EQUITY ANALYSIS

Quantify market behaviours to plan, measure and communicate IR strategy

EQUITY
In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists. In an accounting context, Shareholders' equity represents the remaining interest in assets of a company, spread among individual shareholders of common or preferred stock. Value of an ownership interest in property, including shareholders' equity in a business Liability > Assets = Negative Equity

EQUITY MARKET
The market in which shares are issued and traded, either through exchanges or over-thecounter markets is called as an equity market. Also known as the stock market, it is one of the most vital areas of a market economy because it gives companies access to capital and investors a slice of ownership in a company with the potential to realize gains based on its future performance. This market can be split into two main sectors: the primary and secondary market. The primary market is where new issues are first offered. Any subsequent trading takes place in the secondary market.

STRENGTHS OF EQUITY ANALYSIS

A key element of Equity Analysis is the Market Structure Report. It provides a snapshot of your current trading and market structure, comparative metrics and trends, key macro events, and tactical targeting insights. The Trading Summary outlines what happened in your recent trading, why it happened, and the near-term sentiment for your shares, each critical in communicating with management and board. ModernIR's Rational Price measures how fundamental money competes with other market participants to buy shares. Observe where your shares are trading relative to Rational Price. A wide spread may indicate the market needs more information; risks are higher. Low spreads indicate a well-informed market; the mark of effective investor relations.

USES OF EQUITY ANALYSIS

Set benchmarks for behavioral targets and take actions to influence these behaviors. Use Rational Price to separate noise from substance in your trading activity. Improve targeting efforts by tactically adjusting focus (not story) to match current market structure. Compare the trends in your behaviors to your benchmarks and market averages to measure the effectiveness of your IR program.

DU-PONT ANALYSIS
DuPont analysis helps analysts glean insight from return on equity (ROE) by breaking ROE into several components. By breaking ROE into its components, analysts can pinpoint where returns are being generated, or lost. DuPont analysis also allows analysts to view trends in the components of ROE. For example, whether or not profit margins are improving or if financial leverage has changed

ROE

Net Income Shareholde rs Equity

Sales Total Assets Net Income ROE Shareholders Equtiy Sales Total Assets Sales Total Assets Net Income ROE Sales Total Assets Shareholders Equtiy Profit TotalAsset Equity ROE Margin Turnover Multiplier

LEVERAGE ANALYSIS
DEBT RATIO
Used to gain a general idea as to the amount of leverage being used by a company. A low percentage means that the company is less dependent on leverage, i.e., money borrowed from and/or owed to others. The lower the percentage, the less leverage a company is using and the stronger its equity position. Generally, the higher the ratio, the more risky the company Debt Ratio = Total Debt / Total Assets

PROPRIETARY RATIO
Indicates the ratio of total assets financed by owners. Used to gain a general idea as to the amount of leverage being used by a company. A high percentage means that the company is less dependent on leverage. The higher the percentage, the less leverage a company is using and the stronger its equity position. Generally, the higher the ratio, the less risky the company Proprietary Ratio = Equity / Total Assets

DEBT-EQUITY RATIO
This is a measurement of how much suppliers, lenders, creditors and obligors have committed to the company versus what the shareholders have committed. To a large degree, the debt-equity ratio provides another vantage point on a company's leverage position. A lower percentage means that a company is using less leverage and has a stronger equity position. Debt-Equity Ratio = Long-Term Debt / Equity or = Total Debt / Equity Equity = Paid-Up Capital + Reserves & Surplus

CAPITALIZATION RATIO
There is no right amount of debt. Leverage varies according to industries, a company's line of business and its stage of development. Common sense tells us that low debt and high equity levels in the capitalization ratio indicate investment quality Capitalization Ratio = Long-Term Debt / (Equity + Long-Term Debt)

 CAPITAL-GEARING RATIO
Provides the relationship between equity funds and fixed-income bearing funds. Used to show the effect of the use of Fixed Interest/Dividend vs the use of Dividend based on Profits on the earnings available to equity shareholders Capital-Gearing Ratio = Equity (Shareholders Funds) / Fixed-Income Bearing Capital

