Lecture Presentation Software

to accompany

Investment Analysis and

Portfolio Management
Seventh Edition
by
Frank K. Reilly & Keith C. Brown

Chapter 13
 Chapter 13
Stock Market Analysis
Questions to be answered:
• How do we apply the basic reduced form dividend discount
model (DDM) to the valuation of the aggregate stock
market?
• What would be the prevailing value of the market as
presented by the S&P 400 based upon the reduced form
DDM?
• What would be the prevailing value of the market (S&P 400)
based upon the value of free cash flow to equity (FCFE)
model?
 Chapter 13
Stock Market Analysis
• What are the two components involved in the
two-part valuation procedure?
• Given the two components in the valuation
procedure, which is more volatile?
• What steps are involved in estimating the
earnings per share for an aggregate market
series?
• What variables affect the aggregate operating
profit margin and how do they affect it?
 Chapter 13
Stock Market Analysis
• What are the variables that determine the level
and changes in the market earnings multiplier?
• How do you arrive at an expected market
value and an expected rate of return for the
stock market?
• What has happened to the values for the other
relative valuation ratios - i.e., the P/BV, P/CF,
and P/S ratios?
 Chapter 13
Stock Market Analysis
• What additional factors must be considered
when you apply this microanalysis approach to
the valuation of stock markets around the
world?
• What are some differences between stock
market statistics for the U.S. versus other
countries?
 Applying the DDM
Valuation Model to the Market
• The stream of expected returns
• The time pattern of expected returns
• The required rate of return on the investment
D0 (1  g ) D0 (1  g ) 2
D0 (1  g ) n
Vj    ... 
(1  k ) (1  k ) 2
(1  k ) n

D1 Pi D1 / E1
V j  Pj  
kg E1 kg
 Applying the DDM
Valuation Model to the Market
Pi D1 / E1

E1 kg

Determinants of the Earnings Multiplier:

1. The expected dividend payout ratio
2. The required rate of return on the stock
3. The expected growth rate of dividends for the stock
 Market Valuation Using the
Reduced Form DDM
• 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
 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) and an increase in the earnings multiplier
 Return on Equity (ROE)
Net Income

Common Equity

Net Income Sales Total Assets

  
Sales Total Assets Common Equity

Profit Total Asset Financial

= Margin
x Turnover x Leverage
 Market Valuation Using the Free
Cash Flow to Equity (FCFE) Model
FCFE is:
+ Net Income
+ Depreciation Expense
- Capital Expenditures
-  in Working Capital
- Principal Debt Repayments
+ New Debt issues
 Market Valuation Using the Free
Cash Flow to Equity (FCFE) Model

• The Constant Growth FCFE Model

• The Two Stage Growth FCFE Model

D
k g
p
 Market Valuation Using Relative
Valuation Approach

• The price-earnings ratio (P/E)

• The price-book value ratio (P/BV)
• The price-cash flow ratio (P/CF)
• The price-sales ratio (P/S)
 Market Valuation Using Relative
Valuation Approach
• Two-part valuation procedure
D1
V j  Pj 
kg
Pj D1  1 k  g

D1 Pj  k  g
 Market Valuation Using Relative
Valuation Approach
• Importance of both components of
value
1. Estimating the future earnings per share
for the stock-market series
2. Estimating a future earnings multiplier
for the stock-market series
 Estimating Expected Earnings Per
Share
• Estimating expected earnings per share
Estimate sales per share for a stock-market series
Estimate the operating profit margin for the series
Estimate depreciation per share for the next year
Estimate interest expense per share for the next year
Estimate the corporate tax rate for the next year
• Estimating Gross Domestic Product
• Estimating sales per share for a market series
 Estimating Expected Earnings Per
Share
• Alternative estimates of corporate net profits
– Direct estimate of the net profit margin based on recent
trends
– Estimate the net before tax (NBT) profit margin
– Estimate an operating profit margin to obtain EBITDA;
estimate depreciation and interest to arrive at EBT;
estimate the tax rate (T) and multiply by (1-T) to
estimate net income
 Estimating Expected Earnings Per
Share
• Estimating aggregate operating profit margins
– Capacity utilization rate
– Unit labor costs
– Rate of inflation
– Foreign competition
 Estimating Expected Earnings Per
Share
• Estimating depreciation expense
– time series trends
– estimate based on property, plant, and equipment
• sales and turnover
• depreciation
 Estimating Expected Earnings Per
Share
• Estimating interest expense
– debt levels
• total assets
• expected capital structure
– interest rates
– subtract result from EBIT to estimate EBT
 Estimating Expected Earnings Per
Share
• Estimating the tax rate
– depends on future political action
– multiply (1-T) times the EBT per-share to estimate the
net income per share
 Estimating the Earnings Multiplier
for a Stock Market Series
• Determinants of the earnings multiplier
– Dividend payout ratio
– required rate of return on common stock
– the expected growth rate of dividends for the stocks

Pi D1 / E1

E1 kg
 Estimating the Earnings Multiplier
for a Stock Market Series
• Estimating the required rate of return (k)
– inversely related to the earnings multiplier
– determined by risk-free rate, expected inflation, and the risk
premium for the investment
• Estimating the dividend payout ratio (D/E)
– active decision or residual outcome?
– time series plots
– long-run perspective
 Estimating the Earnings
Multiplier for a Stock Market
Series
• Estimating an Earnings Mutiplier: An
Example
– The Direction of Change Approach
– Specific Estimate Approach

• Calculating an Estimate of the Value for the

Market series
 Other Relative Valuation Ratios
• Price to book value ratio (P/BV)
• Price to cash flow ratio (P/CF)
• Price to sales ratio (P/S)
 Analysis of World Markets
• Individual country analysis
– analyze economy and security markets before
analyzing alternative industries or companies
– macro techniques
– micro techniques
– technical analysis
– top down approach
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Investments Online
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www.agedwards.com
End of Chapter 13
–Stock Market Analysis
 Future topics
Chapter 14
• Why do industry analysis?
• Competition and expected industry
returns
• Estimating an industry earnings
multiplier