Study Session 14

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Study Session 14
2012-04-05 19:15:57
Study Session 14

Study Session 14
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  1. What is industry rotation? Performance Attribution Analysis?
    Overweighting or underweighting industries based on curren phase of the business cycle.

    Perfomrance Attribution analysis is analysis of the sources of portfolio retrun determined relative to a benchmark.
  2. What are different way companies grouped?
    Principal business activity - largest source of sale or earnings.

    Sensitivity to business cycles - cyclical and non-cyclical

    Statistical methods - cluster analysis method groups firms that have historically highly correlated returns. Limitations are historic correlations not same as fuutre. Groupings of firms differ over time and accross coutries. Grouping is sometimes not intuitive. Method is suxceptible to statistical error.
  3. Industry Clasification Systems? Different commercial classification sectors industries?
    Clasifying firms by industry provides methods of examinging firms in different coutnries on similiar basis.

    Broadest is sector levelm, followed by industry, and sub industry.

    • DIfferent industries:
    • -Basic materials and processing
    • -Consumer Discretionary (auto, apparel, hotels, retsaurants)Firms are cylical
    • -Consumer Staples (firms less cyclical, food, beverage, tobacco, personal care)
    • -Financial Services
    • -Heatlh care
    • -Industrial and producer durables (heavy machinery, aerospace, defense, transportation)
    • -Technology
    • -Telecomunications and Utilities.
  4. Government Classifications? Difference betwee commercial and government classifications.
    Several government bodies provid industry classifications of firms.Interantional standard industrial classificaion of all economic activity... North american industry calssification system, etc.

    Methodlolgies of government provers use in compliation of industry group different from commercial provider.

    Most governemtns do not id indiviudal firms. Commercial providers identify constituent firms. Governmetn systems updated less frequently. NAICS updated every 5 years. Govts do not distinguish between small and large firms for profit or NPO, or privat vs public firms. Commercial only include for profit and public firms and can delineate size.
  5. Cyclical Firm vs non cyclical. Within non cyclical what are two types of firms?
    Cyclical are firms whose earnings highly dependant on stage of businss cycle. High earnings volatility and high operating leverage. E.x basic materials and processing, consumer discretionary, energy, financial services, technology, etc.

    Non cyclical firms produce goods which demand is stable. Telecommunications, utilities, consumer staples.

    Within Non cyclical are defensive and growth industries. Defensive industries are least affected by businss cycle. Growth industries have demand so strong they are largley unaffected by stage of business cycle.

    These labels are not always hold true. Cyclical growth companies exist...
  6. Peer group?
    Peer group is a set of similar companies an anlyst will use for valuation comparisons. Will consist of companies with simliar business activity, demand drivers, cost structure drivers,a nd availability of capital.
  7. What are industry growth factors that can be a component of analysts strategic analysis?
    • macroeconmic factors - trends like GDP, interes treates, inflation
    • technology - which dramttically changes industry (think camera's to digital)
    • Demographic factors - age distribution and poulation size
    • Governmeents - taxes and regulations
    • -Social influcnecs - how people work, play, spend money, and conduct lives
  8. What is industry life cycle? What are different stages? Characteristics of industry at each stage.
    Industry life cycle analysis should be compenonet of analysts strategic analysis. stage in cycle has impact on competitoion, growth, profits.

    Embryonic - industry has just started. Slow growth (customers unfamiliar with product), high prices (R&D Costs high vlume for eocmies scale not hit).Large Investment Requried. High Risk of Failure (most ebryonic fail)

    • Growth Stage, industry is in rapid growth.
    • -Rapid Growth(customers discover product)
    • -Limited competitive pressures(threat of new firms coming into market during growth phase, but rapid growth allows firms to growt without competing on price)
    • -Falling prices (economies of scale reched distribution channels increased)
    • -Increasing profitability (due to e of Scale)

    • Shakeout - industry growth and profitablity are slowing due to stong competion.
    • -Growth slowed (demand reaches saturation levle)
    • -Intense competition (Growth slowed, firms growth must come at expesne of others)
    • -Increasing industry overcapacity (firm investment exceeds increases in demand)
    • -Increased cost cutting
    • -Increased failures (weaker brands liquidate or acquired)

    • Mature stage, little growth firms begin to consolidate.
    • -Slow growth(demand only for replacement)
    • -Consildation (market oligopoly evolves)
    • -High Barriers To Entry
    • -Stable Pricing (firms try to avoid price wars)
    • Superior firms gain market share(firms with better prodcuts may grow faster than industry average)

    • Decline Stage,- industry growth negative
    • -declinding prices (intense competion and price war due to overcapacity)
    • -Failing firms exit or merge
  9. Fragmented market usually results in weaker or stronger competition?Does industry concentration effect pricing power? Do barriers to exit affect ROI and Pricing power as well?
    stronger. Many industry members means one firm can't set price tone for entire industry.

    It depends. If low barriers to entry and hi gh concentration not neccesarily much pricing power. If industry capital intenseive and costly to enter or exit, overcapacity can result in intesne competion.

