chapter 11 reily financial forecasting

8/16/2019 Chapter 11 Reily Financial Forecasting

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Chapter 11: SecurityValuation Principles

Analysis of Investments Analysis of Investments&& Management of PortfoliosManagement of Portfolios

10TH EDITION

ReillyReilly&& BrownBrown


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Overview of the Valuation

Process Two General Approaches

1) Top-down three-step approach

!) "otto#-up stoc$ valuation stoc$ pic$in%approach

The difference &etween the two approaches isthe perceived i#portance of econo#ic andindustry influence on individual fir#s and stoc$s

"oth of these approaches can &e i#ple#ented&y either funda#entalists or technicians

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11-4


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Three-Step Valuation

Approach Co#pany Analysis

The purpose of co#pany analysis to identify the &estco#panies in a pro#isin% industry

This involves ea#inin% a fir#.s past perfor#ance &ut#ore i#portant its future prospects

/t needs to co#pare the esti#ated intrinsic value to theprevailin% #ar$et price of the fir#.s stoc$ and decidewhether its stoc$ is a %ood invest#ent

The final %oal is to select the &est stoc$ within a desira&leindustry and include it in your portfolio &ased on itsrelationship 0correlation) with all other assets in yourportfolio

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Theory of Valuation

The value of an asset is the present value of its

epected returns

To convert this strea# of returns to a value forthe security you #ust discount this strea# at

your reuired rate of return

This reuires esti#ates of:

1) The strea# of epected returns!) The reuired rate of return on the

invest#ent

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Theory of Valuation

Strea# of pected 2eturns

(or# of returns

arnin%s

Cash flows

'ividends

/nterest pay#ents

Capital %ains 0increases in value)

Ti#e pattern and %rowth rate of returns

3hen the returns 0Cash flows) occur At what rate will the return %row

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Theory of Valuation

2euired 2ate of 2eturn

2eflect the uncertainty of return 0cash flow)

'eter#ined &y econo#y.s ris$-free rate of return plus

pected rate of inflation durin% the holdin% periodplus

2is$ pre#iu# deter#ined &y the uncertainty ofreturns

&usiness ris$

financial ris$

liuidity ris$ echan%er rate ris$ and country

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Theory of Valuation

/nvest#ent 'ecision Process: A Co#parison of

sti#ated Values and 4ar$et Prices

5ou have to esti#ate the intrinsic value ofthe invest#ent at your reuired rate of

return and then co#pare this esti#ated

intrinsic value to the prevailin% #ar$et price

/f sti#ated Value 6 4ar$et Price "uy

/f sti#ated Value 7 4ar$et Price 'on.t "uy

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Valuation of Co##on Stoc$

Two General Approaches:

1) 'iscounted Cash-(low Techniues

Present value of so#e #easure of cash flow

includin% dividends operatin% cash flowand free cash flow

!) 2elative Valuation Techniues

Value esti#ated &ased on its price relative

to si%nificant varia&les such as earnin%s

cash flow &oo$ value or sales

See hi&it 11,!

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Valuation of Co##on Stoc$

"oth of these approaches and all of these

valuation techniues have several co##on

factors:

1) All of the# are si%nificantly affected &y

investor.s reuired rate of return on the stoc$

&ecause this rate &eco#es the discount rate

or is a #a8or co#ponent of the discount rate9

!) All valuation approaches are affected &y the

esti#ated %rowth rate of the varia&le used inthe valuation techniue

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3hy 'iscounted Cash (low Approach

These techniues are o&vious choices forvaluation &ecause they are the epito#e of howwe descri&e valuethat is the present value ofepected cash flows

1) 'ividends: Cost of euity as the discount rate

!) Operatin% cash flow: 3ei%hted Avera%e Costof Capital 03ACC)

