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FINA3324 Investment Analysis Professor Raymond da Silva Rosa ([email protected]) Page 1 of 5 Wk 5 : Fundamental Analysis – Econom y - Wide F actors Today • Fundam enta l analysis is an approach to estimatin g an asset ’ s va lue by analysing economic a nd financial variable s that affect the suppl y of and demand for the asset • What is the relationship between economic growth, industry characteristics and company value? Today we review economy - wide factors, Ne xt week we focus on industry f ac tors • Analyst must estimate if asset value is equal to market value What determines asset value? What is the relationship between asset value and market price? Analysts have to compa re the estimated price from the following modell against the market price Quiz for you : Imagine it is 1950 and you have to choose to invest in either IBM or Standard Oil of New Jersey. You decide to review some ratios presented by some genie able to look into the future. The comparisons are on the table below (ie, all this is known to you in 1950). Which company would you choose: IBM or Standard Oil? IBM SOJ Advantage Revenue per share 11.91% 8.93% IBM Dividends per share 9.23% 7,12% IBM Earnings per share 10.75% 7.75% IBM Sector growth 12.06% - 12.3% IBM Insight: A good company does not necessarily make a good investment . A good investment is one where value is less or equal to ma r ket price . If v alue is equal to market price then you will make a normal return for the risk, if it is less than market price (ie, undervalued) you wil l make a n abnormall y high return gi ven its risk. ons GrowthOpti R E CF E P t t t + + º å ¥ = 1 ]) [ 1 ( ] [ Asset value Market price FINA3324 Investment Analysis Professor Raymond da Silva Rosa ([email protected]) Page 2 of 5 Review of val uation model • