Equity analysis b Value PV of future

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Equity analysis b Value = PV of future benefits b EIC approach b Applied Valuation • Dividend based models • Earnings based models b Financial Statement Analysis

The EIC Approach b Economy - Industry - Company • Performance of firm is conditioned by how its industry is expected to fare. • Performance of industry is conditioned by how the economy performs • Often called a “top-down” approach • Are you seeking relative or absolute performance?

Economic Analysis b Economic growth tied to (US) Monetary and Fiscal policy as well as Business Cycle b Fed has 4 goals: • • Stable prices (low inflation) Low unemployment Sustained real growth in GDP Reasonable balance in international payments

Economic Analysis b Fed has material control over US monetary policy (reserve requirements, discount rate, open market operations) b Fed can move interest rates! b Fiscal policy: Gov’t ability to tax & spend (Deficit or surplus) b Relevance to an individual firm?

Business Cycles b Economy does expand contract b Helps to know where we are within a business cycle b NBER monitors economic variables that correlate with real GDP growth • • • Leading indicators Coincident indicators Lagging indicators

Industry Analysis b Industry Life Cycle b Common considerations • • • Nature of competition Market share for each firm Labor conditions Regulatory environment Price elasticity of demand supply Sensitivity of demand to economic conditions

Equity Analysis b Basic inputs • • financial statement data position in industry international investment rate of growth breakdowns by product, division, subsidiaries R&D efforts Major litigation

Applied Valuation b Dividend discount model • Value = PV of future Dividends – need forecasts of Dividends (D), growth rate (g), and a required rate of return (k) b Example: KO • • D 0 = 0. 68, EPS 0 = $1. 25 (ttm) g = 8. 2% (five year div. growth) g = ROE x RR =. 3231 x. 5440 = 17. 58% k =. 0351 + 0. 70(. 155 -. 0351) = 11. 90% (CAPM)

Valuing KO b Constant dividend growth • V 0 = D 1/(k - g) • V = (0. 68 x 1. 082)/(. 1190 -. 0820) • V = $19. 89 < $45. 90 (in July ‘ 01] • If dividend growth model is to work, – change assumptions – modify model

Valuing KO b Multiple stage dividend growth • Suppose growth starts at 17. 58% for the first 3 years and then settles out at a long term rate of 8. 2%. – D 1 = 0. 800, D 2 = 0. 940, D 3 = 1. 105, D 4 = 1. 196 • • • V 3 = D 4/(k - g) = 32. 324 PV of D 1, D 2 , D 3 , V 3 = $25. 324 Where have we gone wrong?

Valuing KO b Earnings based models • P/E approach – P/E is measured using current price and either – – – Trailing 12 mo. EPS (P 0/E 0) EPS forecast for the next 12 mo. (P 0/E 1) Leading P/E is considered superior, but practitioners use both ratios. – V 0 = (EPS) x (P/E) – P/E = f( growth, retention rate, inflation)

Valuing KO b Suppose D grows at 17. 58% for 3 years and a (trailing) P/E of 40 will exist at that time • • D 1 = 0. 800, D 2 = 0. 940, D 3 = 1. 105 V 3 = 1. 25(1. 1758)3 (40) = (2. 032)(40) = $81. 28 PV of D 1, D 2 , D 3 , V 3 = $60. 26 IF you can buy KO for$60. 26 or less AND you think your assumptions are plausible, BUY!

Valuing KO b KO’s actual P/E (using best data 7/3/01]: • Trailing = 45. 90/1. 25 = 36. 72 • Leading = 45. 90/1. 78 = 25. 79 b Estimate of P/E may have been aggressive, but D and EPS growth may be conservative. b Forecasting EPS becomes paramount! b Other multipliers: P/S, P/B, P/CF, . . .

Forecasting EPS b Two primary approaches: • Trend analysis • Fundamental approach b Trend Analysis • Do EPS figures exhibit a trend over time? • Is recent growth expected to continue?

Forecasting EPS for DELL b Forecast sales growth for DELL using trend analysis: • Geometric average: 42. 38% b Forecast sales growth for industry! b Will DELL maintain market share? b Build a sales forecast from other data

Forecasting EPS for DELL b Which Income Statement items drive EPS? b Focus on ratios! • • basis for comparison with other firms identifies strategies, competence, deficiencies when examined over time b Ratio Analysis • Liquidity • Asset Utilization Profitability Leverage

Forecasting EPS for DELL b Let’s focus on Sales, NPM, and Payout. • Industry Sales are forecast to increase by 15%. Assume DELL will hold their share. • NPM? It has weakened in past years. Was 7. 0% for FY 01 and is 6. 7% in trailing 4 quarters. • Dividend Payout? None paid currently. None expected in next 2 years.

Forecasting EPS for DELL b EPS = (S x NPM)/#sh b S 1 = (32640. 0)(1. 15) = $37536. 0 b EPS 1 = (37536. 0)(. 07)/2604 = $1. 009 b Suppose we expect DELL to sell at a P/E of 39 next year. b P 1 = $1. 009 x 39 = $39. 35 b P 0 = $39. 35/1. 2989= $30. 29 (>$26. 48]

Valuing DELL b Reality check • • • Growth estimate? Required return? P/E estimate? Sensitivity analysis Qualitative adjustment of critical variables

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