+) (ree cash flow to euity: Cost of euity as

the discount rate

'ependent on %rowth rates and discount rate

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3hy 2elative Valuation Techniues Provides infor#ation a&out how the #ar$et is currently valuin% stoc$s

a%%re%ate #ar$et

alternative industries individual stoc$s within industries

;o %uidance as to whether valuations are appropriate

&est used when have co#para&le entities

a%%re%ate #ar$et and co#pany.s industry are not at a valuationetre#e

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'iscounted Cash (lowValuation Techniues

3here:

V 8 < value of stoc$ 8

n < life of the asset

CF t < cash flow in period t

k < 'iscount rate that is eual to the investor.s

reuired rate of return for asset 8

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∑=

= +=

nt

t t

t j

k

CF V

1 )1(

• The General Formula


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The 'ividend 'iscount

4odel 0''4) The value of a share of co##on stoc$ is the present

value of all future dividends

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∑=

∞∞

+=

+++

++

++

+=

n

t t

t

j

k

D

k D

k D

k D

k DV

1

33

221

)1(

)1(...

)1()1()1(

where:

V j = value of common stock j

Dt = dividend during time period t

k = required rate of return on stock j


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The 'ividend 'iscount4odel 0''4)

/nfinite Period 4odel 0Constant Growth 4odel)

Assu#es a constant %rowth rate for esti#atin% all of future dividends

where:

V 8 < value of stoc$ 8D= < dividend pay#ent in the current period

% < the constant %rowth rate of dividends

k < reuired rate of return on stoc$ 8

n < the nu#&er of periods which we assu#e to &e infinite

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n

n

jk g D

k g D

k g DV

)1()1(...

)1()1(

)1()1( 0

2

2

00

++++

+++

++=


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The 'ividend 'iscount

4odel 0''4) Given the constant %rowth rate the earlierfor#ula can &e reduced to:

Assu#ptions of ''4:

1) 'ividends %row at a constant rate

!) The constant %rowth rate will continue for aninfinite period

+) The reuired rate of return 0$) is %reater thanthe infinite %rowth rate 0%)

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g k

D

V j −=1


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/nfinite Period ''4and Growth Co#panies Growth co#panies have opportunities to earn

return on invest#ents %reater than their reuired

rates of return

To eploit these opportunities these fir#s

%enerally retain a hi%h percenta%e of earnin%s for

reinvest#ent and their earnin%s %row faster than

those of a typical fir#

'urin% the hi%h %rowth periods where %6$ this is

inconsistent with the constant %rowth ''4

assu#ptions11-19


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Valuation with Te#porary

Supernor#al Growth First evaluate the years of supernormal growth and then

use the DDM to compute the remaining years at a

sustainable rate

Suppose a 14% required rate of return with the

following dividend growth pattern

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Dividend

Year Growth Rate

1-3 25% 4-6 20%

7-9 15%

10 on 9%


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Valuation with Te#porary

Supernor#al Growth The alue of the Stoc! "See #$hibit 11&'

11-219

333

9

333

8

233

7

33

6

33

5

23

4

3

3

3

2

2

)14.1(

)09.14(.

)09.1()15.1()20.1()25.1(00.2

14.1

)15.1()20.1()25.1(00.2

14.1

)15.1()20.1()25.1(00.2

14.1

)15.1()20.1()25.1(00.2

14.1

)20.1()25.1(00.2

14.1

)20.1()25.1(00.2

14.1

)20.1()25.1(00.2

14.1

)25.1(00.2

14.1

)25.1(00.2

14.1

)25.1(00.2

−+

++

++

++

++=i

V


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Present Value of

Operatin% (ree Cash (lows 'erive the value of the total fir# &y discountin% the total

operatin% cash flows prior to the pay#ent of interest to thede&t-holders

Then su&tract the value of de&t to arrive at an esti#ate ofthe value of the euity

Si#ilar to the ''4 we can have 3e have use a constant rate forever

3e can assu#e several different rates of %rowth for OC(li$e the supernor#al dividend %rowth #odel

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Present Value ofOperating Free Cash Flows

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Present Value of

(ree Cash (lows to uity >(ree? cash flows to euity are derived after

operatin% cash flows have &een ad8usted for de&tpay#ents 0interest and principle)

