Why Do Individuals Invest ?
By saving money (instead of spending it), individuals tradeoff present consumption for a larger future consumption.
Defining Investment
A current commitment of $ for a period of time in order to derive future payments that will compensate for:
the time the funds are committed
the expected rate of inflation
uncertainty of future flow of funds.
Measures of Historical Rates of Return
Holding Period Return (HPR)
= Ending value of investment/Beginning value of investment
Holding Period Yield 9HPY)
HPY = HPR - 1
*This difference between return and yield proposed by Reilly is not standard terminology.
Readers have to take a note of it.
Annual Holding Period Return can be calculated from HPR
Annual HPR = HPR^(1/n)
where n = number of years investment is held
Annual Holding Period Yield
Annual HPY = Annual HPR - 1
Arithmetic Mean of Annual HPY can be a measure of past annual average yield
Geometric Mean of past HPYs can also be a measure of average past yield.
For a Portfolio of Investments
The mean historical rate of return for a portfolio of investments is measured as the weighted average of the HPYs for the individual investments in the portfolio.
Expected Rates of Return (Future orientation - what is likely to happen in future)
Risk is uncertainty that an investment will earn its expected rate of return
Probability is the likelihood of an outcome
Estimates for the future are made based on the past data.
Risk Aversion
The assumption that most investors will choose the least risky alternative, all else being equal and that they will not accept additional risk unless they are compensated in the form of higher return
Measuring the Risk of Expected Rates of Return
Standard Deviation of the data is a measure of the Risk of Expected Rates of Return
Standard Deviation is the square root of the variance
Coefficient of variation (CV) a measure of relative variability that indicates risk per unit of return
= Standard Deviation of Returns/Expected Rate of Returns
Determinants of Required Rates of Return for Individual investments (Different types of assets, and specific securites in an asset category)
Time value of money
Expected rate of inflation
Risk involved
The Real Risk Free Rate (RRFR)
This rate is arrived at on the basis of:
Assumes no inflation.
Assumes no uncertainty about future cash flows.
Influenced by time preference for consumption of income and investment opportunities in the economy
Nominal Risk-Free Rate
Inflation is factored in.
Dependent upon
Conditions in the Capital Markets
Expected Rate of Inflation
Nominal RFR =
(1+Real RFR) x (1+Expected Rate of Inflation) - 1
Return required by investors will NRFR plus risk premium
Facets of Fundamental Risk
Business risk
Financial risk
Liquidity risk
Exchange rate risk
Country risk
Risk Premium is a function of (Business Risk, Financial Risk, Liquidity Risk, Exchange Rate Risk, Country Risk)
From modern portfolio theory based on equilibrium conditions, it was derived that in equilibrium risk premium depends only on systematic risk.
Systematic risk refers to the portion of an individual asset’s total variance attributable to the variability of the total market portfolio
Beta measures this systematic risk of an asset
Showing posts with label Reilly-Brown-IAPM-PTR. Show all posts
Showing posts with label Reilly-Brown-IAPM-PTR. Show all posts
Tuesday, December 11, 2007
Reilly-Brown-IAPM Ch.2 Asset Allocation - Points to Refresh
Chapter 2 Asset Allocation
Financial Plan Preliminaries
Have adequate insurance before you think of investing for income and growth
Insurance
Life insurance
Term life insurance - Provides death benefit only. Premium could change every renewal period
Universal and variable life insurance – provide cash value plus death benefit
Health insurance
Disability insurance
Automobile insurance
Home/rental insurance
Liability insurance
Cash reserve
Keep adquate cash reserve
To meet emergency needs
Includes cash equivalents (liquid investments)
Equal to six months living expenses recommended by experts
Individual Investor Life Cycle
Accumulation phase – early to middle years of working career
Consolidation phase – past midpoint of careers. Earnings greater than expenses
Spending/Gifting phase – begins after retirement
Saving and Investment - Goals
Near-term, high-priority goals
Long-term, high-priority goals
Lower-priority goals
The Portfolio Management Process
1. Policy statement - Focus: Investor’s short-term and long-term needs, familiarity with capital market history, and expectations
2. Examine current and project financial, economic, political, and social conditions - Focus: Short-term and intermediate-term expected conditions to use in constructing a specific portfolio
3. Implement the plan by constructing the portfolio - Focus: Meet the investor’s needs at the minimum risk levels
4. Feedback loop: Monitor and update investor needs, environmental conditions, portfolio performance
1. Policy statement
specifies investment goals and acceptable risk levels
should be reviewed periodically
2. Study current financial and economic conditions and forecast future trends
determine strategies to meet goals
requires monitoring and updating
guides all investment decisions
3. Select Securities and Construct the portfolio
allocate available funds to minimize investor’s risks and meet investment goals
4. Monitor and update
evaluate portfolio performance
Study current financial and economic conditions and forecast future trends
Monitor investor’s needs and market conditions
revise policy statement as needed
modify investment strategy accordingly
The Need For A Policy Statement
Helps investors understand their own needs, objectives, and investment constraints
Sets standards for evaluating portfolio performance
Reduces the possibility of inappropriate behavior on the part of the portfolio manager
Questions to be answered by the investor in the process of developing a policy statement:
What are the real risks of an adverse financial outcome, especially in the short run?
What probable emotional reactions will I have to an adverse financial outcome?
How knowledgeable am I about investments and the financial markets?
What other capital or income sources do I have? How important is this particular portfolio to my overall financial position?
What, if any, legal restrictions may affect my investment needs?
What, if any, unanticipated consequences of interim fluctuations in portfolio value might affect my investment policy?
Investment Objectives
Risk Tolerance
Absolute or relative percentage return
General goals
-Capital preservation
---minimize risk of real loss
-Capital appreciation
---Growth of the portfolio in real terms to meet future need
-Current income
---Focus is in generating income rather than capital gains
Investment Constraints
-Liquidity needs
---Vary between investors depending upon age, employment, tax status, etc.
-Time horizon
Influences liquidity needs and risk tolerance
Tax concerns
Capital gains or losses – taxed differently from income
Unrealized capital gain – reflect price appreciation of currently held assets that have not yet been sold
Realized capital gain – when the asset has been sold at a profit
Trade-off between taxes and diversification – tax consequences of selling company stock for diversification purposes
interest on municipal bonds exempt from federal income tax and from state of issue
interest on federal securities exempt from state income tax
contributions to an IRA may qualify as deductible from taxable income
tax deferral considerations - compounding
Legal and Regulatory Factors
Limitations or penalties on withdrawals
Fiduciary responsibilities - “prudent man” rule
Investment laws prohibit insider trading
Unique Needs and Preferences
Personal preferences such as socially conscious investments could influence investment choice
Time constraints or lack of expertise for managing the portfolio may require professional management
Large investment in employer’s stock may require consideration of diversification needs
Institutional investors needs
The Importance of Asset Allocation
An investment strategy is based on four decisions
What asset classes to consider for investment
What normal or policy weights to assign to each eligible class
Determining the allowable allocation ranges based on policy weights
What specific securities to purchase for the portfolio
The Importance of Asset Allocation
According to research studies, most (85% to 95%) of the overall investment return is due to the first two decisions, not the selection of individual investments
Returns and Risk of Different Asset Classes
Returns on Treasury Bills have barely kept pace with inflation
Inflation and taxes have a major impact on returns
Historically, small company stocks have generated the highest returns. But the volatility of returns have been the highest too
Measuring risk by probability of not meeting your investment return objective indicates risk of equities is small and that of T-bills is large because of their differences in expected returns
Focusing only on return variability as a measure of risk ignores reinvestment risk
Asset Allocation Summarpzed
Policy statement determines types of assets to include in portfolio
Asset allocation determines portfolio return more than stock selection
Over long time periods, sizable allocation to equity will improve results
Risk of a strategy depends on the investor’s goals and time horizon
Institutional Investors, Objectives and Constraints
Mutual Funds – pool investors funds and invests them in financial assets as per its investment objective
Pension Funds
Receive contributions from the firm, its employees, or both and invests those funds
Defined Benefit – promise to pay retirees a specific income stream after retirement
Defined Contribution – do not promise a set of benefits. Employees’ retirement income is not an obligation of the firm
Endowment Funds
They represent contributions made to charitable or educational institutions
Insurance Companies
Life Insurance Companies
earn rate in excess of actuarial rate
growing surplus if the spread is positive
fiduciary principles limit the risk tolerance
liquidity needs have increased
tax rule changes
Nonlife Insurance Companies
cash flows less predictable
fiduciary responsibility to claimants
Risk exposure low to moderate
liquidity concerns due to uncertain claim patterns
regulation more permissive
Banks
Must attract funds in a competitive interest rate environment
Try to maintain a positive difference between their cost of funds and their return on assets
Need substantial liquidity to meet withdrawals and loan demands
Face regulatory constraints
Financial Plan Preliminaries
Have adequate insurance before you think of investing for income and growth
Insurance
Life insurance
Term life insurance - Provides death benefit only. Premium could change every renewal period
Universal and variable life insurance – provide cash value plus death benefit
Health insurance
Disability insurance
Automobile insurance
Home/rental insurance
Liability insurance
Cash reserve
Keep adquate cash reserve
To meet emergency needs
Includes cash equivalents (liquid investments)
Equal to six months living expenses recommended by experts
Individual Investor Life Cycle
Accumulation phase – early to middle years of working career
Consolidation phase – past midpoint of careers. Earnings greater than expenses
Spending/Gifting phase – begins after retirement
Saving and Investment - Goals
Near-term, high-priority goals
Long-term, high-priority goals
Lower-priority goals
The Portfolio Management Process
1. Policy statement - Focus: Investor’s short-term and long-term needs, familiarity with capital market history, and expectations
2. Examine current and project financial, economic, political, and social conditions - Focus: Short-term and intermediate-term expected conditions to use in constructing a specific portfolio
3. Implement the plan by constructing the portfolio - Focus: Meet the investor’s needs at the minimum risk levels
4. Feedback loop: Monitor and update investor needs, environmental conditions, portfolio performance
1. Policy statement
specifies investment goals and acceptable risk levels
should be reviewed periodically
2. Study current financial and economic conditions and forecast future trends
determine strategies to meet goals
requires monitoring and updating
guides all investment decisions
3. Select Securities and Construct the portfolio
allocate available funds to minimize investor’s risks and meet investment goals
4. Monitor and update
evaluate portfolio performance
Study current financial and economic conditions and forecast future trends
Monitor investor’s needs and market conditions
revise policy statement as needed
modify investment strategy accordingly
The Need For A Policy Statement
Helps investors understand their own needs, objectives, and investment constraints
Sets standards for evaluating portfolio performance
Reduces the possibility of inappropriate behavior on the part of the portfolio manager
Questions to be answered by the investor in the process of developing a policy statement:
What are the real risks of an adverse financial outcome, especially in the short run?
What probable emotional reactions will I have to an adverse financial outcome?
How knowledgeable am I about investments and the financial markets?
What other capital or income sources do I have? How important is this particular portfolio to my overall financial position?
What, if any, legal restrictions may affect my investment needs?
What, if any, unanticipated consequences of interim fluctuations in portfolio value might affect my investment policy?
Investment Objectives
Risk Tolerance
Absolute or relative percentage return
General goals
-Capital preservation
---minimize risk of real loss
-Capital appreciation
---Growth of the portfolio in real terms to meet future need
-Current income
---Focus is in generating income rather than capital gains
Investment Constraints
-Liquidity needs
---Vary between investors depending upon age, employment, tax status, etc.
-Time horizon
Influences liquidity needs and risk tolerance
Tax concerns
Capital gains or losses – taxed differently from income
Unrealized capital gain – reflect price appreciation of currently held assets that have not yet been sold
Realized capital gain – when the asset has been sold at a profit
Trade-off between taxes and diversification – tax consequences of selling company stock for diversification purposes
interest on municipal bonds exempt from federal income tax and from state of issue
interest on federal securities exempt from state income tax
contributions to an IRA may qualify as deductible from taxable income
tax deferral considerations - compounding
Legal and Regulatory Factors
Limitations or penalties on withdrawals
Fiduciary responsibilities - “prudent man” rule
Investment laws prohibit insider trading
Unique Needs and Preferences
Personal preferences such as socially conscious investments could influence investment choice
Time constraints or lack of expertise for managing the portfolio may require professional management
Large investment in employer’s stock may require consideration of diversification needs
Institutional investors needs
The Importance of Asset Allocation
An investment strategy is based on four decisions
What asset classes to consider for investment
What normal or policy weights to assign to each eligible class
Determining the allowable allocation ranges based on policy weights
What specific securities to purchase for the portfolio
The Importance of Asset Allocation
According to research studies, most (85% to 95%) of the overall investment return is due to the first two decisions, not the selection of individual investments
Returns and Risk of Different Asset Classes
Returns on Treasury Bills have barely kept pace with inflation
Inflation and taxes have a major impact on returns
Historically, small company stocks have generated the highest returns. But the volatility of returns have been the highest too
Measuring risk by probability of not meeting your investment return objective indicates risk of equities is small and that of T-bills is large because of their differences in expected returns
Focusing only on return variability as a measure of risk ignores reinvestment risk
Asset Allocation Summarpzed
Policy statement determines types of assets to include in portfolio
Asset allocation determines portfolio return more than stock selection
Over long time periods, sizable allocation to equity will improve results
Risk of a strategy depends on the investor’s goals and time horizon
Institutional Investors, Objectives and Constraints
Mutual Funds – pool investors funds and invests them in financial assets as per its investment objective
Pension Funds
Receive contributions from the firm, its employees, or both and invests those funds
Defined Benefit – promise to pay retirees a specific income stream after retirement
Defined Contribution – do not promise a set of benefits. Employees’ retirement income is not an obligation of the firm
Endowment Funds
They represent contributions made to charitable or educational institutions
Insurance Companies
Life Insurance Companies
earn rate in excess of actuarial rate
growing surplus if the spread is positive
fiduciary principles limit the risk tolerance
liquidity needs have increased
tax rule changes
Nonlife Insurance Companies
cash flows less predictable
fiduciary responsibility to claimants
Risk exposure low to moderate
liquidity concerns due to uncertain claim patterns
regulation more permissive
Banks
Must attract funds in a competitive interest rate environment
Try to maintain a positive difference between their cost of funds and their return on assets
Need substantial liquidity to meet withdrawals and loan demands
Face regulatory constraints
R-B-Ch.6 Efficent Capital Markets - Points to Refresh
Efficient Capital Markets
In an efficient capital market, security prices adjust rapidly to the arrival of new information, therefore the current prices of securities reflect all information about the security
Whether markets are efficient has been extensively researched and remains controversial
Why Should Capital Markets Be Efficient?
