topic 5 investment analysis

INTRODUCTION

This topic will discuss the process of share valuation. It begins by looking at valuation models. The value of an asset can be obtained by determining the present value of its future cash flows. For shares, the cash flow is future dividends. Therefore, the first valuation model is the discounted dividend model. We will also discuss the Price Earnings (PE) ratio model. PE ratio is the most frequently used ratio when investors talk about equity investment. This topic then discusses in detail the process by which we forecast the variables in the valuation model. The investor needs to evaluate the economic background

TTooppiicc

55 Equity

Valuation (Fundamental Valuation)

LEARNING OUTCOMES

By the end of this topic, you should be able to:

1. Calculate the value of shares based on the Discounted Dividend Model,Constant Growth Rate Model and Multistage Growth Model;

2. Interpret the relationship between share price and growth;

3. Explain the importance of price and growth;

4. Explain the importance of earnings ratio from investors point of view;

5. Describe the structure and characteristics of an industry; and

6. Perform a company analysis.

TOPIC 5 EQUITY VALUATION (FUNDAMENTAL VALUATION) 71

of the firm. An economy can be adequately described by looking at the Gross Domestic Product (GDP), inflation and interest rates. The effect of government policy on the economy will also be discussed. The process of understanding the industry is discussed later in the topic. This is finally followed by a discussion on company analysis. This method of analysis is also known as Fundamental Analysis.

VALUATION PROCESS

There are two approaches to evaluate security. They are:

(a) Top-down Approach; and

(b) Bottom-up Approach.

Investment analysts who follow this approach believe that a good economy will provide a good background for the growth of industries and firms.

This module will only discuss the first approach. Before we proceed with the top-down approach, we will first discuss valuation models because factors and variables that affect the Top-down Approach are based on these models.

BASIC VALUATION MODELS

In the basic valuation models, we will look at:

(a) The Discounted Dividend Model;

(b) The Constant Growth Model;

(c) The Relationship between Share Price and Growth; and

(d) Multistage Growth.

5.2

5.1

In the TTop-down Approach, we begin by analysing the economy followed by the industry and then proceed to the firms in the industry.

In the BBottom-up Approach, analysts will try to identify firms that are undervalued. These firms were chosen without taking into account the economic situation and environment.


5.2.1 Discounted Dividend Model

For example, share ABC promises a dividend of RM0.50 a year and the share is being held for only one year. After one year, the share can be sold at RM2.00. Lets assume that the rate of return expected by the investor is 10%. The present value of the share is:

2

2072 4022

3 203 3 203

TO40495

R (5.1)

Formula (5.1) can be simplified as:

3 3

2 3 3*3 + *3 +

F RR

m m (5.2)

If the investors want to hold the share for two years, formula (5.2) will be:

3 4 4

2 3 4 4*3 + *3 + *3 +

F F RR

m m m (5.3)

The value calculated from formula (5.3) will be no different from (5.2) if the investor bought the share at the end of year one. The value of the share will be calculated as follows:

4 4

3 3 3*3 + *3 +

F RR

m m (5.4)

If formula (5.4) is combined with formula (5.2), we will get the following:

4 4

32 3 3

4 4

32 3

3 4 42 3 4

*3 + *3 +

*3 + *3 +

*3 +

*3 +*3 +

*3 + *3 +

F RF m m

Rm m

F RF m

Rmm

F F RR

m m

(5.5)

In the DDiscounted Dividend Model, the share price is calculated by finding the present value of the predicted dividend and the predicted selling price of the share.


Lets say share XYZ promises a dividend of RM0.50 at the end of the first year and RM0.60 at the end of the second year. The price (P2) at the second year is RM2.20. Using formula (5.5), P0 is:

2 4

2072 208 4042

*303+ *303+

TO4099

R

Using formula (5.4), P1 is:

3

2082 4042

*303+ *303+

TO4077

R

By incorporating the above result into formula (5.2), P0 will be:

2

2072 4077

*303+ *303+

TO4099

R

Based on the example discussed, the Discounted Divided Model will look like this:

53 42 3 4 5*3 + *3 + *3 + *3 +

pp

FF F FR

m m m m

(5.6)

where:

P0 = The value or estimated price of share. D1Dn = The dividends from one year to infinity. This is if the share is held

forever. k = The rate of expected return, which is a rate set by the investors

themselves after taking into account the share risk. We can also use the CAPM to determine this return.