These cash flows precede dividend pay#ents to theco##on stoc$holder

The discount rate used is the fir#.s cost of euity 0$)rather than 3ACC

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Present Value of(ree Cash (lows to uity

The (or#ula

where:

V j < Value of the stoc$ of fir# j

n < nu#&er of periods assu#ed to &e infinite

FCFE t < the fir#.s free cash flow in period t

@ 8


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arnin%s 4ultiplier 4odel

P 2atio: This values the stoc$ &ased onepected annual earnin%s

Pricearnin%s 2atio< arnin%s 4ultiplier

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arnin!"#onth-12$%e&ted

'ri&e#aret*rrent=


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Assu#e the followin% infor#ation for AG stoc$ 01)'ividend payout < B= 0!) 2euired return < 1!0+) pected %rowth < D 0E) ' < ,B= and the%rowth rate g


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/n the previous ea#ple suppose the currentearnin%s of !,== and the %rowth rate of H,3hat would &e the esti#ated stoc$ priceF

Given '


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The Price-Cash (low 2atio

3hy PriceC( 2atio

Co#panies can #anipulate earnin%s &ut Cash-flow is less prone to #anipulation

Cash-flow is i#portant for funda#ental valuationand in credit analysis

The (or#ula:

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1

+

+

=

t

t

i

CF

P CF P

where:

P$CF j = the price$cash flow ratio for firm j

P t = the price of the stock in period t

CF t% = e&pected cash low per share for firm

j


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The Price-"oo$ Value 2atio

3idely used to #easure &an$ values

(a#a and (rench 01HH!) study indicated inverse relationship&etween P"V ratios and ecess return for a cross section ofstoc$s

The (or#ula:

1

++

=t

t j

BV

P BV P

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where:

P/BV j = the price$'ook value for firm j

P t = the end of (ear stock price for firm j

BV t+ = the estimated end of (ear 'ook value per

share for firm j


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The Price-Sales 2atio

Sales is su&8ect to less #anipulation than other financial data This ratio varies dra#atically &y industry

2elative co#parisons usin% PS ratio should &e &etween fir#sin si#ilar industries

The (or#ula:

1

+

+

=

t

t j

S

P S P

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where: P$) j = the price to sales ratio for Firm j

Pt = the price of the stock in Period t

)t% = the e&pected sales per share for Firm j


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/#ple#entin% the 2elative ValuationTechniue

(irst Step: Co#pare the valuation ratio for a co#panyto the co#para&le ratio for the #ar$et for stoc$.sindustry and to other stoc$s in the industry

/s it si#ilar to these other P E s

/s it consistently at a pre#iu# or discount

Second Step: plain the relationship

Knderstand what factors deter#ine the specificvaluation ratio for the stoc$ &ein% valued

Co#pare these factors versus the sa#e factors for

the #ar$et industry and other stoc$s

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sti#atin% the /nputs: $ and %

Valuation procedure is the sa#e for securities around theworld

The two #ost i#portant input varia&les are :

1) The reuired rate of return 0k)

!) The epected %rowth rate of earnin%s and other valuationvaria&les 0g) such as &oo$ value cash flow and dividends

These two input varia&les differ a#on% countries in the world

The uality of these esti#ates are $ey

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2euired 2ate of 2eturn 0k)

The investor.s reuired rate of return #ust &e esti#atedre%ardless of the approach selected or techniue applied

This will &e used as the discount rate and also affects

relative-valuation

Three factors influence an investor.s reuired rate of return:

1) The econo#y.s real ris$-free rate 022(2)

!) The epected rate of inflation 0/)

+) A ris$ pre#iu# 02P)

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2euired 2ate of 2eturn 0k) - 22(2

The cono#y.s 2eal 2is$-(ree 2ate:

4ini#u# rate an investor should reuire

'epends on the real %rowth rate of the econo#y

0Capital invested should %row as fast as the econo#y)

2ate is affected for short periods &y ti%htness or ease of

credit #ar$ets

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2euired 2ate of 2eturn 0k) - ;2(2

