainability issues Industry Life Cycle: The industry life cycle can be broken down into five main stages: 1. Introduction: This is the launch phase where a new industry or product is introduced. Companies invest heavily in research and development, and there is significant uncertainty about market acceptance1. 2. Growth: During this phase, the industry experiences rapid market acceptance and increasing profits. Companies focus on scaling up production and distribution2. 3. Shakeout: This stage is characterized by intense competition. Some companies grow rapidly, while others may be forced out of the market. The industry starts to consolidate3. 4. Maturity: Growth slows as the market becomes saturated. Companies focus on efficiency and differentiation to maintain their market share 1. 5. Decline: The industry faces a decrease in demand, leading to reduced sales and profits. Companies may exit the market or innovate to stay relevant. 4 THE AGGREGATE STOCK MARKET Fundamental Analysis is a methodology of stock valuation, which evaluates a stock based on its intrinsic value of security by analyzing various macroeconomic and microeconomic factors. With fundamental analysis, financial statements [income statements, balance sheets, cash flow and other publicly available documents] are used to analyze the financial health of a economy. Fundamental analysis also known as process used to determine whether the stock is overvalued, undervalued, or fair valued. When we talked about stock's, fundamental analysis is refers to a technique that attempts to determined security valued of a company’s actual business and its future prospects. Technical Analysis is a methodology of stock valuation, which evaluates the stock based on charts and trends, and predict price movements of how a stock will perform in the future [i.e.whether its price is expected to increase or decrease over a stock period of time] and examining historical data mainly price and volume of financial markets. Benefits of Technical Analysis. - Quickly Determine Trends; - Create Entry and Exit Strategies; and, - The ability to look at Data Visually Forecasting Characteristics. William Stevenson lists a number of characteristics that are common to a good forecast. a. Accurate; b. Reliable; c. Timely; d. Easy to use and understand; and cost effective. There are four (4) main types of forecasting methods that financial analysts use to predict future revenues, expenses, and capital costs of business. 1. Straight-line method; 2. Moving Average; 3. Single linear regression; and, 4. Multiple linear regression. Forecasting Techniques range from the simple to the extremely complex. These techniques are usually classified as being qualitative or quantitative. 1. Qualitative Forecasting Techniques are generally more subjective than quantitative counterparts. Qualitative techniques are more useful in the earlier stages of the product life cycle, when less past data exists for use in quantitative method. Qualitative methods include: a) The Delphi Technique; [uses panel of experts to produce forecasts]. b) Nominal Group Technique; [similar to the Delphi technique in that it utilizes a group of participants, usually experts]. c) Sales Force Opinions; [the sales staff is often good source of information regarding future deamnd]. d) Executive Opinions; [sometimes upper-managers meet and develop forecasts based on their knowledge of their areas of responsibility, sometimes it refers to jury] and, e) Market Research. [known as consumer surveys used to establish potential demand. It is usually involves constructing a questionnaire that solicit personal, demographic, economic, and marketing information] 2. Quantitative Techniques are generally more objective than qualitative counterparts. 5 Quantitative forecasts can be time-series forecast [i.e., a projection of the past into the future]. Time-series data may have underlying behaviors, some of these behaviors may be patterns or simply random variables. Among the patterns are: a) Trends; [which are long-term movements (up or down) in the data]. b) Seasonality; [which produced short-term variations that are usually related to the time of year, month, or even a particular day, as witnessed by retail sales at Christmas]. c) Cycles; [which are wavelike variations lasting more than a year that are usually tied to economic or political condition]. d) Irregulation variations that do not reflect typical behavior; [such as period of extreme weather or a union strike] and, e) Random variations. [which encompass all non-typical behaviors not accounted for by the other classifications]. Forecasting Process. William J. Stevenson lists the following basic steps in forecasting process. a. Determine the forecast’s purpose; [factors such as how and when the forecast will be used, the degree of accuracy needed, and the level of detail desired determine the cost (time, money, employees) that can be dedicated to the forecast and the type of forecasting method to be utilized. b. Establish a time horizon; [this occurs after one has determined the purpose of forecast. Longer-term forecasts require longer time horizons and vice-versa. c. Select a forecasting technique; [the technique selected depends upon the of the forecast, the time horizon desired, and allowed cost. d. Gather and analyze data; [the amount and type of data needed is governed by forecast’s purpose, the forecasting technique selected, and any cost consideration. Market Anomalies is a price action that contradict the expected behavior of stock market. Market anomalies can be great opportunities for traders and investors, they can use these unusual behaviors to find opportunities throughout the stock market. Market anomalies are trends in stock returns that tend to reoccur every year. Most market anomalies are psychologically driven. Some say that you shouldn’t be able to beat the market with anomalies because everyone would pile into the investment ahead of time and erase benefit to the trend. Playing market anomalies feels a little like trying to play with professionals’ game, which are talked about as the wrong way to win the stock market game, but there may be something to it. Anomalies should influence and not dictate a trading decision. There are four (4) primary explanation for market anomalies. 