5.2.2 Constant Growth Model

If there is a rise in the dividend, the Discounted Dividend Model (formula 5.6) will have to be adjusted. For example, let us assume that a company has just paid a dividend of RM0.50 per share and the dividend of the company increases at a rate of 5% per year. So, if we take three years ahead, the dividend will be:

D1 = 0.50(1.05) = 0.525 D2 = 0.525(1.05) = 0.55125 or 0.05(1.05)2 D3 = 0.55125 (1.05) = 0.579 or 0.05(1.05)3 Generally, the situation above is the same as:

D1 = D0(1+g) D2 = D1(1+g) or D0 (1+g)2 D3 = D2(1+g) or D1(1+g)3 Note: g is the growth rate. If the example above is inserted into formula 5.6, we will have:

3 4 52 2 2 2

2 3 4 5

*3 + *3 + *3 + *3 +

*3 + *3 + *3 + *3 +

p

p

F i F i F i F iR

m m m m

(5.7)

Formula 5.7 can be simplified as:

32 3

2

*3 +F i FR

m i m i

(5.8)

Based on the above example, the share price (P0) will be:

TO20747TO32072

2032 20273F

m i


5.2.3 The Relationship between Share Price and Growth

To see the relationship between share price and growth, let us look at how growth rate is determined. The growth rate is calculated as:

g = ROE b. (5.9) where ROE is the rate of return on equity and b is the portion of profit that is invested back into the firm. b is sometimes known as profit retention rate. For example, lets say Mawar Enterprise has a net income of RM2 million and the dividend payout ratio is 30%. So, b which is equal to (1 dividend payout) = (1 0.3) = 70% or 0.7 Let us say ROE is 12%. So, g = 0.12 0.7 = 0.084 or 8.4%. Therefore, the growth rate of a company depends on the total income reinvested into the company and also the ROE. These two factors are important to help the growth of a company. However, growth will only increase share prices if the ROE is higher than the expected rate of return (k).

Based on your understanding of constant growth, what will happen to the share price if:

(a) The cash dividend increases or decreases.

(b) The growth rate (g) increases or decreases. Please take note that g cannot exceed the rate of return (k).

(c) the rate of return increases or decreases. You can use formula (5.8) to explain how the dividend, growth rate and rate of return affect share prices.

ACTIVITY 5.1


For example, Mawar Enterprise wants to offer a dividend (D1) of RM1.00. Growth rate g is 0 and the expected rate of return k is 10%. By using formula (5.8), the share price of the company is RM10. Since the company does not reinvest its income, there would be no growth that will lead to an increase in income. In another situation, lets say Mawar Enterprise only pays a dividend of RM0.30 out of a earning per share (EPS) of RM1.00. From formula (5.8), we will find that the share price will fall. But then, the company reinvested the income that was not paid out as dividend at a rate of ROE 12%. By using formula (5.9), this will give a growth rate g of 8.4%. Thus, the share price will become:

10

0.30.10 0.084

RM18.75

DPk g

We can see that Mawars share price is higher when the firm reinvests its income. However, this price increase also depends on the companys ROE. The price will only show a further increase if ROE exceeds k. If ROE is 10% and k = 10%, the divided payout ratio is 30%, then:

g = 0.1 x 0.7 = 0.07 or 7%.

If D1 is 0.30, the share price is:

100.3

RM100.10 0.07

DPk g

We can see that although there is a growth of 7%, there is no difference in the share price when growth rate is zero. This occurs because ROE is equal to k. It is important to note that in order for a share to increase in price, the company has to reinvest its income in an investment that exceeds the rate of return expected by the shareholders.