The pected 2ate of /nflation /nvestors are interested in real rates of return that will

allow the# to increase their rate of consu#ption

The investor.s reuired no#inal ris$-free rate of return

0;2(2) should &e increased to reflect any epectedinflation:

1-(,)RRR/1/1 RR E ++=

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where:

E *I+ = e&pected rate of inflation


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sti#atin% the 2euired 2eturnfor (orei%n Securities

(orei%n 2eal 2(2

Should &e deter#ined &y the real %rowth rate within the

particular econo#y, Can vary su&stantially a#on%

countries /nflation 2ate

sti#ate the epected rate of inflation and ad8ust the

;2(2 for this epectation

;2(2


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hi&it 11,I

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pected Growth 2ate

sti#atin% Growth (ro# (unda#entals

'eter#ined &y

1) the %rowth of earnin%s

!) the proportion of earnin%s paid in dividends

/n the short run dividends can %row at a different ratethan earnin%s if the fir# chan%es its dividend payout ratio

arnin%s %rowth is also affected &y earnin%s retention and

euity return

% < 02etention 2ate) 02eturn on uity)

< 22 2O

< /nternally %enerated %rowth rate11-42


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pected Growth 2ate

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ROE

Profit Total Asset Financial Margin Turnover Leverage

= ,,

EquityCommonAssetsTotal

AssetsTotalSales

SalesIncomeNet


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pected Growth 2ate

The first component( net profit margin( indicates the

firm)s profitability on sales

The second component( total asset turnover is the

indicator of operating efficiency and reflect the asset

and capital requirements of business

The final component measure financial leverage *t

indicates how management has decided to finance the

firm

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Financial Forecasting + *nternally

generated growth rate

*f , corporate policies are !ept constant then internally

generated growth in -# ( g -# ( translates into same growth

rate in T.( T/( Sales( 0*( #S( DS( and finally in share price"o'2

ro3ecting concise financial statements if , corporate

policies are !ept unchanged2 and double chec!ing that it is

true that all the above stated financial variables do grow atthe same percentage growth rate

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Financial Forecasting + *nternally

generated growth rate

The , policies that are assumed to be !ept constant are

10*5S ratio( net profit margin showing profitability

6S5T. ratio( total assets turnover showing productivity of

total assets in generating sales

&T.5-# ratio( financial leverage showing capital structure

of the business

4DS5#S ratio( dividend payout ratio showing dividend

policy of the business *t is denoted with symbol )d),0umber of shares outstanding

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*nternally 7enerated 7rowth

8ate /f a Co does not issue new shares to raise fresh cash as

euity invest#ent &y its owners then any %rowth in itsO is internally %enerated throu%h retention of so#e

portion or all of ;/ &y not distri&utin% all the ;/ of thatyear as cash dividends,

2einvestin% a portion of ;/ of a year in the &usinesscauses increase on the ri%ht hand side of &alancesheet 0an increase in its O)9 specifically within Othe 2 0also called reserves) eperience an increase,

Since &alance sheet #ust &alance therefore on theleft hand side of &alance sheet total assets eperiencean increase &y the sa#e a#ount &ecause ! sides of&alance sheet #ust always &e the sa#e a#ount,

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*nternally 7enerated 7rowth

8ate /t is internally %enerated %rowth in O of a &usiness

&ecause this %rowth in O is attained &y retainin% andreinvestin% a portion of ;/9 and is not %enerated &y

issuin% shares to raise eternal euity funds, /t is only lo%ical that if &oth TA N uity are %rowin%

at the sa#e rate then in order to #aintain &alanceT #ust also increase at the sa#e rate, Therefore allthree portions of &alance sheet would %row at this%rowth rate,

Since %rowth in lia&ilities would entail increase ineternal de&t financin% therefore this %rowth ratecannot &e called sustaina&le %rowth rate of a &usinesscorporation,

