Fundamental Analysis Macroeconomics Analysis Industry Analysis Equity Valuation

Fundamental Analysis • Macroeconomics Analysis • Industry Analysis • Equity Valuation Model (Dividend Discount Model- DDM) • Financial Statement Analysis

Macroeconomics Analysis • Global Economy Analysis – affects export, price competition and profits – exchange rate: purchasing power and earnings • Domestic Economy – The ability to forecast the macroeconomy can translate into great investment performance – outperform other analysts to earn extra profits Many variables can affect economy

–Gross Domestic Product (GDP): measures the economy’s total output of goods and services – Employment rate: measures the extent that the economy is operating at full capacity – Inflation measures the general level of prices increase Phillip’s curve – Interest Rate high interest rate reduces PV of cashflows, thus stock values – Budget Deficit large deficit means more borrowing, which implies higher interest rate. – Sentiment consumers and producers confidence

Business Cycles • • business cycles: pattern of recession and recovery peak: the end of expansion and start of recession trough: the bottom of the recession stock returns are decreasing when at peak and increasing at trough • cyclical industries: do well in expansionary periods but poorly in recession, e. g. , durable goods such as automobile and wash machines • defensive industries: little sensitive to business cycles, such food

Industry Analysis • Select a good industry to invest. It is difficult for a firm to do well in a troubled industry • Standard Industry Classification (SIC) code • Value line Investment Survey - reports 1700 firms in 90 industries • Two factors that determine the sensitivity of a firm’s earnings to business conditions: business risk, financial risk

Business risk • Sales sensitivity to business condition some industries are robust (food) while others are not (movie) • operating leverage: the division between fixed and variable costs. – firms with greater amounts of variable cost relative to the fixed cost are subject less to business fluctuations, thus profits are more stable Financial Risk • the degree in using financial leverage (the amount of interest payment) • leverage firm is more sensitive to business cycles

Industry cycles Start-up Build-up Maturity Decline Start-up: increasing growth Build-up/consolidation: stabilized growth maturity: slower growth Decline: shrinking growth

Equity Valuation Model • Dividend Discount Model (DDM) V 0= (D 1+P 1)/(1+k) = D 1/(1+k) + D 2/(1+k)2. . . + Dn/(1+k)n • constant growth assumption V 0 = D 1/(1+k) + D 1(1+g)/(1+k)2 +D 1(1+g)2/(1+k)3 +. . . = D 1/(k-g) or k = expected return = D 1/P 0 + g

Multistage Growth Model • Growth profile may not be constant such as: Expected Growth g 1 g 2 n Time V=D 0(1+g 1)/(1+k)+. . . +D 0(1+g 1)n/(1+k)n + D 0(1+g 1)n(1+g 2)/(1+k)n+1+. . . and so on

Illustration of two-stage Growth Model • A stock pays $1 dividend now and its g 1=30% for 6 yrs. Thereafter, its g 2=6%, its k=15% • yr 1: $1(1+0. 3) =1. 13 yr 2: 1(1+0. 3)2=1. 69 yr 3: 1(1+0. 3)3=2. 20 yr 4: 1(1+0. 3)4 =2. 86. yr 7: 1(1+0. 3)6(1+6%) =5. 12 yr 8: 1(1+0. 3)6(1+6%)2 =5. 42.

Market Value (equity) Market value is the present value of its future dividends Time 0 1 2 3 PV(Dt) 34. 0 37. 8 41. 78 45. 85 Growth rate 11. 17% 10. 52 9. 74 At time 1: FV(Dividends) = 34. 00(1. 15) - 1. 3= 37. 8 At time 2: FV(dividends) = 37. 80(1. 15) - 1. 69=41. 78 Expected return at time 0 (15%) = Yr end dividend/current price + growth rate = 1. 3/34 + 11. 17%

P/E Ratio Behaviors • Price = No growth value/share P 0 = E 1/k + PVGO or • P 0/E 1= [1+ PVGO]/k E 1/k P/E average Time

Pitfalls in P/E Analysis • Denomination of P/E ratio is the accounting earnings (arbitrary rules or historical cost will distort the earnings figures) • Earning should be based on economic earnings (i. e. , net of economic deprecation) • Earnings are future figures vs P/E ratio (which uses past accounting earnings)

Earnings Forecast • Models forecasting: Ei, t = gi + Ei, t-4 +ai(Ei, t-1 -Ei, t-5) where g: growth factor a: adjustment factor E: Earnings • Time Series Analysis ARMA model Exponential smoothing • professional institution forecast • Performance Evaluation MSE or others

Financial Statement Analysis • Preparation of Source/Use Fund Statement • Ratio Analysis – Performance Analysis – Du Pont Analysis

Use/source of Fund Statement • Sources C. Paper $ 5. 8 A/P 17. 8 Div/P 1. 4 S/T debt 4. 6 S/T Lease 3. 8 L/T Debt 20. 6 L/T Lease 25. 0 C/S 3. 2 P/I Cap 0. 6 NI 54. 4 Depreciation 48. 6 Total 185. 8 Uses Cash $ 0. 4 A/R 16. 2 Inv 34. 8 Prep. Ex 0. 4 Lease 82. 8 Others 3. 6 Tax 1. 0 Div. 46. 6 185. 8

Analysis of Use/Source • Sales growth=3. 5% • Uses- major component A/R =8. 72%; Inventory = 18. 73%; Lease = 44. 6% Dividend = 25. 1% • Sources A/P = 9. 5%; L/T debt = 11. 1%; L/T lease = 13. 4% Operation profits = 55. 4% (NI+depreciation) • Why issue shares? • S/T-/LT capital increases so much?

Ratio Analysis • Assets Sales Profit • Liquidity Ratio • Risk Ratio • Du Pond Analysis ROE=Net Income(NI)/Equity (E) = NI Pretax Prof EBIT Sale P. Prof EBIT Sales TA TA E TB IB GPM TAT EM Pretax profit =EBIT - Interest TB = Tax burden IB = interest burden