5.2.4 Multistage Growth

In some instances, we may find firms with non-constant growth rates. This normally occurs at the beginning of the firms or industrys life. Growth is highest in the early periods. However, this high growth cannot persist as competition exists and new firms will be attracted to the industry. Therefore, there seems to be a time horizon for this high growth and we need to forecast the dividend in this time horizon. Let us use an example to explain the situation. A firm is expected to experience a 30% growth per year for the next three years. After that period, it is forecast that growth will be normal at 5% per year forever. The required rate of return is 10%. The price of the share can be determined as below:

5 53 42 4 5 5

65

.*3 + *3 + *3 + *3 +

yjgtg* +

F RF FR

m m m m

FR

m i

Notice that we have a time horizon of three years in the formula and we need to determine the price at the end of the time horizon. The end price is the constant growth dividend model. If the current dividend is RM1.00, then the price of the share is:

2 4 5 5

5

TO3052 TO308; TO4042 TO6804

*3 203+ *303+ *303+ *303+

TO5:0;6

TO4042*3 2027+yjgtg TO68042

*203 2027+

R

R

In the earlier Section (5.2.2), we know that we can use the growth rate to estimate the price of a share. Based on formula (5.8), what is the relationship between the growth rate and the share price? Explain.

SELF-CHECK 5.1


PRICE EARNINGS (PE) RATIO MODEL

Another model to value a share is by using the PE ratio. This model is also known as the earnings multiplier model. This is because the PE ratio is also known as the earnings multiplier.

PriceEarnings multiplier =

Earnings

The above formula can be interpreted as a measure of the investors willingness to buy shares to get an expected return. It also measures the level of confidence of investors in the firm. The dividend model in formula (5.8) can also be used to calculate the PE ratio. If we recall, the formula is:

32

FR

m i

If the model is divided by expected earnings (E1), the model will become:

3

2 3

3

FR G

G m i

The above formula showed that PE ratio will depend on the dividend payout ratio (D1/E1), required rate of return (k) and growth rate for dividend (g). For example, lets say a firm expects to earn RM2 per share and pays dividends of RM1. The rate of return expected by the investors is 15% and the growth rate is 10%. The PE ratio is:

207232

2037 2032

R

G If the firm expects to pay a dividend of RM0.80, the PE ratio will be 8. If the dividend is RM1.20, then the ratio is 12. The higher the ratio, the higher should be the price. We can then compare the calculated PE ratio with the current PE ratio. The calculated PE ratio will be based on forecasted D1, k and g. We will multiply the PE ratio with the forecasted earnings to obtain the estimated price of the share. Using the above example, when earnings are RM2 and the dividend is RM1, the estimated price is 10 RM2 = RM20. When the

5.3


dividend is RM0.80, the estimated price is 8 RM2 = RM16. When the dividend is RM1.20, then the estimated price will be 12 RM2 = RM24.

EXPECTED RATE OF RETURN (k) In Topic 4, we discussed the CAPM. According to CAPM, rate (k) can be calculated as:

( )f M fk R ER R where:

Rf will be affected by the present as well as the economic outlook. By taking into account the inflation factor, this rate will become a nominal rate Rf. Therefore, the basic rate can be affected by the economy and inflation. The rate of return k, will also be influenced by the systematic risk . Risk usually comes in the form of business risks, financial risks, liquidity risks, foreign exchange risks and a countrys political risks.

5.4

Based on the example discussed in section 5.3, how do the followingfactors affect the price of a share:

1. Dividend payout ratio;

2. Required rate of return; and

3. Growth rate of dividend. You should review business magazines and the business information section in the newspapers for more input.

ACTIVITY 5.2


FRAMEWORK TO EVALUATE SECURITY

Generally, if we use formula (5.8) as a basis to obtain the value of a security we will require a prediction of net income (E), the dividend amount (D), the investors rate of return (k) and the growth rate (g). Forecasted net income (E) is obtained by deducting production costs, interest and taxes from expected sales. Therefore, the process of evaluating a security starts by predicting sales and getting the net margin. Then, we have to decide the firms dividend payout. This will affect the retention rate of earnings that can affect growth rate (g). We have seen that ROE can also influence growth.

5.5

Expected rate of return is affected by many factors. Select one share listed in the Bursa Malaysia and analyse how the following factors affect the shares expected rate of return.

Factors Analysis (Findings)

Inflation

Business risk

Financial risk

Liquidity risk

Foreign exchange risk

Countrys political risks

Your analysis should be based on the review of the current economy market in Malaysia and also the companys situation. You can compare your findings with that of your peers.