1. Mispricing; 2. Unmeasured risk; 3. Limits to arbitrage; and, 4. Selection bias. 6 SPECIAL TOPICS - Derivatives - Global Trends - New Market Instruments - Thematic Investing (Ethical Investing, Islamic Equity Funds) **************************MIDTERM PERIOD ENDS HERE************************* 7 EQUITY VALUATION MODELS - Balance Sheet Valuation Methods - Intrinsic Value versus Market Price - Dividend Discount Model - Price-Earnings Ratio - Corporate Finance and Free Cash Flow Approach - Inflation and Equity Valuation Analysts gather and process information to make investment decisions, including buy and sell recommendations. What information is gathered and how it is processed depend on the analyst and the purpose of the analysis. Technical analysis uses such information as stock price and trading volume as the basis for investment decisions. Fundamental analysis uses information about the economy, industry, and company as the basis for investment decisions. Examples of fundamentals are unemployment rates, gross domestic product (GDP) growth, industry growth, and quality of and growth in company earnings. Whereas technical analysts use information to predict price movements and base investment decisions on the direction of predicted change in prices, fundamental analysts use information to estimate the value of a security and 8 to compare the estimated value to the market price and then base investment decisions on that comparison. This reading introduces equity valuation models used to estimate the intrinsic value (synonym: fundamental value) of a security; intrinsic value is based on an analysis of investment fundamentals and characteristics. The fundamentals to be considered depend on the analyst’s approach to valuation. In a top-down approach, an analyst examines the economic environment, identifies sectors that are expected to prosper in that environment, and analyzes securities of companies from previously identified attractive sectors. In a bottom-up approach, an analyst typically follows an industry or industries and forecasts fundamentals for the companies in those industries in order to determine valuation. Whatever the approach, an analyst who estimates the intrinsic value of an equity security is implicitly questioning the accuracy of the market price as an estimate of value. Valuation is particularly important in active equity portfolio management, which aims to improve on the return–risk trade-off of a portfolio’s benchmark by identifying mispriced securities. Equity valuation models are essential tools for estimating the value of a company’s stock. Here are some of the most commonly used models: 1. Discounted Cash Flow (DCF) Model: This model estimates the value of an equity based on the present value of expected future cash flows. It’s particularly useful for companies with predictable and stable cash flows 1. 2. Comparable approach or “trading multiples” or “peer group analysis” This method involves comparing the company’s financial metrics like P/E ratio, P/B ratio to those of similar companies. One of the more popular equity valuation approaches is the comparables approach. This strategy evaluates similar companies and compares relevant valuation metrics. The comparables approach is often one of the easier valuations to perform as long as the company being valued as public company comparables. The comparables valuation can simply be determined by comparing a firm to its key rivals, or at least those rivals that operate similar businesses. Discrepancies in the value between similar firms could spell opportunity. The hope is that it means the equity is undervalued and can be bought and held until the value increases. The opposite could hold true, which could present an opportunity for shorting the stock or positioning one’s portfolio to profit from a decline in its price. Types of Comp Models The comparables Common market multiples include the following: - enterprise-value-to-sales (EV/S), - enterprise multiple, - price-to-earnings (P/E), - price-to-book (P/B), and - price-to-free-cash-flow (P/FCF) To get a better indication of how a firm compares to rivals, analysts can also look at how its margin levels compare. For instance, an activist investor could make the argument that a company with averages below peers is ripe for a 9  turnaround and subsequent increase in value should improvements occur. Example of the Comp Method The comparables approach is best illustrated through an example. Below is an analysis of the largest, most diversified chemical firms that trade in the U.S. The financial information below is current as of May 24, 2022. When performing the comparables approach, it's valuable to not only select similar companies in the same sector but to compare performance against industry average. Although our sample size is small in this example, let's compare Eastman Chemical Company to other companies in addition to the average of our sample. Market Capitalization: Of the companies selected, Eastman is among the smallest in terms of market cap. This is valuable information when comparing dollar figures like net income, net margin, and free cash flow. This also sets the precedent that Eastman may have less operational efficiencies than Dow Chemical, Dupont, or Air Products & Chemicals. Enterprise Value: The enterprise value of Eastman is almost 50% higher than its market cap. The closest comparable is Huntsman, whose enterprise value is roughly 25% higher than its market cap. This indicates that Eastman may have higher debt or lower cash value than the nearest comparable sample. Price/Earnings Ratio: Of our sample of 5 companies, Eastman's P/E ratio is fairly similar to the average. This is important to note when comparing other ratios. Because Eastman is among the higher P/E ratios, the market is pricing in expectations that there will be further company growth (at least compared to the companies with lower P/E ratios such as Huntsman or Dow Chemical). Price/Revenue Ratio: Unlike the P/E ratio, Eastman is below our sample average for the P/R ratio. This indicates the market expects less revenue 10  growth compared to other firms. By comparison, this means the market is anticipating expense savings or operational efficiencies due to the difference in expectations regarding P/E and P/R. Price/Book Ratio: Again, Eastman appears to be on target with our sample average. This is indicates the company's stock is not trading at too high of a premium compared to the industry average. Net Margin: As expected, Eastman has yet to capture many economies of scale that the larger companies have been able to capture. It's net margin is the lowest of the group and below the sample average, indicating that this small company is operating on the smallest margins. This indicates that while Eastman has some favorable metrics, it is likely still operating with inefficiencies due to its size. Free Cash Flow: The industry average does get skewed by Dow Chemical's large free cash flow (which appears to be a potentially unlikely outlier). Still, it is encouraging to see Eastman's free cash flow similar to (and even larger than) some bigger companies like DuPont and Air Products. This may that Eastman may have cash on hand to invest in its infrastructure for future growth. Overall, Eastman has a relatively fair price compared to similar industry leaders Its valuation will likely be negatively impacted by its low net margin compared to other companies; however, Eastman has free cash flow to address operational inefficiencies. 3. Precedent Transactions: This approach looks at historical prices paid for similar companies in past transactions to estimate the value of a company 1. 4. Asset-Based Valuation: This method calculates the value of a company based on the fair market value of its assets minus its liabilities. It’s often used for companies with significant tangible assets1. 5. Book Value Approach: This model values a company based on its book value, which is the net asset value of a company as recorded on its balance sheet. Summary The equity valuation models used to estimate intrinsic value—present value models, multiplier models, and asset-based valuation—are widely used and serve an important purpose. The valuation models presented here are a foundation on which to base analysis and research but must be applied wisely. Valuation is not simply a numerical analysis. The choice of model and the derivation of inputs require skill and judgment. When valuing a company or group of companies, the analyst wants to choose a valuation model that is appropriate for the information available to be used as inputs. The available data will, in most instances, restrict the choice of model and influence the way it is used. Complex models exist that may improve on the simple valuation models described in this reading; but before using those models and assuming that complexity increases accuracy, the analyst would do well to consider the “law of parsimony:” A model should be kept as simple as possible in light of the available inputs. Valuation is a fallible discipline, and any method will result in an inaccurate forecast at some time. The goal is to minimize the inaccuracy of the forecast. Among the points made in this reading are the following: An analyst estimating intrinsic value is implicitly questioning the market’s 11  estimate of value. If the estimated value exceeds the market price, the analyst infers the security is undervalued. If the estimated value equals the market price, the analyst infers the security is fairly valued. If the estimated value is less than the market price, the analyst infers the security is overvalued. Because of the uncertainties involved in valuation, an analyst may require that value estimates differ markedly from market price before concluding that a misvaluation exists. Analysts often use more than one valuation model because of concerns about the applicability of any particular model and the variability in estimates that result from changes in inputs. Three major categories of equity valuation models are present value, multiplier, and asset-based valuation models. Present value models estimate value as the present value of expected future benefits. Multiplier models estimate intrinsic value based on a multiple of some fundamental variable. Asset-based valuation models estimate value based on the estimated value of assets and liabilities. The choice of model will depend upon the availability of information to input into the model and the analyst’s confidence in both the information and the appropriateness of the model. Companies distribute cash to shareholders using dividend payments and share repurchases. Regular cash dividends are a key input to dividend valuation models. Key dates in dividend chronology are the declaration date, ex-dividend date, holder-of-record date, and payment date. In the dividend discount model, value is estimated as the present value of expected future dividends. In the free cash flow to equity model, value is estimated as the present value of expected future free cash flow to equity. The Gordon growth model, a simple DDM, estimates value as D 1/(r – g). The two stage dividend discount model estimates value as the sum of the present values of dividends over a short-term period of high growth and the present value of the terminal value at the end of the period of high growth. The terminal value is estimated using the Gordon growth model. The choice of dividend model is based upon the patterns assumed with respect to future dividends. Multiplier models typically use multiples of the form: P/ measure of fundamental variable or EV/ measure of fundamental variable. Multiples can be based upon fundamentals or comparables. Asset-based valuations models estimate value of equity as the value of the assets less the value of liabilities. 12