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Sustainable 7rowth rate

Sustaina&le %rowth rate is that %rowth rate in saleswhich does not reuire raisin% de&t or euityfinancin% eternally to finance additional assets

needed to support %rowth in production and sales, 2ather the sustaina&le %rowth rate relies only on

raisin% euity internally &y reinvestin% the profits andalso relies on that increase in lia&ilities that ta$esplace spontaneously due to lar%er production andsellin% operations such as increase in accounts

paya&les and salaries paya&les,

Therefore when a company is growing at sustainablegrowth rate then financing for the growth in assetsis not done by taking debt or by issuing shares

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Financial Forecasting 9

#$ample TA < !== T < 1== N O < 1==

Sales < B== ;/ < 1= d < B= @c < 1= N nu#&er ofshares outstandin% < 1= #illion,

Calculate Growth of O

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#$ample TA < !== T < 1== N O < 1==


%O- < 2O01 - d)

< 0;/O) 01- d)

< 01=1==) 01- =,B)

< 1= 01- =,B)

< 1= =,B

< B

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#$ample TA < !== T < 1== N O < 1==


/f B policies are $ept constant calculate 'iv payoutratio ;u#&er of shares outstandin% ;et Profit4ar%in Total Asset Turnover N TAO ratio for thenet yearF

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#$ample1) 'ividend payout policy re#ains unchan%ed i,e, d < =,B

!) ;u#&er of shares outstandin% re#ains unchan%ed at1=# shares9 it #eans durin% the net year no newshares would &e issued nor repurchased,

+) ;et profit #ar%in < 1=B==

E) Turnover of TA < S TA ratio: B==!==

year

B) (inancial levera%e re#ains unchan%ed this year TA Oratio: !==1== < ! ti#es and it would &e ! net yearas well it #eans capital structure would re#ainunchan%ed9 and so would &e financial ris$,

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#$ample TA < !== T < 1== N O < 1==


/f B policies are $ept constant (orecast &alance sheetfor the net yearF

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Financial Forecasting :

Forecasting ;alance SheetO1 < O=0 1 M %O)

< 1==01 M =,=B) < 1=B #

As TA O last year is !== 1== < !Therefore euity #ultiplier 0financial levera%e)will &e sa#e net year so :

TA1 O1 < !

TA1 < !O1

TA1 < !1=B

TA1 < !1=#

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Forecasting ;alance SheetSince &alance sheet is always &alanced thereforeyou can wor$ out net year.s T as:

T1 < TA1 - O1

< !1= L 1=B

< 1=B#

;ow you have pro8ected &alance sheet for thenet year:

TA1 < T1 M O1

!1= < 1=B M 1=B

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#$ample TA < !== T < 1== N O < 1==


/f B policies are $ept constant (orecast /nco#eState#ent 0Sales ;/ penses PS 'PS) for the netyearF

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Forecasting *ncome Statement

As

S TA was last year B==!== < !,B ti#es

Therefore net year this turnover of asset wouldalso &e !,B ti#es so:

S1 TA1 < !,B

S1 < !,B TA1

S1 < !,B!1= S1 < B!B#

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Since last year ;/ S was 1= B== < !

Therefore

;et profit #ar%in for the net year wouldalso &e ! of sales so:

;/1 S1 < !

;/1

< ! S1

;/1 < =,=!B!B

;/1 < 1=,B#11-59


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S1 9 #$penses1 < 0*1

,6, : e$penses < 1=,

#$penses1 < ,6, : 1=, < ,14,

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ast year.s PS was:

PS= < ;/o Shares

< 1=# 2s1=# shares < 1 2eShare;et year PS would &e:

PS1 < ;/1 nu#&er of Shares outstandin%

PS1 < 1=,B# 2s1=#

0note the nu#&er of shares outstandin% is sa#e 1=#illion as last year)

PS1 < 1,=B 2s Share

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ast year:

'PSo< PS= d

'PSo < 1=,B'PSo < =,B 2s Share

;et year 'PS would &e:

'PS1 < PS1d

'PS1 < 1,=B =,B

0note dividend payout ratio d is unchan%ed at B=)