The premises of an efficient market
A large number of competing profit-maximizing participants analyze and value securities, each independently of the others
New information regarding securities comes to the market in a random fashion
Profit-maximizing investors adjust security prices rapidly to reflect the effect of new information
Alternative Efficient Market Hypotheses (EMH)
Random Walk Hypothesis – changes in security prices occur randomly
Fair Game Model – current market price reflect all available information about a security and the expected return based upon this price is consistent with its risk
Efficient Market Hypothesis (EMH) - divided into three sub-hypotheses depending on the information set involved
Weak-Form EMH - prices reflect all security-market information (used by technical analysis)
Semistrong-form EMH - prices reflect all public information (used by fundamental analysis)
Strong-form EMH - prices reflect all public and private information
Weak-Form EMH
Current prices reflect all security-market information, including the historical sequence of prices, rates of return, trading volume data, and other market-generated information
This implies that past rates of return and other market data should have no relationship with future rates of return
Semistrong-Form EMH
Current security prices reflect all public information, including market and non-market information
This implies that decisions made on new information after it is public should not lead to above-average risk-adjusted profits from those transactions
Strong-Form EMH
Stock prices fully reflect all information from public and private sources
This implies that no group of investors should be able to consistently derive above-average risk-adjusted rates of return
This assumes perfect markets in which all information is cost-free and available to everyone at the same time
Tests and Results of Weak-Form EMH
Statistical tests of independence between rates of return
Autocorrelation tests have mixed results
Runs tests indicate randomness in prices
Comparison of trading rules to a buy-and-hold policy is difficult because trading rules can be complex and there are too many to test them all
Filter rules yield above-average profits with small filters, but only before taking into account transactions costs
Trading rule results have been mixed, and most have not been able to beat a buy-and-hold policy
Results generally support the weak-form EMH, but results are not unanimous
Tests of the Semistrong Form of Market Efficiency
Two sets of studies
Time series analysis of returns or the cross section distribution of returns for individual stocks
Event studies that examine how fast stock prices adjust to specific significant economic events
Test results should adjusted a security’s rate of return for the rates of return of the overall market during the period considered
Arit = Rit - Rmt
where:
Arit = abnormal rate of return on security i during period t
Rit = rate of return on security i during period t
Rmt =rate of return on a market index during period t
Time series tests for abnormal rates of return
short-horizon returns have limited results
long-horizon returns analysis has been quite successful based on
dividend yield (D/P)
default spread
term structure spread
Quarterly earnings reports may yield abnormal returns due to
unanticipated earnings change
Quarterly Earnings Reports
Large Standardized Unexpected Earnings (SUEs) result in abnormal stock price changes, with over 50% of the change happening after the announcement
Unexpected earnings can explain up to 80% of stock drift over a time period
These results suggest that the earnings surprise is not instantaneously reflected in security prices
The January Anomaly
Stocks with negative returns during the prior year had higher returns right after the first of the year
Tax selling toward the end of the year has been mentioned as the reason for this phenomenon
Such a seasonal pattern is inconsistent with the EMH
Other calendar effects
All the market’s cumulative advance occurs during the first half of trading months
Monday/weekend returns were significantly negative
For large firms, the negative Monday effect occurred before the market opened (it was a weekend effect), whereas for smaller firms, most of the negative Monday effect occurred during the day on Monday (it was a Monday trading effect)
Predicting cross-sectional returns
All securities should have equal risk-adjusted returns
Studies examine alternative measures of size or quality as a tool to rank stocks in terms of risk-adjusted returns
These tests involve a joint hypothesis and are dependent both on market efficiency and the asset pricing model used
Price-earnings ratios and returns
Low P/E stocks experienced superior risk-adjusted results relative to the market, whereas high P/E stocks had significantly inferior risk-adjusted results
Publicly available P/E ratios possess valuable information regarding future returns
This is inconsistent with semistrong efficiency
Price-Earnings/Growth Rate (PEG) ratios
Studies have hypothesized an inverse relationship between the PEG ratio and subsequent rates of return. This is inconsistent with the EMH
However, the results related to using the PEG ratio to select stocks are mixed
The size effect (total market value)
Several studies have examined the impact of size on the risk-adjusted rates of return
The studies indicate that risk-adjusted returns for extended periods indicate that the small firms consistently experienced significantly larger risk-adjusted returns than large firms
Firm size is a major efficient market anomaly
Could this have caused the P/E results previously studied?
Summary on the Semistrong-Form EMH
Evidence is mixed
Strong support from numerous event studies with the exception of exchange listing studies
Studies on predicting rates of return for a cross-section of stocks indicates markets are not semistrong efficient
Studies on predicting rates of return for a cross-section of stocks indicates markets are not semistrong efficient
Dividend yields, risk premiums, calendar patterns, and earnings surprises
This also included cross-sectional predictors such as size, the BV/MV ratio (when there is expansive monetary policy), E/P ratios, and neglected firms.
Tests and Results of Strong-Form EMH
Strong-form EMH contends that stock prices fully reflect all information, both public and private
This implies that no group of investors has access to private information that will allow them to consistently earn above-average profits
Corporate insiders
Stock exchange specialists
Security analysts
Professional money managers
Insiders include major corporate officers, directors, and owners of 10% or more of any equity class of securities
Insiders must report to the SEC each month on their transactions in the stock of the firm for which they are insiders
These insider trades are made public about six weeks later and allowed to be studied
Corporate insiders generally experience above-average profits especially on purchase transaction
This implies that many insiders had private information from which they derived above-average returns on their company stock
Studies showed that public investors who traded with the insiders based on announced transactions would have enjoyed excess risk-adjusted returns (after commissions), but the markets now seem to have eliminated this inefficiency (soon after it was discovered)
Other studies indicate that you can increase returns from using insider trading information by combining it with key financial ratios and considering what group of insiders is doing the buying and selling
Specialists have monopolistic access to information about unfilled limit orders
You would expect specialists to derive above-average returns from this information
The data generally supports this expectation
Tests have considered whether it is possible to identify a set of analysts who have the ability to select undervalued stocks
This looks at whether, after a stock selection by an analyst is made known, a significant abnormal return is available to those who follow their recommendations
Value Line (VL) publishes financial information on about 1,700 stocks
The report includes a timing rank from 1 down to 5
Firms ranked 1 substantially outperform the market
Firms ranked 5 substantially underperform the market
Changes in rankings result in a fast price adjustment
Some contend that the Value Line effect is merely the unexpected earnings anomaly due to changes in rankings from unexpected earnings
There is evidence in favor of existence of superior analysts who apparently possess private information
Trained professionals, working full time at investment management
If any investor can achieve above-average returns, it should be this group
If any non-insider can obtain inside information, it would be this group due to the extensive management interviews that they conduct
Most tests examine mutual funds
New tests also examine trust departments, insurance companies, and investment advisors
Risk-adjusted, after expenses, returns of mutual funds generally show that most funds did not match aggregate market performance
Conclusions Regarding the Strong-Form EMH
Mixed results, but much support
Tests for corporate insiders and stock exchange specialists do not support the hypothesis (Both groups seem to have monopolistic access to important information and use it to derive above-average returns)
Tests results for analysts are concentrated on Value Line rankings
Results have changed over time
Currently tend to support EMH
Individual analyst recommendations seem to contain significant information
Performance of professional money managers seem to provide support for strong-form EMH
Implications of Efficient Capital Markets
Overall results indicate the capital markets are efficient as related to numerous sets of information
There are substantial instances where the market fails to rapidly adjust to public information
In an efficient capital market, security prices adjust rapidly to the arrival of new information, therefore the current prices of securities reflect all information about the security
Whether markets are efficient has been extensively researched and remains controversial
Why Should Capital Markets Be Efficient?
The premises of an efficient market
A large number of competing profit-maximizing participants analyze and value securities, each independently of the others
New information regarding securities comes to the market in a random fashion
Profit-maximizing investors adjust security prices rapidly to reflect the effect of new information
Alternative Efficient Market Hypotheses (EMH)
Random Walk Hypothesis – changes in security prices occur randomly
Fair Game Model – current market price reflect all available information about a security and the expected return based upon this price is consistent with its risk
Efficient Market Hypothesis (EMH) - divided into three sub-hypotheses depending on the information set involved
Weak-Form EMH - prices reflect all security-market information (used by technical analysis)
Semistrong-form EMH - prices reflect all public information (used by fundamental analysis)
Strong-form EMH - prices reflect all public and private information
Weak-Form EMH
Current prices reflect all security-market information, including the historical sequence of prices, rates of return, trading volume data, and other market-generated information
This implies that past rates of return and other market data should have no relationship with future rates of return
Semistrong-Form EMH
Current security prices reflect all public information, including market and non-market information
This implies that decisions made on new information after it is public should not lead to above-average risk-adjusted profits from those transactions
Strong-Form EMH
Stock prices fully reflect all information from public and private sources
This implies that no group of investors should be able to consistently derive above-average risk-adjusted rates of return
This assumes perfect markets in which all information is cost-free and available to everyone at the same time
Tests and Results of Weak-Form EMH
Statistical tests of independence between rates of return
Autocorrelation tests have mixed results
Runs tests indicate randomness in prices
Comparison of trading rules to a buy-and-hold policy is difficult because trading rules can be complex and there are too many to test them all
Filter rules yield above-average profits with small filters, but only before taking into account transactions costs
Trading rule results have been mixed, and most have not been able to beat a buy-and-hold policy
Results generally support the weak-form EMH, but results are not unanimous
Tests of the Semistrong Form of Market Efficiency
Two sets of studies
Time series analysis of returns or the cross section distribution of returns for individual stocks
Event studies that examine how fast stock prices adjust to specific significant economic events
Test results should adjusted a security’s rate of return for the rates of return of the overall market during the period considered
Arit = Rit - Rmt
where:
Arit = abnormal rate of return on security i during period t
Rit = rate of return on security i during period t
Rmt =rate of return on a market index during period t
Time series tests for abnormal rates of return
short-horizon returns have limited results
long-horizon returns analysis has been quite successful based on
dividend yield (D/P)
default spread
term structure spread
Quarterly earnings reports may yield abnormal returns due to
unanticipated earnings change
Quarterly Earnings Reports
Large Standardized Unexpected Earnings (SUEs) result in abnormal stock price changes, with over 50% of the change happening after the announcement
Unexpected earnings can explain up to 80% of stock drift over a time period
These results suggest that the earnings surprise is not instantaneously reflected in security prices
The January Anomaly
Stocks with negative returns during the prior year had higher returns right after the first of the year
Tax selling toward the end of the year has been mentioned as the reason for this phenomenon
Such a seasonal pattern is inconsistent with the EMH
Other calendar effects
All the market’s cumulative advance occurs during the first half of trading months
Monday/weekend returns were significantly negative
For large firms, the negative Monday effect occurred before the market opened (it was a weekend effect), whereas for smaller firms, most of the negative Monday effect occurred during the day on Monday (it was a Monday trading effect)
Predicting cross-sectional returns
All securities should have equal risk-adjusted returns
Studies examine alternative measures of size or quality as a tool to rank stocks in terms of risk-adjusted returns
These tests involve a joint hypothesis and are dependent both on market efficiency and the asset pricing model used
Price-earnings ratios and returns
Low P/E stocks experienced superior risk-adjusted results relative to the market, whereas high P/E stocks had significantly inferior risk-adjusted results
Publicly available P/E ratios possess valuable information regarding future returns
This is inconsistent with semistrong efficiency
Price-Earnings/Growth Rate (PEG) ratios
Studies have hypothesized an inverse relationship between the PEG ratio and subsequent rates of return. This is inconsistent with the EMH
However, the results related to using the PEG ratio to select stocks are mixed
The size effect (total market value)
Several studies have examined the impact of size on the risk-adjusted rates of return
The studies indicate that risk-adjusted returns for extended periods indicate that the small firms consistently experienced significantly larger risk-adjusted returns than large firms
Firm size is a major efficient market anomaly
Could this have caused the P/E results previously studied?
Summary on the Semistrong-Form EMH
Evidence is mixed
Strong support from numerous event studies with the exception of exchange listing studies
Studies on predicting rates of return for a cross-section of stocks indicates markets are not semistrong efficient
Studies on predicting rates of return for a cross-section of stocks indicates markets are not semistrong efficient
Dividend yields, risk premiums, calendar patterns, and earnings surprises
This also included cross-sectional predictors such as size, the BV/MV ratio (when there is expansive monetary policy), E/P ratios, and neglected firms.
Tests and Results of Strong-Form EMH
Strong-form EMH contends that stock prices fully reflect all information, both public and private
This implies that no group of investors has access to private information that will allow them to consistently earn above-average profits
Corporate insiders
Stock exchange specialists
Security analysts
Professional money managers
Insiders include major corporate officers, directors, and owners of 10% or more of any equity class of securities
Insiders must report to the SEC each month on their transactions in the stock of the firm for which they are insiders
These insider trades are made public about six weeks later and allowed to be studied
Corporate insiders generally experience above-average profits especially on purchase transaction
This implies that many insiders had private information from which they derived above-average returns on their company stock
Studies showed that public investors who traded with the insiders based on announced transactions would have enjoyed excess risk-adjusted returns (after commissions), but the markets now seem to have eliminated this inefficiency (soon after it was discovered)
Other studies indicate that you can increase returns from using insider trading information by combining it with key financial ratios and considering what group of insiders is doing the buying and selling
Specialists have monopolistic access to information about unfilled limit orders
You would expect specialists to derive above-average returns from this information
The data generally supports this expectation
Tests have considered whether it is possible to identify a set of analysts who have the ability to select undervalued stocks
This looks at whether, after a stock selection by an analyst is made known, a significant abnormal return is available to those who follow their recommendations
Value Line (VL) publishes financial information on about 1,700 stocks
The report includes a timing rank from 1 down to 5
Firms ranked 1 substantially outperform the market
Firms ranked 5 substantially underperform the market
Changes in rankings result in a fast price adjustment
Some contend that the Value Line effect is merely the unexpected earnings anomaly due to changes in rankings from unexpected earnings
There is evidence in favor of existence of superior analysts who apparently possess private information
Trained professionals, working full time at investment management
If any investor can achieve above-average returns, it should be this group
If any non-insider can obtain inside information, it would be this group due to the extensive management interviews that they conduct
Most tests examine mutual funds
New tests also examine trust departments, insurance companies, and investment advisors
Risk-adjusted, after expenses, returns of mutual funds generally show that most funds did not match aggregate market performance
Conclusions Regarding the Strong-Form EMH
Mixed results, but much support
Tests for corporate insiders and stock exchange specialists do not support the hypothesis (Both groups seem to have monopolistic access to important information and use it to derive above-average returns)
Tests results for analysts are concentrated on Value Line rankings
Results have changed over time
Currently tend to support EMH
Individual analyst recommendations seem to contain significant information
Performance of professional money managers seem to provide support for strong-form EMH
Implications of Efficient Capital Markets
Overall results indicate the capital markets are efficient as related to numerous sets of information
There are substantial instances where the market fails to rapidly adjust to public information
R-B-Ch.7 Introduction to Portfolio Management - Points to Refresh
Reilly and Brown's Investment Analysis and Portfolio Management
Chapter 7 - An Introduction to Portfolio Management
A good portfolio is not simply a collection of individually good investments.
The relationship between the returns for assets in the portfolio is important.
Your portfolio includes all of your assets and liabilities.
As an investor you want to maximize the returns for a given level of risk.
Given a choice between two assets with equal rates of return, most investors will select the asset with the lower level of risk.
Definition of Risk
1. Uncertainty of future outcomes
or
2. Probability of an adverse outcome
Markowitz Portfolio Theory
Quantifies risk
Shows that the variance of the rate of return is a meaningful measure of portfolio risk
Derives the expected rate of return for a portfolio of assets.
Derives the formula for computing the variance of a portfolio, showing how to effectively diversify a portfolio
Assumptions
1. Investors consider each investment alternative as being presented by a probability distribution of expected returns over some holding period.(Investors determine or know the probability distribution).
2. Investors minimize one-period expected utility, and their utility curves demonstrate diminishing marginal utility of wealth.
3. Investors estimate the risk of the portfolio on the basis of the variability of expected returns.
4. Investors base decisions solely on expected return and risk, so their utility curves are a function of expected return and the expected variance (or standard deviation) of returns only.
5. For a given risk level, investors prefer higher returns to lower returns. Similarly, for a given level of expected returns, investors prefer less risk to more risk.
Using these five assumptions, a single asset or portfolio of assets is considered to be efficient if no other asset or portfolio of assets offers higher expected return with the same (or lower) risk, or lower risk with the same (or higher) expected return.
Expected Rates of Return
For an individual asset can be estimated by summing of the potential returns multiplied with the corresponding probability of the returns. In this case the analyst has to estimate multiple returns and probality of each of the potential returns. Such an estimation process will give the variance of the return also.
In practice I recommend using target price based expected return.
For a portfolio of assets - weighted average of the expected rates of return for the individual investments in the portfolio will be the expected return of the portfolio.
------------------------
statistics Concepts used in this chapter
Variance
Variance is a measure of the variation of possible rates of return Ri, from the expected rate of return [E(Ri)]
Standard deviation
Standard deviation is the square root of the variance
Covariance of Returns
A measure of the degree to which two variables “move together” relative to their individual mean values over time
Correlation
The correlation coefficient is obtained by standardizing (dividing) the covariance by the product of the individual standard deviations
It can vary only in the range +1 to -1.
A value of +1 would indicate perfect positive correlation. This means that returns for the two assets move together in a completely linear manner.
A value of –1 would indicate perfect correlation. This means that the returns for two assets have the same percentage movement, but in opposite directions
---------------------
Estimation Issues
Estimates required
Expected returns
Standard deviation
Correlation coefficients among all pairs of the entire set of assets
With 100 assets, 4,950 correlation estimates
Estimation risk refers to potential errors
With assumption that stock returns can be described by a single market model, the number of correlations required reduces to the number of assets
Single index market model:
Ri = ai + bi*Rm + ei
Ri = return on a security
bi = the slope coefficient that relates the returns for security i to the returns for the aggregate stock market
Rm = the returns for the aggregate stock market
ei = error term
Chapter 7 - An Introduction to Portfolio Management
A good portfolio is not simply a collection of individually good investments.
The relationship between the returns for assets in the portfolio is important.
Your portfolio includes all of your assets and liabilities.
As an investor you want to maximize the returns for a given level of risk.
Given a choice between two assets with equal rates of return, most investors will select the asset with the lower level of risk.
Definition of Risk
1. Uncertainty of future outcomes
or
2. Probability of an adverse outcome
Markowitz Portfolio Theory
Quantifies risk
Shows that the variance of the rate of return is a meaningful measure of portfolio risk
Derives the expected rate of return for a portfolio of assets.
Derives the formula for computing the variance of a portfolio, showing how to effectively diversify a portfolio
Assumptions
1. Investors consider each investment alternative as being presented by a probability distribution of expected returns over some holding period.(Investors determine or know the probability distribution).
2. Investors minimize one-period expected utility, and their utility curves demonstrate diminishing marginal utility of wealth.
3. Investors estimate the risk of the portfolio on the basis of the variability of expected returns.
4. Investors base decisions solely on expected return and risk, so their utility curves are a function of expected return and the expected variance (or standard deviation) of returns only.
5. For a given risk level, investors prefer higher returns to lower returns. Similarly, for a given level of expected returns, investors prefer less risk to more risk.
Using these five assumptions, a single asset or portfolio of assets is considered to be efficient if no other asset or portfolio of assets offers higher expected return with the same (or lower) risk, or lower risk with the same (or higher) expected return.
Expected Rates of Return
For an individual asset can be estimated by summing of the potential returns multiplied with the corresponding probability of the returns. In this case the analyst has to estimate multiple returns and probality of each of the potential returns. Such an estimation process will give the variance of the return also.
In practice I recommend using target price based expected return.
For a portfolio of assets - weighted average of the expected rates of return for the individual investments in the portfolio will be the expected return of the portfolio.
------------------------
statistics Concepts used in this chapter
Variance
Variance is a measure of the variation of possible rates of return Ri, from the expected rate of return [E(Ri)]
Standard deviation
Standard deviation is the square root of the variance
Covariance of Returns
A measure of the degree to which two variables “move together” relative to their individual mean values over time
Correlation
The correlation coefficient is obtained by standardizing (dividing) the covariance by the product of the individual standard deviations
It can vary only in the range +1 to -1.
A value of +1 would indicate perfect positive correlation. This means that returns for the two assets move together in a completely linear manner.
A value of –1 would indicate perfect correlation. This means that the returns for two assets have the same percentage movement, but in opposite directions
---------------------
Estimation Issues
Estimates required
Expected returns
Standard deviation
Correlation coefficients among all pairs of the entire set of assets
With 100 assets, 4,950 correlation estimates
Estimation risk refers to potential errors
With assumption that stock returns can be described by a single market model, the number of correlations required reduces to the number of assets
Single index market model:
Ri = ai + bi*Rm + ei
Ri = return on a security
bi = the slope coefficient that relates the returns for security i to the returns for the aggregate stock market
Rm = the returns for the aggregate stock market
ei = error term
R-B-Ch.8 CAPM - Points to Refresh
Reilly and Brown IAPM
Chapter 8 - An Introduction to Asset Pricing Models
Capital Market Theory: An Overview
Capital market theory extends portfolio theory and develops a model for pricing all risky assets
Capital asset pricing model (CAPM) will allow you to determine the required rate of return for any risky asset
Assumptions of Capital Market Theory
1. All investors are Markowitz efficient investors who want to target points on the efficient frontier.
The exact location on the efficient frontier and, therefore, the specific portfolio selected, will depend on the individual investor’s risk-return utility function.
2. Investors can borrow or lend any amount of money at the risk-free rate of return (RFR).
Clearly it is always possible to lend money at the nominal risk-free rate by buying risk-free securities such as government T-bills. It is not always possible to borrow at this risk-free rate, but we will see that assuming a higher borrowing rate does not change the general results.
3. All investors have homogeneous expectations; that is, they estimate identical probability distributions for future rates of return.
Again, this assumption can be relaxed. As long as the differences in expectations are not vast, their effects are minor.
4. All investors have the same one-period time horizon such as one-month, six months, or one year.
The model will be developed for a single hypothetical period, and its results could be affected by a different assumption. A difference in the time horizon would require investors to derive risk measures and risk-free assets that are consistent with their time horizons.
5. All investments are infinitely divisible, which means that it is possible to buy or sell fractional shares of any asset or portfolio.
This assumption allows us to discuss investment alternatives as continuous curves. Changing it would have little impact on the theory.
6. There are no taxes or transaction costs involved in buying or selling assets.
This is a reasonable assumption in many instances. Neither pension funds nor religious groups have to pay taxes, and the transaction costs for most financial institutions are less than 1 percent on most financial instruments. Again, relaxing this assumption modifies the results, but does not change the basic thrust.
7. There is no inflation or any change in interest rates, or inflation is fully anticipated.
This is a reasonable initial assumption, and it can be modified.
8. Capital markets are in equilibrium.
This means that we begin with all investments properly priced in line with their risk levels.
Risk-Free Asset
An asset with zero standard deviation
Zero correlation with all other risky assets
Provides the risk-free rate of return (RFR)
Will lie on the vertical axis of a portfolio graph
Combining a Risk-Free Asset with a Risky Portfolio
Since both the expected return and the standard deviation of return for such a portfolio are linear combinations, a graph of possible portfolio returns and risks looks like a straight line between the two assets.
The Market Portfolio
Because portfolio M lies at the point of tangency, it has the highest portfolio possibility line
Everybody will want to invest in Portfolio M and borrow or lend to be somewhere on the CML
Therefore this portfolio must include ALL RISKY ASSETS
Because the market is in equilibrium, all assets are included in this portfolio in proportion to their market value
Because it contains all risky assets, it is a completely diversified portfolio, which means that all the unique risk of individual assets (unsystematic risk) is diversified away
Systematic Risk
Only systematic risk remains in the market portfolio
Systematic risk is the variability in all risky assets caused by macroeconomic variables
Systematic risk can be measured by the standard deviation of returns of the market portfolio and can change over time
Examples of Macroeconomic Factors Affecting Systematic Risk
The Capital Market Line (CML) and the Separation Theorem
The CML leads all investors to invest in the M portfolio
Individual investors should differ in position on the CML depending on risk preferences
How an investor gets to a point on the CML is based on financing decisions
Risk averse investors will lend part of the portfolio at the risk-free rate and invest the remainder in the market portfolio
Investors preferring more risk might borrow funds at the RFR and invest everything in the market portfolio
The decision to borrow or lend to obtain a point on the CML is a separate decision based on risk preferences (financing decision)
The Capital Asset Pricing Model: Expected Return and Risk
The existence of a risk-free asset resulted in deriving a capital market line (CML) that became the relevant frontier
An asset’s covariance with the market portfolio is the relevant risk measure
This can be used to determine an appropriate expected rate of return on a risky asset - the capital asset pricing model (CAPM)
CAPM indicates what should be the expected or required rates of return on risky assets
This helps to value an asset by providing an appropriate discount rate to use in dividend valuation models
You can compare an estimated rate of return to the required rate of return implied by CAPM - over/under valued
The Security Market Line (SML)
The relevant risk measure for an individual risky asset is its covariance with the market portfolio (Covi,m)
This is shown as the risk measure
The return for the market portfolio should be consistent with its own risk, which is the covariance of the market with itself - or its variance:
Determining the Expected Rate of Return for a Risky Asset
Ri = RFR + βi(Rm-RFR)
The expected rate of return of a risk asset is determined by the RFR plus a risk premium for the individual asset
The risk premium is determined by the systematic risk of the asset (beta) and the prevailing market risk premium (RM-RFR)
Using Security Market Line for Trading decisions
In equilibrium, all assets and all portfolios of assets should plot on the SML
Any security with an estimated return that plots above the SML is underpriced
Any security with an estimated return that plots below the SML is overpriced
An investor who derives value and return estimates for assets that are consistently superior to the consensus market evaluation (equilibrium returns) will earn better risk-adjusted rates of return than the average investor.
Independent estimates of return for the securities provide price and dividend outlooks
Beta estimation - Time intervals
Number of observations and time interval used in regression vary
Value Line Investment Services (VL) uses weekly rates of return over five years
Merrill Lynch, Pierce, Fenner & Smith (ML) uses monthly return over five years
There is no “correct” interval for analysis
Weak relationship between VL & ML betas due to difference in intervals used
The return time interval makes a difference, and its impact increases as the firm’s size declines
The Effect of the Market Proxy (Index used as market portfolio)
The market portfolio of all risky assets must be represented in computing an asset’s characteristic line
Standard & Poor’s 500 Composite Index is most often used
Large proportion of the total market value of U.S. stocks
Value weighted series
Includes only U.S. stocks
The theoretical market portfolio should include U.S. and non-U.S. stocks and bonds, real estate, coins, stamps, art, antiques, and any other marketable risky asset from around the world
Chapter 8 - An Introduction to Asset Pricing Models
Capital Market Theory: An Overview
Capital market theory extends portfolio theory and develops a model for pricing all risky assets
Capital asset pricing model (CAPM) will allow you to determine the required rate of return for any risky asset
Assumptions of Capital Market Theory
1. All investors are Markowitz efficient investors who want to target points on the efficient frontier.
The exact location on the efficient frontier and, therefore, the specific portfolio selected, will depend on the individual investor’s risk-return utility function.
2. Investors can borrow or lend any amount of money at the risk-free rate of return (RFR).
Clearly it is always possible to lend money at the nominal risk-free rate by buying risk-free securities such as government T-bills. It is not always possible to borrow at this risk-free rate, but we will see that assuming a higher borrowing rate does not change the general results.
3. All investors have homogeneous expectations; that is, they estimate identical probability distributions for future rates of return.
Again, this assumption can be relaxed. As long as the differences in expectations are not vast, their effects are minor.
4. All investors have the same one-period time horizon such as one-month, six months, or one year.
The model will be developed for a single hypothetical period, and its results could be affected by a different assumption. A difference in the time horizon would require investors to derive risk measures and risk-free assets that are consistent with their time horizons.
5. All investments are infinitely divisible, which means that it is possible to buy or sell fractional shares of any asset or portfolio.
This assumption allows us to discuss investment alternatives as continuous curves. Changing it would have little impact on the theory.
6. There are no taxes or transaction costs involved in buying or selling assets.
This is a reasonable assumption in many instances. Neither pension funds nor religious groups have to pay taxes, and the transaction costs for most financial institutions are less than 1 percent on most financial instruments. Again, relaxing this assumption modifies the results, but does not change the basic thrust.
7. There is no inflation or any change in interest rates, or inflation is fully anticipated.
This is a reasonable initial assumption, and it can be modified.
8. Capital markets are in equilibrium.
This means that we begin with all investments properly priced in line with their risk levels.
Risk-Free Asset
An asset with zero standard deviation
Zero correlation with all other risky assets
Provides the risk-free rate of return (RFR)
Will lie on the vertical axis of a portfolio graph
Combining a Risk-Free Asset with a Risky Portfolio
Since both the expected return and the standard deviation of return for such a portfolio are linear combinations, a graph of possible portfolio returns and risks looks like a straight line between the two assets.
The Market Portfolio
Because portfolio M lies at the point of tangency, it has the highest portfolio possibility line
Everybody will want to invest in Portfolio M and borrow or lend to be somewhere on the CML
Therefore this portfolio must include ALL RISKY ASSETS
Because the market is in equilibrium, all assets are included in this portfolio in proportion to their market value
Because it contains all risky assets, it is a completely diversified portfolio, which means that all the unique risk of individual assets (unsystematic risk) is diversified away
Systematic Risk
Only systematic risk remains in the market portfolio
Systematic risk is the variability in all risky assets caused by macroeconomic variables
Systematic risk can be measured by the standard deviation of returns of the market portfolio and can change over time
Examples of Macroeconomic Factors Affecting Systematic Risk
The Capital Market Line (CML) and the Separation Theorem
The CML leads all investors to invest in the M portfolio
Individual investors should differ in position on the CML depending on risk preferences
How an investor gets to a point on the CML is based on financing decisions
Risk averse investors will lend part of the portfolio at the risk-free rate and invest the remainder in the market portfolio
Investors preferring more risk might borrow funds at the RFR and invest everything in the market portfolio
The decision to borrow or lend to obtain a point on the CML is a separate decision based on risk preferences (financing decision)
The Capital Asset Pricing Model: Expected Return and Risk
The existence of a risk-free asset resulted in deriving a capital market line (CML) that became the relevant frontier
An asset’s covariance with the market portfolio is the relevant risk measure
This can be used to determine an appropriate expected rate of return on a risky asset - the capital asset pricing model (CAPM)
CAPM indicates what should be the expected or required rates of return on risky assets
This helps to value an asset by providing an appropriate discount rate to use in dividend valuation models
You can compare an estimated rate of return to the required rate of return implied by CAPM - over/under valued
The Security Market Line (SML)
The relevant risk measure for an individual risky asset is its covariance with the market portfolio (Covi,m)
This is shown as the risk measure
The return for the market portfolio should be consistent with its own risk, which is the covariance of the market with itself - or its variance:
Determining the Expected Rate of Return for a Risky Asset
Ri = RFR + βi(Rm-RFR)
The expected rate of return of a risk asset is determined by the RFR plus a risk premium for the individual asset
The risk premium is determined by the systematic risk of the asset (beta) and the prevailing market risk premium (RM-RFR)
Using Security Market Line for Trading decisions
In equilibrium, all assets and all portfolios of assets should plot on the SML
Any security with an estimated return that plots above the SML is underpriced
Any security with an estimated return that plots below the SML is overpriced
An investor who derives value and return estimates for assets that are consistently superior to the consensus market evaluation (equilibrium returns) will earn better risk-adjusted rates of return than the average investor.
Independent estimates of return for the securities provide price and dividend outlooks
Beta estimation - Time intervals
Number of observations and time interval used in regression vary
Value Line Investment Services (VL) uses weekly rates of return over five years
Merrill Lynch, Pierce, Fenner & Smith (ML) uses monthly return over five years
There is no “correct” interval for analysis
Weak relationship between VL & ML betas due to difference in intervals used
The return time interval makes a difference, and its impact increases as the firm’s size declines
The Effect of the Market Proxy (Index used as market portfolio)
The market portfolio of all risky assets must be represented in computing an asset’s characteristic line
Standard & Poor’s 500 Composite Index is most often used
Large proportion of the total market value of U.S. stocks
Value weighted series
Includes only U.S. stocks
The theoretical market portfolio should include U.S. and non-U.S. stocks and bonds, real estate, coins, stamps, art, antiques, and any other marketable risky asset from around the world
R-B-Ch.11 Valuation - Points to Refresh
Ch. 11 Valuation
The Investment Decision Process
-Determine the required rate of return
-Evaluate the investment to determine if its market price is consistent with your required rate of return
---Estimate the value of the security based on its expected cash flows and your required rate of return
---Compare this intrinsic value to the market price to decide if you want to buy it
-If Estimated Value > Market Price, Buy
-If Estimated Value < Market Price, Don’t Buy
Theory of Valuation
The value of an asset is the present value of its expected returns
To convert this stream of returns to a value for the security, you must discount this stream at your required rate of return
This requires estimates of:
The stream of expected returns, and
The required rate of return on the investment
Form of returns:
Earnings
Cash flows
Dividends
Interest payments
Capital gains (increases in value)
One has to estimate time pattern and growth rate of returns
Required Rate of Return is determined by(Refer Chpater 1):
1. Economy’s risk-free rate of return, plus
2. Expected rate of inflation during the holding period, plus
3. Risk premium determined by the uncertainty of returns
Approaches to the Valuation of Common Stock
Two major approaches have been developed
1. Discounted cash-flow valuation
Present value of some measure of cash flow, including dividends, operating cash flow, free cash flow and residual income
2. Relative valuation technique
Value estimated based on its price relative to significant variables, such as earnings, cash flow, book value, or sales
Dividend discount model:
Infinite constant growth model V = D1/k-g
Two period growth model or multiperiods of above-normal growth models: Discount the dividends expected during above normal growth periods and add it to the last stage normal growth value.
Assumptions of DDM:
1. Dividends grow at a constant rate
2. The constant growth rate will continue for an infinite period
3. The required rate of return (k) is greater than the infinite growth rate (g)
Analyst has to provide estimates that are in alignment with the above assumptions.
Relative Valuation Techniques
Value can be determined by comparing to similar stocks based on relative ratios
Relevant variables include earnings, cash flow, book value, and sales
The most popular relative valuation technique is based on price to earnings
Earnings Multiplier Model
This compares relative value of the stocks based on expected annual earnings
The price earnings (P/E) ratio, or Earnings Multiplier
= Current market price/expected annual earnings
The infinite-period dividend discount model indicates the variables that should determine the value of the P/E ratio
P = D1/k-g
P/E1 = (D1/E1)/k-g
Thus, the P/E ratio is determined by
1. Expected dividend payout ratio
2. Required rate of return on the stock (k)
3. Expected growth rate of dividends (g)
Estimating the Inputs: The Required Rate of Return and The Expected Growth Rate of Valuation Variables
The investor’s required rate of return must be estimated regardless of the approach selected or technique applied.
This will be used as the discount rate and also affects relative-valuation.
Three factors influence an investor’s required rate of return:
The economy’s real risk-free rate (RRFR)
The expected rate of inflation (I)
A risk premium (RP)
The Economy’s Real Risk-Free Rate
Minimum rate an investor should require
Depends on the real growth rate of the economy
(Capital invested should grow as fast as the economy)
Rate is affected for short periods by tightness or ease of credit markets
Expected Growth Rate of Dividends
Determined by
the growth of earnings
the proportion of earnings paid in dividends
In the short run, dividends can grow at a different rate than earnings due to changes in the payout ratio
Earnings growth is also affected by compounding of earnings retention
g = (Retention Rate) x (Return on Equity)
= RR x ROE
Finding historical growth rates of sales, earnings, cash flow, and dividends
Three techniques
1. arithmetic or geometric average of annual percentage changes
2. linear regression models
3. long-linear regression models
All three use time-series plot of data
The Investment Decision Process
-Determine the required rate of return
-Evaluate the investment to determine if its market price is consistent with your required rate of return
---Estimate the value of the security based on its expected cash flows and your required rate of return
---Compare this intrinsic value to the market price to decide if you want to buy it
-If Estimated Value > Market Price, Buy
-If Estimated Value < Market Price, Don’t Buy
Theory of Valuation
The value of an asset is the present value of its expected returns
To convert this stream of returns to a value for the security, you must discount this stream at your required rate of return
This requires estimates of:
The stream of expected returns, and
The required rate of return on the investment
Form of returns:
Earnings
Cash flows
Dividends
Interest payments
Capital gains (increases in value)
One has to estimate time pattern and growth rate of returns
Required Rate of Return is determined by(Refer Chpater 1):
1. Economy’s risk-free rate of return, plus
2. Expected rate of inflation during the holding period, plus
3. Risk premium determined by the uncertainty of returns
Approaches to the Valuation of Common Stock
Two major approaches have been developed
1. Discounted cash-flow valuation
Present value of some measure of cash flow, including dividends, operating cash flow, free cash flow and residual income
2. Relative valuation technique
Value estimated based on its price relative to significant variables, such as earnings, cash flow, book value, or sales
Dividend discount model:
Infinite constant growth model V = D1/k-g
Two period growth model or multiperiods of above-normal growth models: Discount the dividends expected during above normal growth periods and add it to the last stage normal growth value.
Assumptions of DDM:
1. Dividends grow at a constant rate
2. The constant growth rate will continue for an infinite period
3. The required rate of return (k) is greater than the infinite growth rate (g)
Analyst has to provide estimates that are in alignment with the above assumptions.
Relative Valuation Techniques
Value can be determined by comparing to similar stocks based on relative ratios
Relevant variables include earnings, cash flow, book value, and sales
The most popular relative valuation technique is based on price to earnings
Earnings Multiplier Model
This compares relative value of the stocks based on expected annual earnings
The price earnings (P/E) ratio, or Earnings Multiplier
= Current market price/expected annual earnings
The infinite-period dividend discount model indicates the variables that should determine the value of the P/E ratio
P = D1/k-g
P/E1 = (D1/E1)/k-g
Thus, the P/E ratio is determined by
1. Expected dividend payout ratio
2. Required rate of return on the stock (k)
3. Expected growth rate of dividends (g)
Estimating the Inputs: The Required Rate of Return and The Expected Growth Rate of Valuation Variables
The investor’s required rate of return must be estimated regardless of the approach selected or technique applied.
This will be used as the discount rate and also affects relative-valuation.
Three factors influence an investor’s required rate of return:
The economy’s real risk-free rate (RRFR)
The expected rate of inflation (I)
A risk premium (RP)
The Economy’s Real Risk-Free Rate
Minimum rate an investor should require
Depends on the real growth rate of the economy
(Capital invested should grow as fast as the economy)
Rate is affected for short periods by tightness or ease of credit markets
Expected Growth Rate of Dividends
Determined by
the growth of earnings
the proportion of earnings paid in dividends
In the short run, dividends can grow at a different rate than earnings due to changes in the payout ratio
Earnings growth is also affected by compounding of earnings retention
g = (Retention Rate) x (Return on Equity)
= RR x ROE
Finding historical growth rates of sales, earnings, cash flow, and dividends
Three techniques
1. arithmetic or geometric average of annual percentage changes
2. linear regression models
3. long-linear regression models
All three use time-series plot of data
R-B-Ch.13 DDM Valuation of Market - Points to Refresh
Reilly and Brown 7th Edition
Chapter 13 Applying the DDM Valuation to the Market
Estimating k and g for the U.S. equity market
The nominal risk-free rate
The equity risk premium
The current estimate of Risk Premium and k
Estimating the growth rate of dividends (g)
g = f(b,ROE)
ROE = Net Income / Equity
Estimation of k for DDM
Range of specified maturities for Govt. Securities range from three month treasury bill to 30 year bond.
As of mid 2002, these yields are
3 month treasury bill 2%
10 year bond 5.2%
30 year bond 5.60%
Equity Risk Premium – Market Risk Premium Estimate
Estimates of Ibbotson as averages for the period 1926-2001
For long term investment purposes geometric mean or average is a better estimate.
Some authors suggest 20 year moving average as an estimate for risk premium.
Claus and Thomas derived an estimate that equates market valuations with prevailing expectations of future cash flows.
Their results indicate a risk premium between 1985 and 1998 of 3% or less.
Rozeff shows that under some economic assumptions dividend yield can be equal to risk premium.. During the period 1995-99 dividend yield was below 2%
Estimating Growth Rate
Growth rate of dividends is equal to
Retention rate - the proportion of earnings retained and reinvested
Return on equity (ROE) – rate of return earned on investment
An increase in either or both of these variables causes an increase in the expected growth rate (g).
Chapter 13 Applying the DDM Valuation to the Market
Estimating k and g for the U.S. equity market
The nominal risk-free rate
The equity risk premium
The current estimate of Risk Premium and k
Estimating the growth rate of dividends (g)
g = f(b,ROE)
ROE = Net Income / Equity
Estimation of k for DDM
Range of specified maturities for Govt. Securities range from three month treasury bill to 30 year bond.
As of mid 2002, these yields are
3 month treasury bill 2%
10 year bond 5.2%
30 year bond 5.60%
Equity Risk Premium – Market Risk Premium Estimate
Estimates of Ibbotson as averages for the period 1926-2001
For long term investment purposes geometric mean or average is a better estimate.
Some authors suggest 20 year moving average as an estimate for risk premium.
Claus and Thomas derived an estimate that equates market valuations with prevailing expectations of future cash flows.
Their results indicate a risk premium between 1985 and 1998 of 3% or less.
Rozeff shows that under some economic assumptions dividend yield can be equal to risk premium.. During the period 1995-99 dividend yield was below 2%
Estimating Growth Rate
Growth rate of dividends is equal to
Retention rate - the proportion of earnings retained and reinvested
Return on equity (ROE) – rate of return earned on investment
An increase in either or both of these variables causes an increase in the expected growth rate (g).
R-B-Ch.14 Points to Refresh
Why Do Industry Analysis?
To understand how industries differ in terms of what dictates their return on assets?
Help find profitable investment opportunities
It a part of the three-step, top-down plan for selecting attractive countries, attractive industriea and specific individual companies/stocks for a portfolio
What Do We Learn from Industry Analysis?
Is there a difference between the returns for alternative industries during specific time periods?
Will an industry that performs well in one period continue to perform well in the future? That is, can we use past relationships between the market and an individual industry to predict future trends for the industry?
Do firms within an industry show consistent performance over time?
Do firms within an industry show consistent performance over time?
Is there a difference in the risk for alternative industries?
Do firms within an industry show consistent performance over time?
Is there a difference in the risk for alternative industries?
Does the risk for individual industries vary or does it remain relatively constant over time?
Industry Performance
Wide dispersion in rates of return in different industries
Performance varies from year to year
Company performance varies within industries
Risks vary widely by industry but are fairly stable over time
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Refer Research papers
1. Stephen L. Myers, “A Re-examination of Market and Industry Factors in Stock Price behavior,” Journal of Finance, no.3 (June 1973);695-705
2. Miles Livingston, “Industry Movements of Common Stocks,” Journal of Finance 32, no.2 (June 1977): 861-874.
---------
Industry – Macroanalysis topics
The business cycle and industry sectors
Structural economic changes and alternative industries
Evaluating an industry’s life cycle
Analysis of the competitive environment in an industry
The Business Cycle and Industry Sectors
Financial Stocks
Towards end of recession, financial stocks rise in value because investors anticipate that bank’s earnings will rise as both the economy and loan demand recover.
Brokerage houses become attractive investments because their sales and earnings are expected to rise as investors trade securities, businesses sell debt and equity, and there is a rise in merger activity during economic recovery.
Consumer durable firms
Once economy begins recovery, consumer durable firms that produce expensive consumer items, such as cars, personal computers, refrigerators, etc. become attractive investments because a reviving economy will increase consumer confidence and personal income.
Once businesses recognize the economy is recovering, they begin to think about modernizing, renovating, or purchasing new equipment to satisfy rising demand and reduce costs.
Thus, capital goods industries such heavy equipment manufacturers, machine tool makers, and airplane manufacturers become attractive.
Cyclical industries
Basic metal industries
Traditionally, toward the business cycle peak, the rate of inflation increases as demand starts to outstrip supply.
Basic materials industries such as oil, metals, and timber, which transform raw materials into finished products become investor favourites.
Because inflation has little influence on the cost of extracting these products and they can increase prices, these industries experience higher profit margins.
Consumer staples
During a recession, some industries do better than others.
Consumer staples outperform other sectors during a recession because, although overall spending may decline, people still spend money on necessities.
Industries with large export components
If a weak domestic economy causes a weak currency, industries with large export components to growing economies may benefit.
Investor should not invest based on upon the current economic environment.
Rather it is necessary to forecast important economic variables at least three to six months in the future and invest accordingly.
Structural Economic Changes and Alternative Industries
Social Influences
Demographics
Lifestyles
Technology
Politics and regulations
Economic reasoning
Fairness
Regulatory changes affect numerous industries
Regulations affect international commerce
-------------
Refer
For excellent discussion of structural changes in the US economy and the implications for the stock market
William C.Dudley and Edward F.Mckelvey, “the Brave New Business Cycle: No Recession in Sight” (New York: Goldman, Sachs &Co., January 1997).
-------------
Evaluating the Industry Life Cycle
Five Stage Model
Pioneering development
Rapidly accelerating industry growth
Mature industry growth
Stabilization and market maturity
Deceleration of growth and decline
Analysis of Industry Competition
Competition and Expected Industry Returns
Porter’s concept of competitive strategy is described as the search by a firm for a favorable competitive position in an industry
To create a profitable competitive strategy, a firm must first examine the basic competitive structure of its industry
The potential profitability of a firm is heavily influenced by the profitability of its industry
Competitive Structure of an Industry
Porter’s Competitive Forces
Rivalry among existing competitors
Threat of new entrants
Threat of substitute products
Bargaining power of buyers
Bargaining power of suppliers
----------
Refer
Michael Porter, “Industry Structure and Competitive Strategy: Keys to Profitability,” financial Analysts Journal, 36, no.4 (July-August)
----------
Estimating Industry Rates of Return
Present value using required rate of return for the equity in the industry
Two-step P/E ratio approach uses expected value at the end of investment horizon and compute the expected dividend return during the period
Valuation using the reduced form DDM
S&P Retail Drug Store Index
Is used to demonstrate valuing industry index.
The index contains three companies
1. Longs Drug Stores
2. rite Aid
3. Walgreen company
Estimating the Required Rate of Return – page 500
the risk-free rate and Expected inflation rate are same for industry as well as market.
Risk premium for the industry versus the market depends on the industry’s
business risk (BR)
financial risk (FR)
liquidity risk (LR)
exchange rate risk (ERR)
country political risk (CR)
Can calculate systematic risk (beta) for the industry to the market beta of 1.0
Business Risk for RSD
Sales of RSD less volatile than PCE.
OPM of RSD less volatile than S&P Ind.
Hence BR for RDS less than Market.
Financial risk
Without accounting for financial leases, the debt of RSD less than market.
If we include financial leases the debt may be more.
We can conclude, this industry probably has financial risk about equal to the market.
Liquidity Risk
Walgreen is liquid in the markets.
Others not so.
A conservative view is that the RDS industry probably has above average liquidity risk.
Exchange Risk and country Risk
Do not exist because the industry is totally domestic.
Summary
For the RDS BR is below market, FR at best equal to, and LR above.
ER and CR non existent.
Consensus overall risk less than market.
Beta estimate = 0.82
Confirms the above analysis.
Specific estimate of k for RSD
R.F.R. = 5.2%
Market Return = 9.2%
K = 5.2 +0.82*4
= 8.48 rounded to 8.5%
Estimating the Expected Growth Rate
Earnings and dividend growth are determined by the retention rate and the return on equity
Earnings retention rate of industry compared to the overall market
Return on equity is a function of
the net profit margin
total asset turnover
a measure of financial leverage
Earnings Retention Rate
The retention rate data in Exhibit 14.54 indicate that the industry has a higher retention rate (69% vs. 55% for market).
Return on equity: is a function of profit margin, total asset turnover, and leverage
Profit margins are lower for RSD than market.
Retail store - lower margins –higher turnovers
Asset turnover for S&P I.I> 1.06
RDS 2.70
Return on Total assets (ROTA) for market went from 6.54% in 1977 to 5.29% in 2000.
For RDS it went down from 11.56% to 8.89% and averaged 8.35%.
--------------
Refer
For the analysis of components of ROA and its relation to industry’s economics and strategy
Thomas Selling and Clyde Stickney, ‘The Effects of Business Environment and Strategy on a Firm’s Rate of Return on Assets,” Financial Analysts Journal 39, no. 1 (January-February 1983)
--------------
Leverage
For index leverage went up from 2.08 to 3.09.
For industry it went up from 1.53 to 2.00
ROE estimate based on total period average (1977-2000)
Margin*TAT*(Total Assts/Equity)
S&P II 4.82*1.06*2.88 = 14.71
RDS 3.06*2.70*1.93 = 15.95
Historical trend and averages are important.
But don’t forget that expectations about future will determine value of equity shares.
In this particular case, as an analyst, it is necessary to determine whether the change during the recent period (1993-99) is permanent change.
If one uses the average of recent 5 years the ROE figures for the market and industry will be
S&P I.I. 5.84*0.88*3.34 = 17.16
RDS 2.70*2.2.6*2.27 = 13.85
Combining recent ROE with historical RR and Recent RR gives
Growth rate estimates
S&P II 17.16*0.55 = 9.44
S&P II 17.16*0.64 = 10.98
RDS industry 13.85*.69 = 9.56
RDS industry 13.85*.72 = 9.97
Given the decline in g for the industry in recent results it is probably appropriate to use a growth estimate for industry below the recent conservative estimate that 9.5%.
DDM for RDS - Combining the Estimates
K = 0.085
G = 0.095
D0 = $4.80
D1 = $4.80*1.095 = $5.26(Estd.Div. for 2002)
The long constant growth rate is below market at 7%.
Dividend Growth pattern predicted
2003-05 0.095
2006-07 0.090
2008-09 0.080
2010 onward 0.070
Discount dividends and terminal value gives I.V. estimate of $423.45
The current index value is 640.
So according to valuation of this model industry is overvalued by appx. 50%.
Is the valuation justified?
If you cannot justify a value lower than 8.5% for k and a value higher than 7% for g, you have to conclude that this industry is overvalued.
The Earnings Multiple Technique for RDS Industry
Estimating earnings per share
start with forecasting sales per share
Industrial life cycle
Input-output analysis
Industry-aggregate economy relationship
earnings forecasting and analysis of industry competition
competitive strategy
competitive environment
industry operating profit margin
industry earnings estimate
industry earnings multiplier
Forecasting Sales per Share
If analyst has understood the following
1. effect of business cycle on the industry.
2. structural changes that occurred in the industry in the recent period.
3. life cycle stage of the industry
He will be able to incorporate their implications in the estimates for the future.
Three estimation techniques suggested – page 510
Time series analysis of sales of the industry.
Input-output analysis of supply side and demand side.
Analysis of industry-economy relationship.
Time series analysis of industry sales
Analysing this series on a plot along with the sings for business cycle periods (expansions and recessions) and other major events will provide good insight into the behaviour of sales of the industry.
For many industries, it is possible to extrapolate the time series to derive a very useful estimate.
For industries that have experienced consistent growth, this can be a very useful estimate.
If sales growth has been constant rate, you should do the plot on semi-log paper where the constant growth shows as a straight line.
Input-output analysis
The goal of this analysis is to identify long-run sales outlook for its major customers and the supply capabilities and constraints of its suppliers.
Industry-Economy Relationships
The most rigorous and useful analysis involves comparing sales for an industry with one or several aggregate economic series that are related to the good and services produced by the industry.
Industry-Economic Relationship analysis for RDS Industry
Industry sells medical supplies as well as some non medical items like cosmetics, snacks, pop, and liquor.
Therefore, we want series that (1) reflects broad expenditures and (2) that gives weight to medical expenditure
Hence we consider PCE and PCE-Med-care
Both aggregate and per-capita values were given for the two series in Ex.14.12
A Casual analysis will shows that PCE increased at about 7.5% per year.
PCE-med increased at about 10% years.
Now PCE-med constitutes 15% of PCE where it was 9.6% in 1977.
Still one can see a decline in the PCE-med in recent days.
Industry is showing a growth of 13% per year.
The scatter plot in Ex.14.13 shows a good relationship between ind. Sales and PCE-med.
A good relationship was found between ind. Sales and PCE also.
Multivariate models having more variables can also be useful.
For example, for tire industry, new car-production, new-truck production, and a series that would reflect replacement tire demands may be used.
The best relation was found between RDS sales and PCE-med among the possible series.
The regression results was:
% Δ in RDS sales = 5.40 + 0.55(% Δ in PCE med-care)
R2 = 0.22
Using the Regression Equation
Find an estimate for PCE from estimates by banks and Financial Institutions.
Estimate the proportion of PCE med-care in PCE.
Find its increase from the previous year.
Use the figure in the equation to derive estimate of RDS sales increase.
Industry Profit Margin Forecast
Industry’s operating profit margin
(EBITDA / Sales)
Depreciation expense
interest expense
tax rate
Industry Profit Margin Forecast
Industry’s operating profit margin
(EBITDA / Sales)
Regression analysis can be done w.r.t. market’s operating margin.
Time series analysis of margin of the industry can be done.
It is a matter of judgement based on the scatter plots and fit of the model whether you use regression analysis or the time series for final estimation.
Long-term considerations including competitive structure are to be taken into consideration.
Regression and Time series techniques can be useful tools, but neither technique should be applied mechanically.
Mathematical techniques should be considered a supplement to the economic analysis of the competitive environment for the industry.
The analyst has to be aware of price areas, contract negotiations, building plans or foreign competition etc.
Industry Depreciation Forecast
Depreciation expense can be estimated
W.r.t to market depreciation estimate (regression)
Time series analysis of ind depreciation
Specific estimate based on estimate of PPE for the industry
Industry Depreciation Forecast
Depreciation expense
Generally increasing time series
Specific estimate technique using the depreciation expense/PPE ratio
Subtract depreciation from operating profit margin to determine industry’s net before interest and taxes
Specific estimate technique using the depreciation expense/PPE ratio
1. calculate the annual PPE turnover for the RDS industry.
2. Based on your sales estimate and your PPE turnover ratio estimate, estimate the expected PPE for the year.
3. Calculate the annual depreciation expense as a percent of PPE for the RDS industry
Industry Interest Expense Forecast – page 518
Interest expense is a function of financial leverage and interest rates
1. Calculate the annual total asset turnover (TATO)
2. Use your current sales estimate and an estimate of TATO to estimate total assets next year
3. Calculate the annual long-term (interest bearing) debt as a percent of total assets,
4. Estimate long-term debt for the next year
Industry Interest Expense Forecast
Interest expense (cont.)
5. Calculate the annual interest cost as a percent of long-term debt and analyze the trend
6. Estimate next year’s interest cost of debt for this industry based upon your prior estimate of market yields
7. Estimate interest expense based on the following estimates: (Interest Cost of Debt) (Outstanding Long-Term Debt)
Industry Tax Expense Forecast
Tax rate
Regression analysis
Time series plot
After estimating the tax rate, multiply the EBT per share value by (1 - tax rate) to estimate earnings per share
Derive an estimate of industry’s net profit margin as a check on your EPS estimate
Actual Estimate of EPS for 2002 for RDS industry
The outlook for PCE is for an increase of 5.0% in 2001(to about $7,100 BIL) AND A 3.6% INC. IN 2002 (TO $7,355 BIL).
PCE med care will be 14.8% of PCE in 2001 and 2002.
This gives PCE med as $1,088 billion in 2002.
Using this result in regression equation estimated earlier gives RDS sales estimate in 2002 as $870.
OPM for a retail drug store industry was 6.88% in 1999.
Although the OPM for the S&P II declined during 2000,RDS margins were expected to be stable at about 6.55.
The aggregate OPM was expected rebound in 2002 starting year of expansion.
Thus the OPM for RDS is expected to increase also. Hence estimate = 6.6%
Operating Profit - RDS index =.066*$870
= $57.42.
Depreciation estimate RDS 2002
The PPE turnover had tended to decline during the recent period.
A conservative estimate would be a PPE turnover of 7.40.
As the sales estimate is $870, the PPE estimate will be $117.57 for 2002.
Dep. Expense/PPE ratio was is in 10 and 12% range during 1997-2000.
The recent fiver year average indicates an estimate of 10.6%.
10.6% of $117.57 = $12.46
Hence PBIT = $57.42 - $12.46 = $44.96
Interest Expense Estimate for RDS for 2002 – p.519
Sales estimate $870
TAT has average about 2.15 over the most recent years
Hence total assets for 2002 = $405
Long-term interest bearing debt average about 15% for the RDS.
Implies debt next year = $405*0.15 = $61.
Int. expense during the most recent period has averaged 6.85% for this industry.
Based upon the expectation of a small increase in market interest rates during 2002, we would estimate this interest rate to be 7.00% in 2002.
Hence interest expense = 0.07*$61 = $4.27
Tax Expense p 519
Ex. 14.19.
Except for 1997, the RDS tax rate has moved with the economy’s tax rate.
But you have to consider pending national legislation and unique industry tax factors.
The tax rate of the RDS has been consistently higher than the aggregate.
The aggregate is expected to be stable in 2001 and 2002.
Hence a rate of about 39% seems to be appropriate for RDS.
This implies tax of 15.87 (40.69*0.39)
Hence EPS = 40.69 – 15.87 = 24.82
This implies a net profit margin for the RDS industry of 2.83% (24.82/870) which is slightly below the recent experience.
We will round up the estimate to $25.
Estimating an Industry Earnings Multiplier
Macroanalysis
relationship between multiplier for the industry and the market
variables that influence the multiplier:
required rate of return (k)
function of the nominal risk-free rate plus a risk premium
expected growth rate of earnings and dividend
dividend payout ratio
P/E ratio Relationship between industry and market
Study Reilly and Zeller (1974) showed a significant relationship P/e ratios for 71 S& P industries and S&P Ind. Index.
Between 1977 and 1999, ratio for drug stores was generally higher above the market’s.
In 1989 market P/E ratio went up and industry ratio was stable.
This was reversed in 1996 and industry ratio went above market.
Also industry ratio is less volatile.
Still the analyst has answer why the RDS multiplier is higher and also whether it will persist?
Estimating an Industry Earnings Multiplier
Microanalysis
Estimate the variables that influence the industry earnings multiplier and compare them to the comparable values for the market P/E
Industry multiplier versus the market multiplier
Comparing dividend-payout ratios
Estimating the required rate of return (k)
Estimating the expected growth rate (g)
g = Retention Rate (b) X Return on Equity (ROE)
= (b) X (ROE)
Comparing dividend payout ratios
Analyzing data in Ed.14.5 indicates that the retention rates in RDS are consistently higher than the aggregate (69% vs. 54%)
This indicates higher payout for S&P, which implies higher P/E for S&P.
Comparing the required rate of return
Estimate of k for the industry is 8.5.
Estimate for the market is 9.5.
Hence industry P/E must be higher than the market P/E
Comparing growth rate
Industry growth rate estimate is 9.5.
S& p II growth rates are estimated to be between 8.10% and 11.0%. The mean is 9.5%.
But we opt to bear the high value, we may take it as 10%.
Hence based on growth industry can be below market.
Thus overall the market may have a higher multiple.
As our estimate for P/E for S&P II is 30 to justify prevailing market price, industry P/E may be estimated as 25.
Estimate of Industry value
Expected EPS = $25
It is not possible to derive a specific estimate as g>k.
The comparative estimate gives 25 with a range of 20 to 30
Industry value range can be 500$-$625-$750
The industry index is overpriced w.r.t to expected value and slightly underpriced with respect to optimistic value.
To understand how industries differ in terms of what dictates their return on assets?
Help find profitable investment opportunities
It a part of the three-step, top-down plan for selecting attractive countries, attractive industriea and specific individual companies/stocks for a portfolio
What Do We Learn from Industry Analysis?
Is there a difference between the returns for alternative industries during specific time periods?
Will an industry that performs well in one period continue to perform well in the future? That is, can we use past relationships between the market and an individual industry to predict future trends for the industry?
Do firms within an industry show consistent performance over time?
Do firms within an industry show consistent performance over time?
Is there a difference in the risk for alternative industries?
Do firms within an industry show consistent performance over time?
Is there a difference in the risk for alternative industries?
Does the risk for individual industries vary or does it remain relatively constant over time?
Industry Performance
Wide dispersion in rates of return in different industries
Performance varies from year to year
Company performance varies within industries
Risks vary widely by industry but are fairly stable over time
--------
Refer Research papers
1. Stephen L. Myers, “A Re-examination of Market and Industry Factors in Stock Price behavior,” Journal of Finance, no.3 (June 1973);695-705
2. Miles Livingston, “Industry Movements of Common Stocks,” Journal of Finance 32, no.2 (June 1977): 861-874.
---------
Industry – Macroanalysis topics
The business cycle and industry sectors
Structural economic changes and alternative industries
Evaluating an industry’s life cycle
Analysis of the competitive environment in an industry
The Business Cycle and Industry Sectors
Financial Stocks
Towards end of recession, financial stocks rise in value because investors anticipate that bank’s earnings will rise as both the economy and loan demand recover.
Brokerage houses become attractive investments because their sales and earnings are expected to rise as investors trade securities, businesses sell debt and equity, and there is a rise in merger activity during economic recovery.
Consumer durable firms
Once economy begins recovery, consumer durable firms that produce expensive consumer items, such as cars, personal computers, refrigerators, etc. become attractive investments because a reviving economy will increase consumer confidence and personal income.
Once businesses recognize the economy is recovering, they begin to think about modernizing, renovating, or purchasing new equipment to satisfy rising demand and reduce costs.
Thus, capital goods industries such heavy equipment manufacturers, machine tool makers, and airplane manufacturers become attractive.
Cyclical industries
Basic metal industries
Traditionally, toward the business cycle peak, the rate of inflation increases as demand starts to outstrip supply.
Basic materials industries such as oil, metals, and timber, which transform raw materials into finished products become investor favourites.
Because inflation has little influence on the cost of extracting these products and they can increase prices, these industries experience higher profit margins.
Consumer staples
During a recession, some industries do better than others.
Consumer staples outperform other sectors during a recession because, although overall spending may decline, people still spend money on necessities.
Industries with large export components
If a weak domestic economy causes a weak currency, industries with large export components to growing economies may benefit.
Investor should not invest based on upon the current economic environment.
Rather it is necessary to forecast important economic variables at least three to six months in the future and invest accordingly.
Structural Economic Changes and Alternative Industries
Social Influences
Demographics
Lifestyles
Technology
Politics and regulations
Economic reasoning
Fairness
Regulatory changes affect numerous industries
Regulations affect international commerce
-------------
Refer
For excellent discussion of structural changes in the US economy and the implications for the stock market
William C.Dudley and Edward F.Mckelvey, “the Brave New Business Cycle: No Recession in Sight” (New York: Goldman, Sachs &Co., January 1997).
-------------
Evaluating the Industry Life Cycle
Five Stage Model
Pioneering development
Rapidly accelerating industry growth
Mature industry growth
Stabilization and market maturity
Deceleration of growth and decline
Analysis of Industry Competition
Competition and Expected Industry Returns
Porter’s concept of competitive strategy is described as the search by a firm for a favorable competitive position in an industry
To create a profitable competitive strategy, a firm must first examine the basic competitive structure of its industry
The potential profitability of a firm is heavily influenced by the profitability of its industry
Competitive Structure of an Industry
Porter’s Competitive Forces
Rivalry among existing competitors
Threat of new entrants
Threat of substitute products
Bargaining power of buyers
Bargaining power of suppliers
----------
Refer
Michael Porter, “Industry Structure and Competitive Strategy: Keys to Profitability,” financial Analysts Journal, 36, no.4 (July-August)
----------
Estimating Industry Rates of Return
Present value using required rate of return for the equity in the industry
Two-step P/E ratio approach uses expected value at the end of investment horizon and compute the expected dividend return during the period
Valuation using the reduced form DDM
S&P Retail Drug Store Index
Is used to demonstrate valuing industry index.
The index contains three companies
1. Longs Drug Stores
2. rite Aid
3. Walgreen company
Estimating the Required Rate of Return – page 500
the risk-free rate and Expected inflation rate are same for industry as well as market.
Risk premium for the industry versus the market depends on the industry’s
business risk (BR)
financial risk (FR)
liquidity risk (LR)
exchange rate risk (ERR)
country political risk (CR)
Can calculate systematic risk (beta) for the industry to the market beta of 1.0
Business Risk for RSD
Sales of RSD less volatile than PCE.
OPM of RSD less volatile than S&P Ind.
Hence BR for RDS less than Market.
Financial risk
Without accounting for financial leases, the debt of RSD less than market.
If we include financial leases the debt may be more.
We can conclude, this industry probably has financial risk about equal to the market.
Liquidity Risk
Walgreen is liquid in the markets.
Others not so.
A conservative view is that the RDS industry probably has above average liquidity risk.
Exchange Risk and country Risk
Do not exist because the industry is totally domestic.
Summary
For the RDS BR is below market, FR at best equal to, and LR above.
ER and CR non existent.
Consensus overall risk less than market.
Beta estimate = 0.82
Confirms the above analysis.
Specific estimate of k for RSD
R.F.R. = 5.2%
Market Return = 9.2%
K = 5.2 +0.82*4
= 8.48 rounded to 8.5%
Estimating the Expected Growth Rate
Earnings and dividend growth are determined by the retention rate and the return on equity
Earnings retention rate of industry compared to the overall market
Return on equity is a function of
the net profit margin
total asset turnover
a measure of financial leverage
Earnings Retention Rate
The retention rate data in Exhibit 14.54 indicate that the industry has a higher retention rate (69% vs. 55% for market).
Return on equity: is a function of profit margin, total asset turnover, and leverage
Profit margins are lower for RSD than market.
Retail store - lower margins –higher turnovers
Asset turnover for S&P I.I> 1.06
RDS 2.70
Return on Total assets (ROTA) for market went from 6.54% in 1977 to 5.29% in 2000.
For RDS it went down from 11.56% to 8.89% and averaged 8.35%.
--------------
Refer
For the analysis of components of ROA and its relation to industry’s economics and strategy
Thomas Selling and Clyde Stickney, ‘The Effects of Business Environment and Strategy on a Firm’s Rate of Return on Assets,” Financial Analysts Journal 39, no. 1 (January-February 1983)
--------------
Leverage
For index leverage went up from 2.08 to 3.09.
For industry it went up from 1.53 to 2.00
ROE estimate based on total period average (1977-2000)
Margin*TAT*(Total Assts/Equity)
S&P II 4.82*1.06*2.88 = 14.71
RDS 3.06*2.70*1.93 = 15.95
Historical trend and averages are important.
But don’t forget that expectations about future will determine value of equity shares.
In this particular case, as an analyst, it is necessary to determine whether the change during the recent period (1993-99) is permanent change.
If one uses the average of recent 5 years the ROE figures for the market and industry will be
S&P I.I. 5.84*0.88*3.34 = 17.16
RDS 2.70*2.2.6*2.27 = 13.85
Combining recent ROE with historical RR and Recent RR gives
Growth rate estimates
S&P II 17.16*0.55 = 9.44
S&P II 17.16*0.64 = 10.98
RDS industry 13.85*.69 = 9.56
RDS industry 13.85*.72 = 9.97
Given the decline in g for the industry in recent results it is probably appropriate to use a growth estimate for industry below the recent conservative estimate that 9.5%.
DDM for RDS - Combining the Estimates
K = 0.085
G = 0.095
D0 = $4.80
D1 = $4.80*1.095 = $5.26(Estd.Div. for 2002)
The long constant growth rate is below market at 7%.
Dividend Growth pattern predicted
2003-05 0.095
2006-07 0.090
2008-09 0.080
2010 onward 0.070
Discount dividends and terminal value gives I.V. estimate of $423.45
The current index value is 640.
So according to valuation of this model industry is overvalued by appx. 50%.
Is the valuation justified?
If you cannot justify a value lower than 8.5% for k and a value higher than 7% for g, you have to conclude that this industry is overvalued.
The Earnings Multiple Technique for RDS Industry
Estimating earnings per share
start with forecasting sales per share
Industrial life cycle
Input-output analysis
Industry-aggregate economy relationship
earnings forecasting and analysis of industry competition
competitive strategy
competitive environment
industry operating profit margin
industry earnings estimate
industry earnings multiplier
Forecasting Sales per Share
If analyst has understood the following
1. effect of business cycle on the industry.
2. structural changes that occurred in the industry in the recent period.
3. life cycle stage of the industry
He will be able to incorporate their implications in the estimates for the future.
Three estimation techniques suggested – page 510
Time series analysis of sales of the industry.
Input-output analysis of supply side and demand side.
Analysis of industry-economy relationship.
Time series analysis of industry sales
Analysing this series on a plot along with the sings for business cycle periods (expansions and recessions) and other major events will provide good insight into the behaviour of sales of the industry.
For many industries, it is possible to extrapolate the time series to derive a very useful estimate.
For industries that have experienced consistent growth, this can be a very useful estimate.
If sales growth has been constant rate, you should do the plot on semi-log paper where the constant growth shows as a straight line.
Input-output analysis
The goal of this analysis is to identify long-run sales outlook for its major customers and the supply capabilities and constraints of its suppliers.
Industry-Economy Relationships
The most rigorous and useful analysis involves comparing sales for an industry with one or several aggregate economic series that are related to the good and services produced by the industry.
Industry-Economic Relationship analysis for RDS Industry
Industry sells medical supplies as well as some non medical items like cosmetics, snacks, pop, and liquor.
Therefore, we want series that (1) reflects broad expenditures and (2) that gives weight to medical expenditure
Hence we consider PCE and PCE-Med-care
Both aggregate and per-capita values were given for the two series in Ex.14.12
A Casual analysis will shows that PCE increased at about 7.5% per year.
PCE-med increased at about 10% years.
Now PCE-med constitutes 15% of PCE where it was 9.6% in 1977.
Still one can see a decline in the PCE-med in recent days.
Industry is showing a growth of 13% per year.
The scatter plot in Ex.14.13 shows a good relationship between ind. Sales and PCE-med.
A good relationship was found between ind. Sales and PCE also.
Multivariate models having more variables can also be useful.
For example, for tire industry, new car-production, new-truck production, and a series that would reflect replacement tire demands may be used.
The best relation was found between RDS sales and PCE-med among the possible series.
The regression results was:
% Δ in RDS sales = 5.40 + 0.55(% Δ in PCE med-care)
R2 = 0.22
Using the Regression Equation
Find an estimate for PCE from estimates by banks and Financial Institutions.
Estimate the proportion of PCE med-care in PCE.
Find its increase from the previous year.
Use the figure in the equation to derive estimate of RDS sales increase.
Industry Profit Margin Forecast
Industry’s operating profit margin
(EBITDA / Sales)
Depreciation expense
interest expense
tax rate
Industry Profit Margin Forecast
Industry’s operating profit margin
(EBITDA / Sales)
Regression analysis can be done w.r.t. market’s operating margin.
Time series analysis of margin of the industry can be done.
It is a matter of judgement based on the scatter plots and fit of the model whether you use regression analysis or the time series for final estimation.
Long-term considerations including competitive structure are to be taken into consideration.
Regression and Time series techniques can be useful tools, but neither technique should be applied mechanically.
Mathematical techniques should be considered a supplement to the economic analysis of the competitive environment for the industry.
The analyst has to be aware of price areas, contract negotiations, building plans or foreign competition etc.
Industry Depreciation Forecast
Depreciation expense can be estimated
W.r.t to market depreciation estimate (regression)
Time series analysis of ind depreciation
Specific estimate based on estimate of PPE for the industry
Industry Depreciation Forecast
Depreciation expense
Generally increasing time series
Specific estimate technique using the depreciation expense/PPE ratio
Subtract depreciation from operating profit margin to determine industry’s net before interest and taxes
Specific estimate technique using the depreciation expense/PPE ratio
1. calculate the annual PPE turnover for the RDS industry.
2. Based on your sales estimate and your PPE turnover ratio estimate, estimate the expected PPE for the year.
3. Calculate the annual depreciation expense as a percent of PPE for the RDS industry
Industry Interest Expense Forecast – page 518
Interest expense is a function of financial leverage and interest rates
1. Calculate the annual total asset turnover (TATO)
2. Use your current sales estimate and an estimate of TATO to estimate total assets next year
3. Calculate the annual long-term (interest bearing) debt as a percent of total assets,
4. Estimate long-term debt for the next year
Industry Interest Expense Forecast
Interest expense (cont.)
5. Calculate the annual interest cost as a percent of long-term debt and analyze the trend
6. Estimate next year’s interest cost of debt for this industry based upon your prior estimate of market yields
7. Estimate interest expense based on the following estimates: (Interest Cost of Debt) (Outstanding Long-Term Debt)
Industry Tax Expense Forecast
Tax rate
Regression analysis
Time series plot
After estimating the tax rate, multiply the EBT per share value by (1 - tax rate) to estimate earnings per share
Derive an estimate of industry’s net profit margin as a check on your EPS estimate
Actual Estimate of EPS for 2002 for RDS industry
The outlook for PCE is for an increase of 5.0% in 2001(to about $7,100 BIL) AND A 3.6% INC. IN 2002 (TO $7,355 BIL).
PCE med care will be 14.8% of PCE in 2001 and 2002.
This gives PCE med as $1,088 billion in 2002.
Using this result in regression equation estimated earlier gives RDS sales estimate in 2002 as $870.
OPM for a retail drug store industry was 6.88% in 1999.
Although the OPM for the S&P II declined during 2000,RDS margins were expected to be stable at about 6.55.
The aggregate OPM was expected rebound in 2002 starting year of expansion.
Thus the OPM for RDS is expected to increase also. Hence estimate = 6.6%
Operating Profit - RDS index =.066*$870
= $57.42.
Depreciation estimate RDS 2002
The PPE turnover had tended to decline during the recent period.
A conservative estimate would be a PPE turnover of 7.40.
As the sales estimate is $870, the PPE estimate will be $117.57 for 2002.
Dep. Expense/PPE ratio was is in 10 and 12% range during 1997-2000.
The recent fiver year average indicates an estimate of 10.6%.