EQUITY VALUATION MODELS

INTRINSIC VALUE OF INVESTMENTS
P=(CF1/(1+r1))+(CF2/(1+r2)2)+..+ (CFn/(1+rn)n) Problem with This Model for Equity: Irregular & Unpredictible Cash Flows No Definite Date of Maturity for Common Stock Discount Rate is not directly observable

NOTE: In performing any analysis of Equity, there is Forecasting Risk that the Analyst is wrong Ways to MINIMIZE Forecasting Risk Use SCENARIO Analysis with ranges & probabilities of valuation Use SENSITIVITY Analysis to see how important each variable is to the Valuation Use SIMULATION Analysis Monte Carlo Method

DIVIDEND DISCOUNT MODEL

PCS = [D1/(1 + rCE)1] + [D2/(1 + rCE)2] ++ [D / (1+rCE)] Advantages & Disadvantages of the Dividend Discount Valuation Model PRO CON

Simplicity Able to distinguish Over Valued & Under Valued Firms Models Apply ONLY to Dividend Paying Stocks Risk is not an EXPLICIT Function of the market Largely subjective measure of risk Small Errors of g & r can result in HUGE errors (therefore, only good to come up with a range)

Applying Dividend Discount Models to Growth Stocks 1. Three Stage Dividend Discount Model Make Assumptions about the stages of development; High Growth, Deceleration of Growth, Stable Growth Use a Computer to Determine future dividends 2. H-Model (2 Stage Dividend Discount Model) Assumes ONLY 2 Stages of Growth: High & Stable 3. Growth Duration Model Compare Relative P/E between the Stock & Market

GENERAL FREE CASH FLOW VALUATION MODEL

FCF = CFO + Interest Expense Net Cash Used for Investing Cash Retained for Business Purpose FCF = Cash Interest Expense + Net Cash Used for Financing FCF = EBIT(1-t) + DEPR NWA CAPEX + (t*Interest) FCF* = EBIT(1-t) + DEPR NWA CAPEX

FCF v. DDM: FCF to the Firm FCF to CE

In theory, FCF & DDM should produce the same value for the common shares of a publicly traded firm. However, in practice, they usually produce different valuations. Which is Better? Most analysts prefer using the FCF over the DDM. FCF focus on the key factors: Ability to generate cash from operations, uses of corporate cash, and level of operating risk. More or less ignore the distributional & financing issues.

OTHER VALUATION METHODS

1. P/E Ratios
o o If Investors have LOW Confidence, tends to be about 7-9 If Investors have HIGH Confidence, tends to be about 15-18

2. Dividend Yields
o For Market, Tends to fall toward 3% when there is Excessive Optimism, and up to 6% during periods of Pessimism. In normal times, 3.5-4.5%

3. Price/Sales Ratios
o o Sales are less prone to Manipulation than Earnings For Large Firms, should be .4 - .8

4. Price/Asset Value Ratios

o o o S&P 500 between 1.5 2.0 Price to Book. When pessimistic 1.0-1.5 & when optimistic, 2.0-3.0 Price to Book PROBLEM: Book Value is Arbitrarty derived from Accounting Conventions. Liquidation might be a little better, but useful ONLY if thinking about breaking up the firm.

PRACTICAL PROBLEMS WITH VALUATION MODELS

1. Dividend Discount Models
Very sensitive to small changes in Discount Rate & Growth Rate (which are difficult to predict)

2. FCF Models
WACC is objectively, but FCF* is difficult to determine from accounting data Assumes increases in Working Capital are equal to that which is required to maintain existing operations, which may not be true Assumes firms invest up to the point where the last dollar invested produces a return = WACC Assumes Current Capital Structure is Optimal

3. Economic Earnings Based Models

Theoretically useful, but accrual accounting has faults

CONCLUSION
Important for every company and individual investor Equity Analysis will transform the way you understand and respond to the markets