Investment analysis and portfolio management 8th reilly and brown chapter 11

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Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Eighth Edition by Frank K Reilly & Keith C Brown Chapter 11 Chapter 11 - An Introduction to Security Valuation Questions to be answered: • What are the two major approaches to the investment process? • What are the specifics and logic of the top-down (three-step) approach? • What empirical evidence supports the usefulness of the top-down approach? • When valuing an asset, what are the required inputs? Chapter 11 - An Introduction to Security Valuation • After you have valued an asset, what is the investment decision process? • How you determine the value of bonds? • How you determine the value of preferred stock? • What are the two primary approaches to the valuation of common stock? Chapter 11 - An Introduction to Security Valuation • Under what conditions is it best to use the present value of cash flow approach for valuing a company’s equity? • Under what conditions is it best to use the present value of cash flow approach for valuing a company’s equity? • How you apply the discounted cash flow valuation approach and what are the major discounted cash flow valuation techniques? Chapter 11 - An Introduction to Security Valuation • What is the dividend discount model (DDM) and what is its logic? • What is the effect of the assumptions of the DDM when valuing a growth company? • How you apply the DDM to the valuation of a firm that is expected to experience temporary supernormal growth? • How you apply the present value of operating cash flow technique? Chapter 11 - An Introduction to Security Valuation • How you apply the present value of free cash flow to equity technique? • How you apply the relative valuation approach? Chapter 11 - An Introduction to Security Valuation • What are the major relative valuation ratios? • How can you use the DDM to develop an earnings multiplier model? • What does the DDM model imply are the factors that determine a stock’s P/E ratio? • What two general variables need to be estimated in any of the cash flow models and will affect all of the relative valuation models? Chapter 11 - An Introduction to Security Valuation • How you estimate the major inputs to the stock valuation models (1) the required rate of return and (2) the expected growth rate of earnings and dividends? • What additional factors must be considered when estimating the required rate of return and growth for foreign security? The Investment Decision Process • Determine the required rate of return • Evaluate the investment to determine if its market price is consistent with your required rate of return – Estimate the value of the security based on its expected cash flows and your required rate of return – Compare this intrinsic value to the market price to decide if you want to buy it Valuation Process • Two approaches – Top-down, three-step approach – Bottom-up, stock valuation, stock picking approach • The difference between the two approaches is the perceived importance of economic and industry influence on individual firms and stocks The Expected Rate of Inflation • Investors are interested in real rates of return that will allow them to increase their rate of consumption The Expected Rate of Inflation • Investors are interested in real rates of return that will allow them to increase their rate of consumption • The investor’s required nominal risk-free rate of return (NRFR) should be increased to reflect any expected inflation The Expected Rate of Inflation • Investors are interested in real rates of return that will allow them to increase their rate of consumption • The investor’s required nominal risk-free rate of return (NRFR) should be increased to reflect any expected inflation: Where: NRFR = [1 + RRFR][1 + E (I)] - E(I) = expected rate of inflation The Risk Premium • Causes differences in required rates of return on alternative investments • Explains the difference in expected returns among securities • Changes over time, both in yield spread and ratios of yields Estimating the Required Return for Foreign Securities • Foreign Real RFR – Should be determined by the real growth rate within the particular economy – Can vary substantially among countries • Inflation Rate – Estimate the expected rate of inflation, and adjust the NRFR for this expectation NRFR=(1+Real Growth)x(1+Expected Inflation)-1 Risk Premium • Must be derived for each investment in each country • The five risk components vary between countries Risk Components • • • • • Business risk Financial risk Liquidity risk Exchange rate risk Country risk Expected Growth Rate • Estimating growth from fundamentals • Determined by – the growth of earnings – the proportion of earnings paid in dividends • In the short run, dividends can grow at a different rate than earnings due to changes in the payout ratio • Earnings growth is also affected by compounding of earnings retention g = (Retention Rate) x (Return on Equity) = RR x ROE Breakdown of ROE ROE = Net Income Sales Total Assets = × × Sales Total Assets Common Equity = Profit Margin Total Asset x Turnover Financial x Leverage Breakdown of ROE • The first operating ratio, 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 It indicates how management has decided to finance the firm Estimating Growth Based on History • Historical growth rates of sales, earnings, cash flow, and dividends • Three techniques arithmetic or geometric average of annual percentage changes linear regression models log-linear regression models • All three use time-series plot of data Estimating Dividend Growth for Foreign Stocks • • • • Differences in accounting practices affect the components of ROE Retention Rate Net Profit Margin Total Asset Turnover Total Asset/Equity Ratio The Internet Investments Online http://www.leadfusion.com http://www.lamesko.com/FinCalc http://www.numeraire.com http://www.moneychimp.com End of Chapter 11 –An Introduction to Security Valuation Future topics Chapter 12 • Macroanalysis and Microvaluation of the Stock Market ... risk and country Investment Decision Process: A Comparison of Estimated Values and Market Prices You have to estimate the intrinsic value of the investment at your required rate of return and. .. valuation approach and what are the major discounted cash flow valuation techniques? Chapter 11 - An Introduction to Security Valuation • What is the dividend discount model (DDM) and what is its... technique? Chapter 11 - An Introduction to Security Valuation • How you apply the present value of free cash flow to equity technique? • How you apply the relative valuation approach? Chapter 11 -
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