    Barriers to exit and pricing power have a big ipact on ROI an dpricing power.
  10. Capacity is (insert) in the short run and (insert) in the long run.

    Is capacity phycial?
    Capacity is fixed in short run and variable in long run.

    Industry capacity has a huge imapct on pricing power. Undercapacity means demand exceeds supply which means a lot of pricing power. Cyclical industry's have capacity issues.

    Capacity is not neccesarily physical. Increase in demand for insurance can be more easily and quickly met than increasei n demand for other physical products.

    If cphyisal and specialized overcapacity can exist for extend period of time. Specialized products may have low liquiditaiton value and costly to reallocate to different product. Non0physical capacity can be reallocated more quickly (financial capacity)
  11. Do high switching costs lead to more ROI and Pricing Power?
    Yes, because it costs more time and money to switch
  12. Economic profit?Strategic analysis michael porter, 5 things to look at?What are first 2 to look at typically?
    Economic profit is return on invested capital minus its costs. Degree depends on pricing power.

    • 5 forces delineating industry competition
    • 1.Rivalry among existing competiors
    • 2Threat of new entrant
    • 3threat of substitue product
    • 4. bargaing power of buyers
    • 5bargaing power of suppliers.

    First 2 are: threat of new entrant, and rivalry amont existing compeitors (competion)
  13. In a company analysis what are most important things to look at?

    What are 2 competitive stratgies defined by porter?
    -finacial position, producst and services, and competitive strategy

    -Low cost and Differentiated. Must decide on one to compete effectivley.
  14. Explain rationale for using present value of cash flow models to value equity and describe dividen discount and free cahs flow to equity models?DDM?One Year hodling period DDM?Multi year DDM?FCFE model?
    In the discounted cash flow models a stocks value is estimated and present of cash distributed to shareholders (dividend discount models) or the present value of cash avaialbe to shareholders after firm meets its necessary capital expenditure and working capital expenses ( FCFE model)

    • DDM is based on intrinsic value of stock is present value of future dividend.
    • -current stock value is Future dividend/reuired return on common equity.
    • -One year is Future dividend/rrequired rate of return+Future Price/Required rate of return=Expected value

    Multi Year - A stock recntyly paid out dividend of 1.00$ and expected to grow at 5% per year. Required rate of return is 13.2%. Calculate value of stock assuming priced at 14.12 in 2 years.

    • D1 = 1*1.05=1.05
    • D2= 1.05*1.05=1.103


    14.12/(1.132)^2= 11.02+1.79= 12.81 is the current value based on investor expectation.

    • FCFE = Net income +Depreciation-Increase in working capital-Investment in fixed capital-Debt Principal Repayments+new debt issue.
    • Also, FCFE = CFO-FCInv+net Borrowing.

    Net borrowing is amount borrowed mius amt repaid.
  15. -A company's 100$ par prefered stock pay 5.00 annual dividend and has a requried raeturn of 8%. Calculate value of prefered stock.

    -Prefered Stock With a 1-year maturity, there are two semiannual dividends of 2.50 remainng. 100$ price.Required semianual return of 4%.

    b. 2.5/1.04+2.5/(1.04)^2+100/(1.04)^2= 97.17
  16. What is gordon growth model? What does it assume?

    Calculate value of stock paid a 2$ dividend last year, if dividends are expted to grow 5% forever and required return on equity is 12%.
    Gordon growth model assumes annual growth rate of dividends is constant.

    Equation is Value = D0*Growth=D1

    D1/Required rate of return equity-Growth.

    -Assumptions are dividends are appropriat measure of shareholder weatlh. Constandt dividend gorwth rate and reqruied return on stock never expected to change. Requried rate of return must be greater than growth rate or math doesnt work.

    2*1.05= 2.1

    2.1/.12-.05 = 30$
  17. How do you estimate growth rate in dividends? How do you get sustainable growth rate?
    • go through 3 steps
    • 1. use historical growth in dividends in firm
    • 2. use median industry dividend growth rate
    • 3. estimate sustainable growth rat.

    Sustainbalbe growth rate is ROE *(1-Payout ratio)
  18. A firm currently pays no dividend but is expected to pay a dividend at end of year 4. Year 4 earnings are expected to be 1.64 and firm maintain payout ratio of 50%. Assuming constant growth rate of 5% and required rate of return of 10% what is current value of stock.
    • Earnings 1.64 *.5=.82
    • Take.82/(.1-.5)= 16.40 value at year 3
    • 16.4/(1.1)^3 = 12.32 Present value
  19. Multistage dividend discount model. Consider a stock with dividens expected to grow at 20% per year for four eyars, after which expected to grow at 5% per year indefinitley. Last dividend paid was 1 and cost of equity is 10%.
    • first calculate dividend=
    • 1*1.2=1.2 Expected Dividend Year 1
    • 1.2*1.2=1.44 Year 2
    • =1.73 Year 3
    • =2.08 Year 4

    Year 4 = 2.08/.1-.05=41.6 Expected price at Year 3

    • Must discount to PV:
    • 1.2/1.1+1.44/(1.1)^2+1.73/(1.1)^3+41.6/(1.1)^3= 34.84
  20. Identify companies for which constrant growth or multistage dividend discount model is appropriate.
    Gordon growth model uses single constant growth rate of dividends and most appropriat for stable, mature, no cyclical dividend paying firms.

    For dividend paying firms with dividends expected to grow rapidly, multistage growth model should be employed. Multistage is good for high current growth drop in future, or firm temporarily losing market share and growing slowly or getting smaller, as long as it stabilizes in the future.

    When firm does not pay dividends, estimate of dividend payments are specutlative, and FCFE is appropriate as long as growth rates of earnings can be estimated.
  21. Rationale for using price multiples to value equity. What is difference between multiples based on comparables and multiples based on fundamentals?
    because dividend discount model is very sensitive to inputs, price multipple approach can be used. I n this approach analyst compares stock price multiple to a benchmakr value based on an index. Can be easily calculutated and be used in time series and cross sectional comparisons. Critique is that they reflect history which is not indicator of future.

    Multiple based on comparables are based comparisons to other firms market prices. Price multiples based on fundaments tell us what a multiple should be based on some valution maodel and are not dpeendt on current marke prices of other tcompanies.
  22. PE Ratio based on fundamentals/ expected PE Ratio. A firm has expected dividen payout ratio of 60%, required rate of return of 11% and dexpected dividend growth rate of 5%. What is leading(Justified) P/E Ratio?

    P/E= .6/(.11-.5)=10.
  23. Divide3nd Displacement of Earnings?
    Bc if you increase Dividends, payout ratio, firm value increases bc of P/E=(D/E)/(RRR-G). However, as you increase dividends, growth rate also decreases, which decreases firm value. This counteracts the idea that if firms had 100% dividend payout ratio, their firm value would be very high. The net effect of increased Dividend payout ratio is ambigous.
  24. Does higher debt to equity increase or decrease P/E ratio?
    If higher debt, means Holt is greater risk and has higher Required rate of return on equity, meaning P/E ratio is lower.
  25. Rules for mulitple based on comparables
    law of one price that asserts two identical assets should sell at same price or have same multiple.

    Must use comparable companies or industry(laggin) are in same industry, have same size, and will grow at same rate. P/E ratios for cyclcial firms complicated ude to sensitivey to economic condistions. P/S may be favored.

    Disadvatanges of price multiple based on comparable 1. stock may appear over or undervaleud compared with fundamental method 2. different accounting methods can result in proice multiples not copmariable 3. price multiples for cyclical firms mayb e greatly affected by economic conditions at agiven point

    Just get price per share/ Value looking at per share wheter it be earnings or whatever
  26. Enterprise value method measres? Equation?

    Steps to calculate?
    Method measure value of firm/ cost to acquire firm

    EV = Market value of Total Equity (prefered and common)+ Market value of Short and Long Term Debt- Cash and short term investments

    EBITDA is common denomiator in this formula. Advantage is EBITDA is ually positive when earning are not. If denominator is negative, then multiples are meaningless.Disadvantage is it often includes non-cash revneues and expenses(depreciation).

    • Find Long term debt Market value (usually given)
    • Find short term debt (take book value of total debt minus book value of short term debt.

    Take Market value of Equity. add all together and subtract cash.

    Get final EV and divide by EBITDA to get formula.
  27. Expain asset based valuation models and demonstrate use of model to calculate equity value.
    Asset based models based on idea that equity value is market or fair value of assets minus market or fair value of liabilities. Asset based models are usually considered the floor or minimum bc book values donn't encesarily reflect marekt values.

    Problematic especially with firms that have a large amount of intangible assets. Often used to value privat companies, firms being liquidited, or consists of primarily short term assets with ready market values, and tangible assets.

    Find market Asset value find market liability value subtract two. Divide by number of Shares
  28. Advantages and disadvatages of cash flow models, price multiples on comparables, fundamentals, and asset based models.
    • Advantage of cash flow models: deeply rooted in finance theory, widely accepted analysis.
    • Disadvatages: inputs very sensitive, inputs must be estimated.

    • Adv of Comparable valuation multiples:
    • -wieldy used
    • -readily avilable
    • -can be used in time series and cross sectional
    • -EV/EBITD useful when comparing firm value independent of capital structure or when earnings are negative and P/E ratio can't be used

    • Disavatages
    • -laggin price multiples reflect past.
    • -mayb not be comparable firms
    • -stock may appear over or undervalued.
    • -negative denominator makes ratio meaningless

    • Adantages of fundamental price multple:based on theoretically sound valuation models, correspon to widely accepted value metrics
    • Disadvatages: price multples based on fundamentals verys enstitive

    • Asset based advatages - provide floor values - more reliable when tangible assets and short term market ready assets comprise the firms assets
    • -increasingly useful for valuing public firms that report fair values
    • Disadvantages
    • -market values difficult to obtain
    • -market values usually differnt from book values
    • -inancurate when a firm has high proportion of intangible asset or future cash flows not reflecte
    • -asset can be difficult to value in period of hyperinflation