Equities

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Introducing The Stock Market

Cover 5 Topics

• The role of the stock market and how indices act as its storefront
• The nature of equities
  • Key differences between rights or equity and bond holders
• Equity research
• Absolute valuation
• Relative valuation

You will learn…

• Calculate equity index performance
• Appeal of equities
• Reason for stock-market volatility
• Importance of company ecosystems to valuation
• Earnings forecast generation process
• Absolute value process and limitations
• Relative valuation process and earnings

The Stock Market

• Equities = stocks = shares
  • Part ownership of a company

Purpose of the Stock Market

• To allocate resources to productive enterprise
• Appealing for two reasons:
  • Stock market makes it easy to enter and exit company investments
  • Potential to make money form companies

Total Market Value

• The world market value is smaller than the world bond market both in terms of total value and total number of securities
• How do investors keep tabs on overall stock market movements?
  • By using indices

Indices

• Indices are baskets of stocks
• There are more indices in the world than the equities that comprise them
• Indices tell market movements and if a money manager has beaten the market
• World Equities Index (WEI) shows equity markets by geography
• Emerging Markets Equities Indices (EMEQ) shows emerging indices
• World Equity Markets (WM) shows the change in equity index prices on a color coated interactive world map so you can spot trends in equity markets in real time

Index Composition

• S&P 500 is most closely watched index
  • Accounts for a quarter of the world’s market cap
  • Broken down into 11 industry groups
• Each industry is broken down into sub industries, which are ultimately composed of single stocks
• Company size, industry, and country are the most common organizing principles for stock market indices
• Size determines the membership of the S&P 500
• Size is not just used to determine whether a stock should be in or out of an index
  • It is also used to determine how much it contributes to moves of the index
• Index Weight % = Market Cap of One Stock B
• You can view all the stock contributions by going to WEI > S&P 500 (or other index) > Table tab > All Securities row > Index Point
• Aggregate member moves drive overall index moves

Summary

• IPOs raise money and/or transfer ownership
• Companies delist from the stock market when they are bought, go bust, or balk at reporting requirements
• Equity indices come in all shapes and sizes
• Index performance is calculated from the performance of the index members

The Nature of Equities

What is an Equity?

• An entitlement to future cashflows
• While a bond promises fixed repayments, an equity promises residual cashflows from a company from what is left after all other claims have been paid

Comparison of Bonds and Equities

• The following is from example of a person with fluctuating salary, fixed mortgage, 30% income tax, fixed necessity spending, and fluctuating discretionary spending
• What are they entitled to?
  • Bond holder: Mortgage repayments from pretaxed income
  • Shareholder: Whatever else is left after everyone else has been paid and she has covered the basics
• What do they ask themselves?
  • Bond holder (Bank): Will Jenny be able to repay us from her salary?
  • Shareholder (Jenny): How much “play money” will she have?
• What do they calculate?
  • Bond holder: = 20,000 mortgage repayment = 6 times interest cover (can pay back 6 times over)
  • Shareholder: = 20,000 mortgage - 16,000 necessities = $54,000 discretionary income
• What is effect of inflation
  • Bond holder: no effect
  • Shareholder: She gets pay raises to shield her from inflation
• What is the upside?
  • Bondholder: 5.2% yield
  • Shareholder: Higher increases in discretionary income when she gets pay raises
• What is the downside?
  • Bond holder: Limited downside due to collateral
  • Shareholder: she loses everything

Factors to Consider When Comparing Returns

• The role of dividends in equity returns
  • The Total Return (TRA) shows the return investors would get from an index if they were to reinvest the dividends
    • Shows white line excluding dividends
    • Shows brown line with dividends reinvested
  • Standard indices ignore dividends in charts
    • Dividends are very valuable, so take into account when investing
• The nominal nature of stock and bond returns
  • They are nominal, meaning not including inflation

Summary

• Shareholders own a share of a company’s earnings and assets
• Stocks are volatile because earnings are volatile
• Shareholder returns come from both shares going up and payments of dividends
• The range of shareholder returns is asymmetrical. Shares can go to zero or multiply in value

Equity Research

Equity Ownership

• Stock owners own a portion of a company’s profit after expenses
• They also own a portion of their assets

Volatility of Earnings

• Drivers of earnings = revenues - costs
• Revenue and cost volatility is the cause for earnings volatility