ACTIVITY 5.3

What is the expected rate of return and why is it important in stockvaluation?

SELF-CHECK 5.2


Each of these variables can be influenced by external factors. In the next section, we will discuss economic and industrial factors that affect security valuation. Before we proceed, let us test your understanding by attempting the following exercise.

ECONOMIC ANALYSIS

The prospect and future of a firm depends on the economic situation and business environment in which the firm operates. Sometimes, the environment plays a big role in the performance of a firm. In the previous section, we introduced the top-down approach to analyse the prospects of a firm in the future. The first step in this approach is to evaluate the position of the countrys economy. Malaysia practises an open economy system. Therefore, the position of the countrys economy will also be affected by the international environment. In the evaluation of share prices, we have to evaluate the following economic and industrial situations:

(a) World environment;

(b) Domestic economy; and

(c) Government policy.

5.6

1. The last dividend paid by Denting Bhd. was RM0.24. In view of the companys strong position and its consequent low risk, its required rate of return is only 12%. If dividends are expected to grow at a constant rate, g of 5% in the future, what is Dentings expected share price five years from now?

2. Compron Bhd is experiencing a period of rapid growth. Earnings and dividends are expected to grow at a rate of 15% during the next two years, at 10% in the third year and at a constant rate of 6% thereafter. Comprons last dividend was RM0.15 and the required rate of return on the share is 12%. Determine the price of the share. Calculate the variance and the standard deviation for the five-year investment.

EXERCISE 5.1


(a) WWorld environment Every country trades with other countries. The economy of a country will at

least be affected by the economic situation in other countries. The factors that can influence the relations or trade between countries include:

(i) Political situations.

(ii) Trade policies. Are any of the policies too restrictive in terms of free trade?

(iii) Foreign exchange rates. An increase or decrease of the exchange rate of a country will affect the industry that deals with imports and exports.

(b) DDomestic economy The economic situation of a country can be observed from a few indicators.

(i) GGross Domestic Product

It also shows the activities that take place in an economy. GDP can be studied through the demand and supply aggregate.

From the demand point of view, the GDP will show information as follows:

Consumer spending that is divided between the private sector and government spending.

The formation of fixed capital by the private and public sectors. This is the investment by the country.

The countrys imports and exports.

From the supply point of view, GDP can be seen as the productivity of the sectors of the economy.

Please refer to the BNM report at http://www.bnm.gov.my to know what sectors are available in Malaysia for the purpose of valuation.

Gross Domestic Product (GDP) measures the total production of goods and services in a country.


(ii) IInflation

An increasing rate reflects that an economy might have reached its peak. Products and services demand exceeds supply. It might also be an indicator that the production factors have come to full capacity and can no longer meet consumers demand. From another point of view, high inflation means an unhealthy economy. There are not enough products to meet demand, causing prices to increase. Lack of products might have been caused by a lack of economic activities and production. We have to study the reasons for the lack of activity. The inflation rate can affect the rate of return expected by investors evaluating a security. They will increase the expected return if they predict an increase in the inflation rate. Inflation can also affect a firms returns. However, the effect is not clear. Some firms can increase the price of their products by adapting to the inflation rate and have no effect on their profit. Some firms cannot increase their prices as they might lose their customers. Some firms will have to bear higher costs of production during inflation and sustain a lower profit margin.

(iii) IInterest Rates Interest rates are decided by the demand and supply of funds. Any

increase in interest rates will increase the cost of loans. This will reduce capital investment and business growth will slow down or stop.

Increasing costs will decrease profit. However like inflation, the

relationship between cost and profit is not clear. Some firms can increase their product prices because of increasing cost, without affecting sales, and therefore increase their profit margin. Some firms cannot increase price and their profit margin will decrease.

Inflation is the rate of price increase of goods and services or a currencys buying power.


(c) GGovernment policy The economy can also be influenced by government policies. Every policy

will influence aggregate supply and demand. There are two types of policies:

(i) FFiscal policy is the government spending and tax policy. A deficit

budget occurs when the government spends more than its income or tax. In this situation, the government will take loans. A surplus budget occurs when income exceeds spending. Thus, the government will make investments.

Demand will increase when government increases spending. This will

accelerate economic growth and provide a multiple effect. A budget deficit is sometimes used to trigger the economy.

(ii) MMonetary policy is a policy where the level of total money supply is

managed to control the economy. Changes in the money supply levels can affect interest rates and inflation. For example, by increasing the money supply, interest rates will drop. The drop in interest rates will increase business growth. Increasing the money supply will also increase the liquidity. The excess liquidity will be used to buy securities, thus increasing price. However, too much liquidity may inflate prices.

One of the ways in which a government influences the money supply

is by entering the market. When the government buys back treasury instruments, the money supply will increase. The government can also increase the money supply by decreasing the banks reserve requirements.

The speculation of the ringgit in 1997 led our economy into a recession.Review the economic situation at that time and analyse how thesituation affected share prices. You can obtain more input for the analysis from the Internet, the OUMDigital Library and archived news.

ACTIVITY 5.4


INDUSTRY ANALYSIS

The purpose of industrial analysis is to understand the characteristics and structure of an industry. There is a relationship between the character and structure of the industry with earnings that can be generated by firms in the industry. In addition, a good firm usually is in a healthy and growing industry. It is quite hard to identify an industry. A simple definition would be a group of firms running the same business. However, these firms are sometimes involved in different kind of activities. The Bursa Malaysia has its own classifications of industry. The first step is to identify the factors that can influence industry sales. There are four techniques used to predict sales.

(a) Sales level and industry life cycle;

(b) Input-output analysis;

(c) Relation between sales and economy; and

(d) Competitive structure in industry. Let us discuss this further. (a) SSales Level and Industry Life Cycle In this technique, an industry is said to go through a life cycle. The life cycle

is divided into a few stages as shown in Figure 5.1.

Figure 5.1: Industry life cycles

5.7


(i) PPioneering Development During this stage, the industry sales increase slowly. Profit margin is

low and sometimes negative. Development cost is high. (ii) RRapid Growth During this stage, demand for products from the industry will be

increasing. The market for the product will be developing at a fast rate and the profit margin will start to increase. Demand exceeds supply and firms may not be able to fulfil orders.

(iii) MMature Growth During this stage, sales are still high. However the sales growth will

be decreasing. Profit margin will decrease because more firms will enter the industry and increase competition.

(iv) SStable Stage and Matured Market During this stage, the industrial growth is in line with the economy. If

the economy goes up, so will the growth. Profit margin will depend on the ability of firms to control costs and the market.

(v) GGrowth Reduction During this stage, there will be a replacement for the product. The

profit margin will be smaller and there will be firms losing. There will also be firms running out of business. Firms that are still running will have low rates of return.

(b) IInput-Output Analysis In this analysis, a particular industry is classified as either a supplier or a

consumer. It means the industry is classified between the industry that supplies products and the consumer industry that uses the product. Both industries will depend on each other. The future of the supply industry will depend on the potential and future of the consumer industry and vice versa. Sales of the supply industry are calculated based on predictions of the consumer industry. The growth of the consumer industry depends on the constant supply from the supplier industry.

(c) RRelation between Sales and Economy Industry sales can also be predicted by looking at its relation with the

economy. This relation can be examined in a global as well as domestic perspective. For example, consumer products or retail industries can be related to consumers income. Industrial products can be related to economic growth or government spending.


(d) CCompetitive Structure in Industry We can complete the industry analysis by examining the competitive

structure of an industry. The competitive structure can give insight into the earnings of firms in the industry. The tighter the competition, the harder it will be for firms to get or maintain high profit.

According to Michael Porter, there are five factors that depict the

competitive structure of an industry.

(i) EEntry of New Firms whether the industry can easily accept new firms

Among the challenges of entering an industry are high investment cost, good distribution systems, consumers loyalty to brands, firms with copyright and sometimes government sanctions. If it is difficult to enter the industry, there will be lower competition between firms in the industry. Thus, profit can be controlled easily.

(ii) CCompetition from Existing Firms Is competition in the industry tight? Usually when the industry

consists of firms of the same size, competition will be high. Competition will occur in terms of price and cost controls. In this situation, firms can only gain moderate profit.

Industries that have slow growth will also have tight competition.

This is because there are limited markets and competition will be fierce.

(iii) CCompetition from Alternative Products Industries are also vulnerable to product alternatives. A product that

can be easily replaced will affect the industrys potential and future profit. Price cannot be altered easily. Example: between palm oil and soya bean.

(iv) BBuyers Bargaining Power If there is only one buyer who requires most of the industrys

products, this buyer can influence the price. For instance, the tyre industry can push the rubber producers to decrease the price. This can decrease the profit of plantation companies.


(v) SSuppliers Bargaining Power If there is only one supplier, then price will be controlled by this

supplier. Firms that depend on this supplier will find that their profit will depend on the suppliers price.

COMPANY ANALYSIS

The objective of a company analysis is to examine the nature and characteristics of a company. It also involves examining the financial affairs of that company and determining the quality of its earnings. The basic input in undertaking a company analysis is the companys financial statements. There are three main financial statements. They are:

(a) BBalance Sheet which is a statement of the companys assets, liabilities and stockholders equity.

(b) IIncome Statement which provides a summary of operating results.

(c) SStatement of Cash Flows which provides a summary of cash flow and events that caused the cash position to change.

A detailed description and analysis of the above statements should have been covered in a basic finance course. A normal analysis will include ratio analysis, common size statements, trend analysis and intra firm analysis. This module will not go into detail about these analyses. However, we will pick some pertinent features in the statements for further analysis. In section 5.2.3, we observed that growth can be affected by ROE. It is also indicated that this ROE must be more than the return required by the investor for share price to increase. Based on this fact, we will examine this variable very closely. ROE can be formulated into the following:

Pgv"Rtqhkvu Rtg/vcz"Rtqhkvu GDKV Ucngu CuugvuTQG"?"

Rtg/vcz"Rtqhkvu GDKV Ucngu Cuugvu Gswkv{ Pre-tax profit is profit before tax. EBIT is earnings before interest and tax. The second factor is the interest factor. Pretax profit divided by the EBIT will indicate the interest burden that the firm has to bear. A high interest factor will indicate that a high amount of debt has been used. The third factor is the profit margin. Profit margin shows the capability of a firm to generate income through sales. Therefore, it is important to identify factors that can influence sales. Be alert that cost of operation can affect profit margin.

5.8


The fourth factor is asset turnover. The firm must be able to utilise its assets optimally. The fifth factor is the leverage ratio. If leverage ratio equals to one, then all the assets will be financed by equities. If it is equal to two, then 50% of the assets is financed by debt. A higher ratio means more debt has been used. However, take note that any undue increase in the fifth factor will increase the financial risk of the company. Any increase in debt will also decrease the second factor. Therefore, it is important for the analyst to examine the quality of the increase in ROE. There are two main strategies that a company can use in order to increase earnings. They are: (a) LLow Cost Strategy Through this strategy the company endeavours to increase earnings by

controlling costs. This is only done when there is no opportunity to increase the price of the product.

(b) DDifferentiation Strategy Through this strategy the company will maintain its pricing policy, being

confident that customers will not stop buying its products as it is perceived to be different and maybe of high quality.

1. An investor estimates next years sales of Amal Bhd. should amountto RM75 million. The company has 2.5 million shares outstanding,generates a net profit margin of about 5% and has a payout ratio of50%. All figures are expected to hold for next year. Given thisinformation, compute the following.

(a) Estimated net earnings for next year.

(b) Next years dividend per share.

(c) The expected price of the share (assuming the PE ratio is 24.5times earnings)

2. If an economy is in recession, what kind of monetary and fiscal

policies should be adopted?

EXERCISE 5.2


There are two approaches to evaluate a security, namely:

(a) The Top-down Approach; and

(b) The Bottom-up Approach. In the Discounted Model, the share price is calculated by finding the present

value of the predicted dividend and the predicted selling price of the share. The basic valuation includes discussion of the following:

(a) The discounted dividend model;

(b) The constant growth model;

(c) The relationship between share price and growth; and

(d) Multistage growth. The investors need to undertake economic analysis industry analysis as well

as company analysis in evaluating share prices as well as the business environment in which the firm operates.

topic 5 investment analysis

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