'PS1 < =,B!B 2sSh

0net year.s esti#ated dividend per share) 11-62


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#$ample TA < !== T < 1== N O < 1==


Calculate %rowth rate of Sales ;/ PS 'PS TA N T

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#$ample TA < !== T < 1== N O < 1==


Calculate %rowth rate of Price N pected 2ate of2eturn for shareholders

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#$amplePo < 'PS1 0@c L %) < =,B!B 0=,1 - = ,=B)

Po < 1=,B 2s Sh

'PS ! < 'PS101 M %) < =,B!B01 M =,=B)

< =,BB 2sShare

Therefore share price at the end of this year 0year one) P1 is esti#ated as:

P1 < 'PS! 0@c L %) < =,BB0=,1 - =,=B)

P1


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#$ampleGrowth in share price 0capital %ains yield) fro# now till theend of the year is esti#ated as:

% Po < 0P1 - Po) Po

< 011,=! - 1=,B) 1=,B

< B

Rence

gOE = gTA = g TL = gS = gNI = gEPS = g DPS= g Po =

(P1 - Po )/Po

5% = 5%= 5% = 5% = 5% = 5% = 5% = 5%

=5%

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#$pected 8ate of 8eturn for

shareholderspected 2O2 net year 0@c1)

< 0P1 - P=) P= M 'PS1 P=

< 0B) M 0=,B!B 1=,B)

< B M B

< 1=

Please note that epected @c ca#e 1= &ecause whiledoin% valuation of share in year = N1 to esti#ate P= N P1

the ris$ ad8usted reuired rate of return used @c was 1=in the Gordon.s valuation for#ula: P= < 'PS1 0@c - %),

The Price at which epected rate of return N reuired rateof return euate is referred to as (air 4ar$et price,

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*nvestment implications

Shareholders of fast %rowin% co#panies are li$ely to&eco#e richer sooner than shareholders of slow%rowin% co#panies9 therefore fast %rowin% co#paniesare dee#ed as #ore valua&le in the stoc$ #ar$et

&ecause their share price is epected to %row fasterand their shareholders are li$ely to %et richer #oreuic$ly,

That is why when you %o out loo$in% for investin% inshares you should search for fast %rowin% co#panies9also as finance #ana%er who is loo$in% for tar%etco#panies for friendly #er%ers and acuisitions orfor hostile ta$eovers you should loo$ for co#panieswhich have hi%h %rowth potential,

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*nvestment *mplications 9

#$ample A co has paid 2s + per share cash dividends its ris$

ad8usted reuired rate of return esti#ated usin%CAP4 #odel is 1J and it is esti#ated to %row at theconstant %rowth rate of + per year for ever this%rowth rate was esti#ated as 2O 01 - d) under theassu#ption of constancy of B corporate policies,

2euired: sti#ate its fair value of share todayFOr in other words9 at what price it should &e tradin%in the #ar$etF

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#$ample Suppose you do not a%ree that this co has a

%rowth potential and decide that it is a no%rowth co that #eans its % < =9 what would &e

your esti#ate of its fair value per shareF

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#$ample P= < 'PS=01 M %) 0 @c - %)

< + 01 M =) 0=,1J - =)

< +=,1J

< 1J,IE 2s per share,

esson: Growin% co#panies are #orevalua&le than non-%rowin% co#panies,

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#$ample Suppose you as an analyst &elieve this

co.s product lines are losin% #ar$etshare to co#petitors therefore youthin$ it is li$ely to eperience ne%ative+ %rowth per year in foreseea&lefuture, 3hat is your esti#ate of its fairvalue per shareF

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#$ample P= < 'PS=01 M %) 0 @c M %)

< + 01 M - =,=+) 0=,1J M =,=+)

< !,H1 =,!

< 1E,BB 2s per share,

esson: Co#panies that are li$ely toshrin$ in future are less valua&le,

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>onclusion 9 8-# + aluation

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Than! you for your Time +atience

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chapter 11 reily financial forecasting

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