Earnings Announcement

• Companies typically report revenues, costs, and earnings on a quarterly basis
• Can see a company’s earnings report by the Earnings Calendar (EVTS)
• Have scheduled release dates
• Most companies release their quarterly reports in certain seasons
  • But some do not follow the typical calendar year, thus earnings report releases are continuous throughout the year

Estimating Earnings

• How to estimate future company earnings
  • Industry Classification
  • Suppliers & buyers
  • Revenue projections
  • Cost base

Industry Classification

• A lot of revenue and cost information is industry dependent
• It is easy if a company operates in one industry, but some don’t
• Company Classification Browser (CCB) shows what industries a company generates revenue from

Industry Hierarchies

• Industries are arranged into hierarchies
• You can see the industry classification hierarchy with Industry Classification (ICS)
  • ICS is a useful market sizing tool
  • In total, contains over 2000 distinct industries

Suppliers and Buyers

• By analyzing suppliers and buyers, an analyst can generate more accurate revenue forecasts
  • Can better anticipate supplier problems such as bankruptcy, product problems, or currency movements
• You can see a company’s supply chain by using the Supply Chain (SPLC) function after searching a specific company

Revenue Projections

• How big is the pie? And how big is the company’s slice of that pie?
• Bloomberg Intelligence (BI)
  • Can be used to analyze market shares and many other things

Cost Base

• Want to know which costs are fixed, which are variable, cost of labor, and any cost exposure to commodity prices
• Can use BI to see the Cost Analysis of industry/products/etc.

Rolls-Royce Case Study

• You are an analyst trying to understand why Rolls-Royce’s revenue rose from 6 billion pounds in 2003 to 14 billion pounds in 2014
• First off, what industry is Rolls-Royce in?
  • Type in Rolls-Royce > select its stock
  • Type in Company Classification Browser (CCB)
    • 67% revenue comes from aircraft engines
    • 10% from marine propulsion systems
• How big was the pie in its major line of business, aircraft engines?
  • Search Bloomberg Intelligence (BI) > Industries > Industrials > Aerospace & Defense dashboard > Market Share > look at the Engines market (tab)

Historic Analysis

• Once an analyst knows the relevant industries, she can the generate financial estimates for the company in question
  • The first step is to analyze historic performance using the reported financial numbers, otherwise known as, the actuals
  • By modeling historic company performance, the analyst can project the drivers of revenues and cost and use these to estimate earnings
• The first thing an analyst does when she picks up coverage of a company is to analyze previous earnings statements and read the transcripts of recent company investor conference calls
  • She does this by typing Events (EVT) after searching a company, and checking the earnings call checkbox to see conference call transcripts
    • These provide the context to the company’s performance, in particular, the management’s Q&A with analysts

Estimating Revenue and Cost

• Determining underlying company drivers is both an art and a science
  • An art because it demands imagination
  • A science because then an analyst must demonstrate mathematically causal, intuitive link between the driver and the company’s financial results
  • This simplification process it frequently where the biggest errors occur

Beats and Misses

• Analysts of a stock race one another to compare the announced numbers with the consensus estimates
• The difference between the reported results and the estimates is called the surprise\
  • When the actual results are above the estimates, it is called a Beat
  • And when below, a Miss
• Whether a company beats or misses tends to be in a headline of an earnings news story

BlackBerry and Apple Case Study

• Looking at the quarterly revenue for blackberry; we can see from 2006-08 there was a positive surprise (beat) for 9 consecutive quarters
  • Analysts have missed the boat
• When Apple released iPhone, people switched to iPhone and BlackBerry missed for many quarters. Analysts again were behind

Surprises Move Share Prices

• Analyze company earnings announcements and resulting share price moves with Earnings Surprise (SURP)
• For Apple from 2011-2014, 6 times a positive surprise was met with an increase in share price
  • On 3 occasions, a negative surprise was met with a falling share price
  • However, on 5 occasions, the share price did not move in the direction that analysts would have guessed
  • So it was right 9/14 times, which is pretty good odds
• We can visualize this phenomenon with another terminal function: Earnings Analysis (EA)
  • View stock price movement for each member of the S&P 500 in the wake of its results announcement
  • Price reaction vs Surprise
    • The x-axis shows the scale of the earnings surprise
      • If the data point is to the right of the vertical line, it means the company surprised positively, and if to the left, negatively
    • The y-axis shows the share price performance for the day after the earnings results were released
      • If the data points are above the horizontal line, it means the shares went up the day after results, and if below, down
  • When the surprise was positive, more often than not, the shares went up
    • Hence there are more points in the top right quadrant than in the bottom right quadrant
  • When the surprise was negative, more often than not, the shares went down
    • Hence there are more points in the bottom left quadrant than in the top left
  • But there are points all over the chart, so the relationship is not foolproof
    • Just because an analyst has a high conviction that a company will surprise positively at its results does not mean he knows for sure how the company’s shares will react after the results are published
• There’s more to guessing share price movements than accurately estimating earnings, its called valuation