10.6% of $117.57 = $12.46
Hence PBIT = $57.42 - $12.46 = $44.96
Interest Expense Estimate for RDS for 2002 – p.519
Sales estimate $870
TAT has average about 2.15 over the most recent years
Hence total assets for 2002 = $405
Long-term interest bearing debt average about 15% for the RDS.
Implies debt next year = $405*0.15 = $61.
Int. expense during the most recent period has averaged 6.85% for this industry.
Based upon the expectation of a small increase in market interest rates during 2002, we would estimate this interest rate to be 7.00% in 2002.
Hence interest expense = 0.07*$61 = $4.27
Tax Expense p 519
Ex. 14.19.
Except for 1997, the RDS tax rate has moved with the economy’s tax rate.
But you have to consider pending national legislation and unique industry tax factors.
The tax rate of the RDS has been consistently higher than the aggregate.
The aggregate is expected to be stable in 2001 and 2002.
Hence a rate of about 39% seems to be appropriate for RDS.
This implies tax of 15.87 (40.69*0.39)
Hence EPS = 40.69 – 15.87 = 24.82
This implies a net profit margin for the RDS industry of 2.83% (24.82/870) which is slightly below the recent experience.
We will round up the estimate to $25.
Estimating an Industry Earnings Multiplier
Macroanalysis
relationship between multiplier for the industry and the market
variables that influence the multiplier:
required rate of return (k)
function of the nominal risk-free rate plus a risk premium
expected growth rate of earnings and dividend
dividend payout ratio
P/E ratio Relationship between industry and market
Study Reilly and Zeller (1974) showed a significant relationship P/e ratios for 71 S& P industries and S&P Ind. Index.
Between 1977 and 1999, ratio for drug stores was generally higher above the market’s.
In 1989 market P/E ratio went up and industry ratio was stable.
This was reversed in 1996 and industry ratio went above market.
Also industry ratio is less volatile.
Still the analyst has answer why the RDS multiplier is higher and also whether it will persist?
Estimating an Industry Earnings Multiplier
Microanalysis
Estimate the variables that influence the industry earnings multiplier and compare them to the comparable values for the market P/E
Industry multiplier versus the market multiplier
Comparing dividend-payout ratios
Estimating the required rate of return (k)
Estimating the expected growth rate (g)
g = Retention Rate (b) X Return on Equity (ROE)
= (b) X (ROE)
Comparing dividend payout ratios
Analyzing data in Ed.14.5 indicates that the retention rates in RDS are consistently higher than the aggregate (69% vs. 54%)
This indicates higher payout for S&P, which implies higher P/E for S&P.
Comparing the required rate of return
Estimate of k for the industry is 8.5.
Estimate for the market is 9.5.
Hence industry P/E must be higher than the market P/E
Comparing growth rate
Industry growth rate estimate is 9.5.
S& p II growth rates are estimated to be between 8.10% and 11.0%. The mean is 9.5%.
But we opt to bear the high value, we may take it as 10%.
Hence based on growth industry can be below market.
Thus overall the market may have a higher multiple.
As our estimate for P/E for S&P II is 30 to justify prevailing market price, industry P/E may be estimated as 25.
Estimate of Industry value
Expected EPS = $25
It is not possible to derive a specific estimate as g>k.
The comparative estimate gives 25 with a range of 20 to 30
Industry value range can be 500$-$625-$750
The industry index is overpriced w.r.t to expected value and slightly underpriced with respect to optimistic value.
R-B-Ch.15 Points to Refresh
Estimating Intrinsic Value
A. Present value of cash flows (PVCF)
1. Present value of dividends (DDM)
2. Present value of free cash flow to equity (FCFE)
3. Present value of free cash flow (FCFF)
B. Relative valuation techniques
1. Price earnings ratio (P/E)
2. Price cash flow ratios (P/CF)
3. Price book value ratios (P/BV)
4. Price sales ratio (P/S)
Present Value of Dividends
Simplifying assumptions help in estimating present value of future dividends
Assumption of constant growth rate
Intrinsic Value = D1/(k-g)
D1= D0(1+g)
Growth Rate Estimates
Average Dividend Growth Rate
Average Dividend Growth Rate – Calculation of Historical Value
My recommendation is log-linear regression
Sustainable Growth Rate = RR X ROE
For Walgreen
Historical Growth rate = 11.42%
Sustainable growth rate = 0.82*.183
= 15.09%
Average = 13.24%
Use a growth rate estimate of 13%
Required Rate of Return Estimate
Nominal risk-free interest rate
Risk premium
Market-based risk estimated from the firm’s characteristic line using regression
Required Rate of Return Estimate
Nominal risk-free interest rate
Risk premium
Market-based risk estimated from the firm’s characteristic line using regression
Assumptions regarding WalGreen – page 552
NRFR = 5 percent – the current ytm for intermediate term govt. bond.
For market risk premiums the authors will use 4.50%.
Beta is estimated using return during five year period (1996-2001) 60 observations.
The beta coefficient was estimated as 0.90
Hence required rate of return = 0.5 + .9*(.045)
= 0.090 = 9%
The Present Value of Dividends Model (DDM)
Model requires k>g
With g>k, analyst must use multi-stage model
As k = 9% & g = 13%
Multistage DDM is to be used
Growth periods
G1 = 7 years (growing at 13% per year)
G2 = 5 tears during which growth will decline by 1% per year
G3 = constant perpetual growth of 8 percent
*I am not in agreement with 8%.
*8% growth estimate will mean dividend yield of 1% during maturity period. It is very low.
Share Value DDM – page 554
The share value at the start of the maturity growth comes as 0.55(1.08)/(.09-.08)
= $59
*0.55 is dividend in the first year of maturity growth period
Discounting all dividends and maturity value to present value share value now = $23.11.
CMP of Walgreen
$38
Earnings Multiple or P/E Multiple Technique
Relative Valuation Techniques
Price Earnings Ratio
Affected by two variables:
1. Required rate of return on its equity (k)
2. Expected growth rate of dividends (g)
Estimating Company Earnings per Share
An estimate of the earnings per share for the company is a function of the sales forecast and the estimated profit margin.
The sales forecast includes an analysis of the relationship of company sales to various relevant economic series and to the concerned industry sales.
These comparisons tell use how the company is performing relative to the economy and to its closest competition.
These relationships provide background to the company, and also help us to develop specific sales estimates for Walgreen.
For estimating the relationship for Walgreen’s sales to the economy, several alternative series were considered.
Personal consumption expenditure for medicine (PCE medical care) had the strongest relationship.
The scatter plot of walgreen sales and the PCE medical care expenditures indicates the strong relationship
Walgreen sales and sales per share for the RDS industry were also compared.
It did not reflect as strong a relationship and was not used subsequently.
PCE medical vs. PCE
Proportion of PCE allocated to medical care went up from 10% in 1977 to almost 15% in 2001.
The increase in percentage is because of the growing proportion of population over 65 and the rising cost of medical care.
The increase in PCE medical occurred during economic recessions in 1981-82 and in 1990-91 also
Examination of Sales growth of Walgreen
Internal sales growth for Walgreen resulted from an increase in number of stores (from 644 in 1975 to 3,520 in 2001).
An increase in the annual sales per store also occurred because of the upgrading of stores.
The net increase in stores includes number of new large stores, and the closing of many smaller stores.
As a result, the average size of stores has increased.
More important, the firm has continued to increase its sales per thousand square feet at over 4 percent a year. This is a critical statistic in the retail industry.
Estimate of Walgreen’s Sales based macroeconomic data
To estimate PCE medical care, you should initially project total PCE.
As noted in Ch.14, economists were forecasting an increase in 3 percent in PCE during 2002.
This implies a PCE 2002 estimate of $7,267.
The PCE medical was estimated to be 15% of total PCE.
Hence PCE medical 2002 will be $1,090 billion.
This means a growth of 4.4% on 2001.
Historical relationship between PCE medical care and Walgreen sales (Exhibit 15.7) implies a 7.5% increase in Walgreen sales. (Please check)
This is below the firm’s recent growth in sales.
Alternative estimate using square footage
Industry/companies provide data on square footage and the number of stores.
If we estimate the increase in store area of Walgreen during 2002 as 4.5 million square feet (which is less than in most years), the firm’s total sales area would be about 42.7 million square feet.
As noted, sales per square foot have likewise increased.
Assuming a conservative increase of $650 of sales per thousand square feet implies a sales forecast of about $27.75 billion for 2002, a 12.7 percent increase over 2001 sales of $24.62 billion.
Alternative estimate using number of stores
Walgreen is expected to open 475 stores during 2002.
Assuming it closes 60, this would be a net addition of 415 stores. Total stores will reach 3,935 stores at the end of 2002.
Assuming sales per store to reach $7.25 million, will an estimate of $28.53 billion (3,935*7.25 million) .
This will mean an increase of 16 percent over 2001.
Final estimate
Given the three estimates, the preference is for an estimate close to the high value because of the positive economic environment and the company’s ability to increase sales between 16 and 18 percent a year during 2001 and 2000.
Therefore we will assume 15 percent increase, which implies a final sales forecast for 2002 of $28 billion.
Estimating the Company Profit Margin
Projection of earnings per share should include three considerations.
1. Identifaction and evaluation of the firm’s specific competitive strategy – that is either, low-cost or differentiation.
2. Firm’s internal performance, including general company trends and consideration of any problems that might affect its future performance.
And (3) the firm’s relationship with its industry, which should indicate whether the company’s past performance is attributable to its industry or if it is unique to the firm.
These examinations should help us understand the firm’s past performance and should also provide the background to make meaningful estimate for the future.
Walgreen’s competitive Strategies ( No value implication found)
Based on annual reports, walgreen has pursued both strategies with different segments of its business.
The firm’s size and buying power allow it to be a cost leader for some its nonprescriptive products such liquor, icecream, candy and softdrinks.
These items are advertised heavily to attract customer traffic and to build customer loyalty.
At the same time Walgreen has attempted to build a strong franchise in the medical prescription business based on differentiation in service.
The Internal performance
Exhibit 15.9
The profit margins for Walgreen increased from 1977 to the mid-1980s followed by a decline through 1988 and a recovery beginning in 1991.
In contrast, the margins for the RDS industry experienced a relatively steady decline after a peak in 1983.
Overall, Walgreen experienced a positive trend in its operating and net profit margins over the past 24 years.
To predict future values, you need to determine the reason for the overall decline in the industry profit margin and, more important, what factors have contributed to Walgreen’s strong positive performance.
Internal Performance - Industry Factors
Industry profit margins have declined over the last two decades due to price discounting by aggressive regional chains.
Ch.14 suggested this as one of the competitive structure conditions that affect long-run profitability.
Industry analysts have observed that price cutting has subsided, and they foresee relative price stability.
In addition, drugstores have tended toward a more profitable product mix featuring high-profit-margin items, such as cosmetics, and this has had a positive influence on profit margins.
Company - Performance
Walgreen’s profit margin has shown consistent improvement.
The outlook for profit margin is good because the firm has developed a strong position in the pharmacy business and has invested in service including mail-order prescriptions and inventory-control technology that will help the firm experience strong margins on this business.
The firm also emphasized high-profit margin items, such as greeting cards, photofinishing, and cosmetics.
Specific Estimate for Walgreens
Specific estimates for Walgreen’s future margins typically would begin with an analysis of the firm’s relationship with drugstore industry margins using time-series plots (Ex. 15.10)
This time series (1977-2000) showed good results for Walgreen versus its industry prior to 1997 followed by Walgreen outperforming through 2000.
You should consider any unique factors that would influence this long run relationship,such as price wars or an abnormal number of store openings or closings by the firm
Following a consideration of the long-run company-industry profit-margin relationship, you should analyse the firm’s common-size income statement for several years.
The breakdown of the income statement depends on the consistent detail provided by the firm
Analysis of cost of goods sold and SG&A expenditure is encouraging.
The cost of goods sold increased slightly less than 1%.
There was a larger decline in the percentage of SGA expense through 2000.
As a result, the operating profit margin increased from 5.46% to 5.68%.
Interest expense was not a factor.
Tax rate remained between 38 and 40 percent during the last several years.
Net Profit Margin Estimate
The overall industry outlook is encouraging because of stable prices, an increase in mechanization within the industry, and the inclusion of more high-profit-margin items.
Therefore, the industry profit margin is expected to increase slightly during 2002.
Because of Walgreen’s strong performance relative to its industry profit margin and the increase in margin since 1995 (Ex.15.11) it is estimated that the firm will show a small increase during 2002 to 3.55%.
Computing Earnings per Share
This margin estimate combined with the prior sales estimate of $28 billion, indicates net income of $994 million.
Assuming about 1,030 million common shares outstanding, earnings should be about $0.97 per share for 2002.
This estimates gives an increase of 13% of EPS of $0.86 in 2001.
Importance of Quarterly Estimates
It is essential to derive quarterly estimates from annual estimates.
First it will confirm our annual estimates. Do quarterly estimates reasonable and sum up to annual figure?
Second, unless we have quarterly forecasts, we will not be able in a position to determine whether the subsequent actual results are a positive surprise, negative surprise, or not surprise.
Further, if the actual results are a surprise relative to our estimate, we will want to understand the reason for the surprise.
We have to understand whether we under- or overestimated sales growth and/or profit margin.
This understanding is needed for an estimated earnings revision that reflects the new information from the company.
We would probably revise each of our future quarterly estimates to arrive at a new annual estimate.
Estimating Company Earnings Multipliers
Two approaches
Macro analysis – starting from market and industry.
Micro analysis – Estimate a multiplier based on its three components: the dividend-payout ratio, the required rate of return, and the rate of growth
We then resolve the estimates derived from each approach and settle on one estimate.
Macro Analysis of the Earnings Multiplier p.569
Ratio for the period of 1977-2000.
After 1987 walgreen’s P/E has generally followed industry multiple with ration between 1.00 to 1.5
Walgreen multiple is also higher than market from 1994 with ratio between 1.10 and 1.40
Is the higher value for Walgreen’s P/E relative to both its industry and the market that generally prevailed since 1992 justified?
Microanalyses should provide some insights regarding this question.
Micro analyses
Div pay out ratio:
Walgreen almost always had a lower payout.
Implies lower P/e relative to market and industry
k
Walgreen should have relatively lower BR due to its stable sales growth.
Fin Risk: leverage ration less than 2.0 less than market and comparable to the industry.
The liquidity risk is low compared to its industry and average in the market.
Exchange risk and country risk very little in relation to market.
This implies overall risk for Walgreen should be lower than the market.
Beta is also 0.90
Hence based on k P/E should be higher for Walgreen.
Expected Growth Rate
Using the average of results of the last three years ROEs will approximately as follows
NPM TAT ROA Ta/Equity ROE
Wal 3.54 3.04 10.76 1.68 18.08
Ind 2.77 2.35 6.51 2.52 16.40
S&P 5.86 0.84 4.92 3.60 17.71
Exp. Growth Rates
Using the average recent retention rates
R.R. ROE Exp.Gr.Rate
Walgreens 0.79 18.08 0.1428
RDS 0.77 16.40 0.1148
S&P 0.63 17.71 0.1116
Comparing estimates of D/D, K and g to comparable values for the industry and the market, we find that Walgreen’s multiplier should be greater than the industry and market.