Summary

• Analysts must know the industries in which a company operates
• Industry estimates are foundational to a company financial model
• Industry drivers help formulate earnings estimates
• Investors assess company results by comparing them to estimates

Absolute Valuation

Share Price Mechanics

• Shares are equal slices of ownership of the company
• How many shares is decided by the company treasurer
• The total # of shares multiplied by the number of shares gives you the size of the company, otherwise known as market capitalization
• The market capitalization is what investors care about, the share price tells us almost nothing
• Comparing share prices of different stocks is not meaningful - a rookie mistake

Stock Splits and Reverse Stock Splits

• You cannot change the size of the market capitalization by tampering with the number of shares
• A stock split is when a company feels its share price is too high for retail investors so it divides each share into 2 or more shares
• Reverse stock split, or stock consolidation, is the opposite
• To locate these kinds of stocks, type ‘News on Reverse Stock Splits” into the command line
  • Also works with news on stock splits
• Stock buybacks shows a company has faith in itself, which may encourage investors to buy more stock
• When a company does a stock buyback, the value of each remaining stock goes up because there are now fewer slices of the company
• Stock splits and reverse stock splits have no impact on equity valuation, so the market cap stays the same

Role of Earnings Estimates

• Share prices are facts, while equity valuations are opinions
• Type Estimates for the Earnings Estimates Graph (EEG) to see earnings estimates for a company

Absolute and Relative Valuation

• Assessing fair market capitalization
  • Absolute valuation
    • Is when an analyst estimates future earnings and then estimates how much those estimates are worth in todays money
  • Relative valuation
    • When an analyst compares a company to a similar company or to the overall market to define relative value
    • This process is more intuitive than absolute valuation
• Both approaches try to find out what the fair market value is for the company

	Absolute Valuation	Relative Valuation
Pros	Precise - rests on detailed evaluations of the future	Easier to understand
	Anchored to earnings	Simple to calculate
	Disciplined thought process	Does not demand long-term forecasts
Cons	Demands clairvoyance	Directional - describes if under or over value, but not by how much
	Laborious	Hard to find truly comparable companies
	Prone to subtle manipulations	Presupposes that the company you are comparing it to is itself fairly valued

• Absolute valuation demands both short and long-term financial forecasts while relative valuation only demands short-term forecasts
  o   Relative valuation does not necessarily require any historic financial data

Absolute Valuation - Discounting Cash Flow Valuation

• Estimating a company’s cashflows into infinity and figuring out how much those cash flows are worth today
  • This can then be translated into a market capitalization and therefore share price
• 5 Step Process
  1. Understand historic performance → Estimate long-term future cash flows
  2. Estimate the rate at which to discount those cash flows to determine todays value
     • Estimate discount rate aka “WACC”
     • Weighted average cost of capital
  3. Discount the cash flows using the WACC
  4. Deduct the firm’s indebtedness and add the firm’s cash pile to derive market cap
  5. Divide estimated market cap by the number of shares to give the estimated fair share price from the valuation

Estimating Cash Flows

• Must look at the whole firms cash flows, not just bottom line
• Analyst will use his company’s projections of revenues and costs to project the Free Cash Flow
  • The cash the firm has available to bondholders and shareholders
• The mechanics is ruled based, so the hard part is not getting the info but making the predictions of the future

Estimating Discount Rates

• Estimate the rate at which you will discount the cash flows
  • Weighted Average Cost of Capital
• A bird in the hand is worth two in the bush
• Given the inherent uncertainty of the future investors are willing to trade the promise of a larger sum tomorrow for the certainty of a lower sum today
• This is the reason investors assign a lower value to, or discount, the cash flows
• What percentage rate should investors use?
  • US Gov. bond yields set the discount rate for equity investors
  • But, equities are riskier than bonds, so investors must increase the discount rate to reflect the added risk, but by how much?
• A typical firm is finance by both shareholders and bondholders
  • Equity and debt have different risk profiles and therefore have different discount rates
  • The discount rate used for the overall firm is a blend of the discount rates of both equity and debt
    • Blended in proportion to the relative split of both equity and debt financing
• Weighted Average Cost of Capital (WACC) function for a company shows the blend of equity and debt financing
  • To find this number (WACC), one must first find the proportion in which a company’s financing breaks down into both equity and debt
    • Displayed in the pie chart at the top right of the page
  • Multiply the weight of equity and debt by their respective % cost = W x C and then add them together to get WACC
• The cost of debt is calculated from the yield of a firms bonds
  • Corporate bond yields are typically higher than government bond yields due to the greater risk

Estimating Cost of Equity

• Where does the cost of equity come from?
  • The calculation analysts use is based on the Capital Asset Pricing Model (CAPM)
    • Uses the general riskiness of the stock market as a starting point
    • It then takes into account the volatility of the stock being valued compared to that of the overall market in order to calculate stock specific risk
    • It therefore uses stock volatility as a proxy for the earnings estimates
• 6 Step process to estimate the cost of equity (lets call them A-F)
  • A: Take the 10 year government bond yield - Type World Bonds (WB) to get US bond yield
    • Known as the risk-free rate
  • B: Calculate the historic overall market return
    • Type Country Risk Premium (CRP)
    • Identify US market return
  • C: Calculate the market risk premium
    • Click on the US market return in the CRP function and it is in the last column
    • It is calculated by taking the market return minus the 10-year gov. bond yield
  • D: Estimate beta for the stock (estimate how much riskier this stock is to the overall market)
    • Type Beta after searching a stock
    • Calculation is based on a regression with the returns of an index (such as S&P 500) on the x-axis and the daily returns of the company on the y-axis
    • Function runs a regression between the two datasets to find a best fit line
    • Beta is the slope of the best fit line
      • It is a measurement of a stocks sensitivity to the movement of the overall stock market
  • E: multiply market risk premium by beta to get the equity risk premium
  • F: add back the risk-free rate to the equity risk premium to get the cost of equity
• The WACC function constantly updates current cost of equity by clicking on the cost of the equity number

Discount the Cash Flows at the WACC

• Use the company’s WACC to discount the future cash flows
• We are trying to calculate the value of these cash flows today
• The estimated value of the size at the start of the period is the sum of the total values of these discounted cash flows
• Each cash flow diminished in value the further out it goes
• The riskier the firm (higher the WACC) the smaller its valuation

Deriving Market Capitalization

• Pull up the “Enterprise Value” (EV) of a stock
  • The total value of the whole firm
• Enterprise value is the value of stocks and equity
• So to get the equity valuation we subtract the value of the bonds, or the company’s debt on the balance sheet
• Cash balances also belong to the shareholders, so we add the cash balance

Estimating Share Price

• Divide the estimated market cap by the number of shares to get the fair share price

Absolute Valuation Observations

• 10 year bond yields are foundational to the WACC
  • The lower the 10 year bond yields, the lower the WACC
  • The lower the WACC, the higher the estimated share price
• Economic growth and interest rates offset each other when it comes to stock market valuation
• No company can grow faster than nominal GDP growth in the long-term or it would subsume the global economy
  • Therefore long-term company revenue is limited to GDP growth which averages about 5%
• WACC is typically higher than nominal GDP growth, 8% being a common level
  • This means that WACC will ultimately grind down company cash flows to nothingness
  • This is why the very long run is unimportant to equity investors
• WACC > Nominal GDP Growth
• Heavily indebted companies have more volatile share prices than companies with no debt
  • This is because when the total value of a company changes, the total amount owed back to investors does not
  • Therefore the piece owned by the shareholders, market cap, moves more sharply
  • E.g., Mortgages

Absolute Value Sensitivities

• Absolute valuation has many moving parts and thus sensitivities
• Many of the inputs are quite changeable and have nothing to do with the company in question
• This is one of the reasons for the volatility in company equities
• Common sensitivities to be mindful of when valuing a company:
  • Estimates will be affected by the economic cycle
    • Retail sales
    • Housing starts
    • New home sales
  • Companies operating around the world, revenues and costs may be in other currencies which therefore will be buffeted by moves in the FX market
  • Many companies are affected by the commodities market
  • WACC will be affected by moves in the overall stock market, which change the equity risk premium
  • Moves in the 10 year bond yield which change the risk free rate
  • The share price itself can affect the share price

Summary

• Absolute valuation involves the discounting of future cash flows
• Future profits in the long term are worth less than future profits in the short term
• Good financial models balance simplicity and insight
• The concept of absolute valuations are usually precisely wrong

Relative Valuation

Relative Valuation is when an analyst compares a company to itself, a similar company, or the overall market to derive a relative value.