Assuming a market multiple of 23 for market, 26 for RDS industry Walgreen can have a multiple of 30. with range of 28-30-32
Value of Walgreen
Exp. EPS = 0.97
Value range
28*0.97 = $27.16
30*0.97 = $29.10
32*$0.97 = $31.04
The CMP of Walgreen is $38.
We cannot recommend Walgreen for buy.
Site Visits and the Art of the Interview
Focus on management’s plans, strategies, and concerns
Restrictions on nonpublic information
“What if” questions can help gauge sensitivity of revenues, costs, and earnings
Management may indicate appropriateness of earnings estimates
Discuss the industry’s major issues
Review the planning process
Talk to more than just the top managers
When to Sell
Holding a stock too long may lead to lower returns than expected
If stocks decline right after purchase, is that a further buying opportunity or an indication of incorrect analysis?
Continuously monitor key assumptions
Evaluate closely when market value approaches estimated intrinsic value
Know why you bought it and watch for that to change
Efficient Markets
Opportunities are mostly among less well-known companies
To outperform the market you must find disparities between stock values and market prices - and you must be correct
Concentrate on identifying what is wrong with the market consensus and what earning surprises may exist
Influences on Analysts
Investment bankers may push for favorable evaluations
Corporate officers may try to convince analysts
Analyst must maintain independence and have confidence in his or her analysis
Global Company and Stock Analysis
Factors to Consider:
Availability of Data
Differential Accounting Conventions
Currency Differences (Exchange Rate Risk)
Political (Country) Risk
Transaction Costs
Valuation Differences
A. Present value of cash flows (PVCF)
1. Present value of dividends (DDM)
2. Present value of free cash flow to equity (FCFE)
3. Present value of free cash flow (FCFF)
B. Relative valuation techniques
1. Price earnings ratio (P/E)
2. Price cash flow ratios (P/CF)
3. Price book value ratios (P/BV)
4. Price sales ratio (P/S)
Present Value of Dividends
Simplifying assumptions help in estimating present value of future dividends
Assumption of constant growth rate
Intrinsic Value = D1/(k-g)
D1= D0(1+g)
Growth Rate Estimates
Average Dividend Growth Rate
Average Dividend Growth Rate – Calculation of Historical Value
My recommendation is log-linear regression
Sustainable Growth Rate = RR X ROE
For Walgreen
Historical Growth rate = 11.42%
Sustainable growth rate = 0.82*.183
= 15.09%
Average = 13.24%
Use a growth rate estimate of 13%
Required Rate of Return Estimate
Nominal risk-free interest rate
Risk premium
Market-based risk estimated from the firm’s characteristic line using regression
Required Rate of Return Estimate
Nominal risk-free interest rate
Risk premium
Market-based risk estimated from the firm’s characteristic line using regression
Assumptions regarding WalGreen – page 552
NRFR = 5 percent – the current ytm for intermediate term govt. bond.
For market risk premiums the authors will use 4.50%.
Beta is estimated using return during five year period (1996-2001) 60 observations.
The beta coefficient was estimated as 0.90
Hence required rate of return = 0.5 + .9*(.045)
= 0.090 = 9%
The Present Value of Dividends Model (DDM)
Model requires k>g
With g>k, analyst must use multi-stage model
As k = 9% & g = 13%
Multistage DDM is to be used
Growth periods
G1 = 7 years (growing at 13% per year)
G2 = 5 tears during which growth will decline by 1% per year
G3 = constant perpetual growth of 8 percent
*I am not in agreement with 8%.
*8% growth estimate will mean dividend yield of 1% during maturity period. It is very low.
Share Value DDM – page 554
The share value at the start of the maturity growth comes as 0.55(1.08)/(.09-.08)
= $59
*0.55 is dividend in the first year of maturity growth period
Discounting all dividends and maturity value to present value share value now = $23.11.
CMP of Walgreen
$38
Earnings Multiple or P/E Multiple Technique
Relative Valuation Techniques
Price Earnings Ratio
Affected by two variables:
1. Required rate of return on its equity (k)
2. Expected growth rate of dividends (g)
Estimating Company Earnings per Share
An estimate of the earnings per share for the company is a function of the sales forecast and the estimated profit margin.
The sales forecast includes an analysis of the relationship of company sales to various relevant economic series and to the concerned industry sales.
These comparisons tell use how the company is performing relative to the economy and to its closest competition.
These relationships provide background to the company, and also help us to develop specific sales estimates for Walgreen.
For estimating the relationship for Walgreen’s sales to the economy, several alternative series were considered.
Personal consumption expenditure for medicine (PCE medical care) had the strongest relationship.
The scatter plot of walgreen sales and the PCE medical care expenditures indicates the strong relationship
Walgreen sales and sales per share for the RDS industry were also compared.
It did not reflect as strong a relationship and was not used subsequently.
PCE medical vs. PCE
Proportion of PCE allocated to medical care went up from 10% in 1977 to almost 15% in 2001.
The increase in percentage is because of the growing proportion of population over 65 and the rising cost of medical care.
The increase in PCE medical occurred during economic recessions in 1981-82 and in 1990-91 also
Examination of Sales growth of Walgreen
Internal sales growth for Walgreen resulted from an increase in number of stores (from 644 in 1975 to 3,520 in 2001).
An increase in the annual sales per store also occurred because of the upgrading of stores.
The net increase in stores includes number of new large stores, and the closing of many smaller stores.
As a result, the average size of stores has increased.
More important, the firm has continued to increase its sales per thousand square feet at over 4 percent a year. This is a critical statistic in the retail industry.
Estimate of Walgreen’s Sales based macroeconomic data
To estimate PCE medical care, you should initially project total PCE.
As noted in Ch.14, economists were forecasting an increase in 3 percent in PCE during 2002.
This implies a PCE 2002 estimate of $7,267.
The PCE medical was estimated to be 15% of total PCE.
Hence PCE medical 2002 will be $1,090 billion.
This means a growth of 4.4% on 2001.
Historical relationship between PCE medical care and Walgreen sales (Exhibit 15.7) implies a 7.5% increase in Walgreen sales. (Please check)
This is below the firm’s recent growth in sales.
Alternative estimate using square footage
Industry/companies provide data on square footage and the number of stores.
If we estimate the increase in store area of Walgreen during 2002 as 4.5 million square feet (which is less than in most years), the firm’s total sales area would be about 42.7 million square feet.
As noted, sales per square foot have likewise increased.
Assuming a conservative increase of $650 of sales per thousand square feet implies a sales forecast of about $27.75 billion for 2002, a 12.7 percent increase over 2001 sales of $24.62 billion.
Alternative estimate using number of stores
Walgreen is expected to open 475 stores during 2002.
Assuming it closes 60, this would be a net addition of 415 stores. Total stores will reach 3,935 stores at the end of 2002.
Assuming sales per store to reach $7.25 million, will an estimate of $28.53 billion (3,935*7.25 million) .
This will mean an increase of 16 percent over 2001.
Final estimate
Given the three estimates, the preference is for an estimate close to the high value because of the positive economic environment and the company’s ability to increase sales between 16 and 18 percent a year during 2001 and 2000.
Therefore we will assume 15 percent increase, which implies a final sales forecast for 2002 of $28 billion.
Estimating the Company Profit Margin
Projection of earnings per share should include three considerations.
1. Identifaction and evaluation of the firm’s specific competitive strategy – that is either, low-cost or differentiation.
2. Firm’s internal performance, including general company trends and consideration of any problems that might affect its future performance.
And (3) the firm’s relationship with its industry, which should indicate whether the company’s past performance is attributable to its industry or if it is unique to the firm.
These examinations should help us understand the firm’s past performance and should also provide the background to make meaningful estimate for the future.
Walgreen’s competitive Strategies ( No value implication found)
Based on annual reports, walgreen has pursued both strategies with different segments of its business.
The firm’s size and buying power allow it to be a cost leader for some its nonprescriptive products such liquor, icecream, candy and softdrinks.
These items are advertised heavily to attract customer traffic and to build customer loyalty.
At the same time Walgreen has attempted to build a strong franchise in the medical prescription business based on differentiation in service.
The Internal performance
Exhibit 15.9
The profit margins for Walgreen increased from 1977 to the mid-1980s followed by a decline through 1988 and a recovery beginning in 1991.
In contrast, the margins for the RDS industry experienced a relatively steady decline after a peak in 1983.
Overall, Walgreen experienced a positive trend in its operating and net profit margins over the past 24 years.
To predict future values, you need to determine the reason for the overall decline in the industry profit margin and, more important, what factors have contributed to Walgreen’s strong positive performance.
Internal Performance - Industry Factors
Industry profit margins have declined over the last two decades due to price discounting by aggressive regional chains.
Ch.14 suggested this as one of the competitive structure conditions that affect long-run profitability.
Industry analysts have observed that price cutting has subsided, and they foresee relative price stability.
In addition, drugstores have tended toward a more profitable product mix featuring high-profit-margin items, such as cosmetics, and this has had a positive influence on profit margins.
Company - Performance
Walgreen’s profit margin has shown consistent improvement.
The outlook for profit margin is good because the firm has developed a strong position in the pharmacy business and has invested in service including mail-order prescriptions and inventory-control technology that will help the firm experience strong margins on this business.
The firm also emphasized high-profit margin items, such as greeting cards, photofinishing, and cosmetics.
Specific Estimate for Walgreens
Specific estimates for Walgreen’s future margins typically would begin with an analysis of the firm’s relationship with drugstore industry margins using time-series plots (Ex. 15.10)
This time series (1977-2000) showed good results for Walgreen versus its industry prior to 1997 followed by Walgreen outperforming through 2000.
You should consider any unique factors that would influence this long run relationship,such as price wars or an abnormal number of store openings or closings by the firm
Following a consideration of the long-run company-industry profit-margin relationship, you should analyse the firm’s common-size income statement for several years.
The breakdown of the income statement depends on the consistent detail provided by the firm
Analysis of cost of goods sold and SG&A expenditure is encouraging.
The cost of goods sold increased slightly less than 1%.
There was a larger decline in the percentage of SGA expense through 2000.
As a result, the operating profit margin increased from 5.46% to 5.68%.
Interest expense was not a factor.
Tax rate remained between 38 and 40 percent during the last several years.
Net Profit Margin Estimate
The overall industry outlook is encouraging because of stable prices, an increase in mechanization within the industry, and the inclusion of more high-profit-margin items.
Therefore, the industry profit margin is expected to increase slightly during 2002.
Because of Walgreen’s strong performance relative to its industry profit margin and the increase in margin since 1995 (Ex.15.11) it is estimated that the firm will show a small increase during 2002 to 3.55%.
Computing Earnings per Share
This margin estimate combined with the prior sales estimate of $28 billion, indicates net income of $994 million.
Assuming about 1,030 million common shares outstanding, earnings should be about $0.97 per share for 2002.
This estimates gives an increase of 13% of EPS of $0.86 in 2001.
Importance of Quarterly Estimates
It is essential to derive quarterly estimates from annual estimates.
First it will confirm our annual estimates. Do quarterly estimates reasonable and sum up to annual figure?
Second, unless we have quarterly forecasts, we will not be able in a position to determine whether the subsequent actual results are a positive surprise, negative surprise, or not surprise.
Further, if the actual results are a surprise relative to our estimate, we will want to understand the reason for the surprise.
We have to understand whether we under- or overestimated sales growth and/or profit margin.
This understanding is needed for an estimated earnings revision that reflects the new information from the company.
We would probably revise each of our future quarterly estimates to arrive at a new annual estimate.
Estimating Company Earnings Multipliers
Two approaches
Macro analysis – starting from market and industry.
Micro analysis – Estimate a multiplier based on its three components: the dividend-payout ratio, the required rate of return, and the rate of growth
We then resolve the estimates derived from each approach and settle on one estimate.
Macro Analysis of the Earnings Multiplier p.569
Ratio for the period of 1977-2000.
After 1987 walgreen’s P/E has generally followed industry multiple with ration between 1.00 to 1.5
Walgreen multiple is also higher than market from 1994 with ratio between 1.10 and 1.40
Is the higher value for Walgreen’s P/E relative to both its industry and the market that generally prevailed since 1992 justified?
Microanalyses should provide some insights regarding this question.
Micro analyses
Div pay out ratio:
Walgreen almost always had a lower payout.
Implies lower P/e relative to market and industry
k
Walgreen should have relatively lower BR due to its stable sales growth.
Fin Risk: leverage ration less than 2.0 less than market and comparable to the industry.
The liquidity risk is low compared to its industry and average in the market.
Exchange risk and country risk very little in relation to market.
This implies overall risk for Walgreen should be lower than the market.
Beta is also 0.90
Hence based on k P/E should be higher for Walgreen.
Expected Growth Rate
Using the average of results of the last three years ROEs will approximately as follows
NPM TAT ROA Ta/Equity ROE
Wal 3.54 3.04 10.76 1.68 18.08
Ind 2.77 2.35 6.51 2.52 16.40
S&P 5.86 0.84 4.92 3.60 17.71
Exp. Growth Rates
Using the average recent retention rates
R.R. ROE Exp.Gr.Rate
Walgreens 0.79 18.08 0.1428
RDS 0.77 16.40 0.1148
S&P 0.63 17.71 0.1116
Comparing estimates of D/D, K and g to comparable values for the industry and the market, we find that Walgreen’s multiplier should be greater than the industry and market.
Assuming a market multiple of 23 for market, 26 for RDS industry Walgreen can have a multiple of 30. with range of 28-30-32
Value of Walgreen
Exp. EPS = 0.97
Value range
28*0.97 = $27.16
30*0.97 = $29.10
32*$0.97 = $31.04
The CMP of Walgreen is $38.
We cannot recommend Walgreen for buy.
Site Visits and the Art of the Interview
Focus on management’s plans, strategies, and concerns
Restrictions on nonpublic information
“What if” questions can help gauge sensitivity of revenues, costs, and earnings
Management may indicate appropriateness of earnings estimates
Discuss the industry’s major issues
Review the planning process
Talk to more than just the top managers
When to Sell
Holding a stock too long may lead to lower returns than expected
If stocks decline right after purchase, is that a further buying opportunity or an indication of incorrect analysis?
Continuously monitor key assumptions
Evaluate closely when market value approaches estimated intrinsic value
Know why you bought it and watch for that to change
Efficient Markets
Opportunities are mostly among less well-known companies
To outperform the market you must find disparities between stock values and market prices - and you must be correct
Concentrate on identifying what is wrong with the market consensus and what earning surprises may exist
Influences on Analysts
Investment bankers may push for favorable evaluations
Corporate officers may try to convince analysts
Analyst must maintain independence and have confidence in his or her analysis
Global Company and Stock Analysis
Factors to Consider:
Availability of Data
Differential Accounting Conventions
Currency Differences (Exchange Rate Risk)
Political (Country) Risk
Transaction Costs
Valuation Differences
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