• Goal is not to determine a fair share price, but to determine if a company is overvalued, undervalued, or fairly valued

Introduction

• 2 step process
  • Metrics
    • Dividend Yield
    • P/E
  • Application
    • Self
    • Peers
    • Market

Dividend Yields

• 2 Key differences between dividend yields and bond yields
  • Dividends payments may vary while bond payments usually do not
  • Dividend yields are easier to calculate than bond yields
    • Uses a one year or part year dividend payment as the basis for calculation
• Type Coca-Cola and click company and then type Dividend  (DVD) into command line shows dividend payments of a company
• Equities, unlike bonds, can last a very long time, and unlike bonds, can grow
• Dividend yield is calculated by taking the price per share = Dividend Yield %
• \ earnings\ per\ share\ /\ $\ price\ per\ share$

Price to Earnings Ratio (P/E)

• earnings per share = P/E ratio
• Since P/E ratios are usually greater than 1, they are referred to as P/E multiples
• Earnings yield and P/E ratio are reciprocals of each other
  • You can see this as a time series chart on GF function of a company equity

Use of P/E Ratio in Valuation

• Earnings (E) x P/E ratio = share price (P)
• Estimated earnings x P/E ratio = Market cap
• This framework gives two reasons why share prices may go up
  1. If the P/E ratio stays the same and the Earnings goes up, then the Price will go up
     • Earnings growth drives the share price
  2. If E stays the same and P/E goes up, then P increases
     • Known as multiple expansion drives share price
• Both the guesses of Earnings and a reasonable P/E ratio are fiercely hard to generate
• Estimating P/E hinges on ones belief in the growth of E

Relative Value Versus Self

• Just because share prices go up or down, it does not mean it is expensive or cheap
  • One must always look at P/E multiples in the context of earnings

Relative Value Versus Peers

• Select a company and type Relative Valuation (RV) into command line
  • RV function suggests relevant peers
  • Shows a table called Table of Comparables
    • Known to bankers as a Comps Table
• Type Relative Valuation Correlation (RVC)
  • Shows a bubble chart plotting expected sales growth of peers on the x-axis against their P/E ratios on the y-axis
  • The bubble size is proportionate to the market size of each peer
  • The pink bubble plots the average sales growth, P/E, and market cap for the whole group
  • The blue bubble is your selected security

Relative Valuation Versus Market

• The World Equities Index (WEI) function shows the equity index markets and P/E and Div Yield for them
• You can compare your security’s P/E and Div Yield to that of the overall market’s

Valuation of the Market

	E	x	P/E	=	P
For a single stock	Net Income		Share price/earnings per share		Share price
For the S&P 500	Total net income for all index members		Aggregate market cap for all index members/total net income		Aggregate market cap for all index members

• The higher the P/E ratio, the more expensive the stock.
• The lower the dividend yield, the more expensive the stock.
  • This is because a dividend yield is the annual dividend divided by the share price, so if the share price is high in relation to the dividend, the dividend yield is low
• Share price = earnings per share / earnings yield
  • Earnings yield = earnings per share + share price
• While a high sales growth is attractive, it will be weighed against the reasonableness of the multiples being paid for the shares
  • Buying a rapidly growing company for a low multiple is the goal for many portfolio managers

Summary

• Relative valuation is the quick and easy comparison of one valuation to another
• The risk of relative valuation is being led astray by unrealistic reference points
• Earnings and multiples are used to estimate fair share prices
• Fast growing companies warrant high multiples and vice versa
• The state of the economy is a key driver of relative valuation

Summary of Module

5 Key Takeaways

• Index movements are driven by movements in member stocks
• The volatility of earnings leads to volatility, and high potential, of share prices
• Uncovering industry drivers is key to estimating earnings
• Absolute valuation is in theory perfect but has practical limitations
• Relative valuation is easier but sensitive to earnings growth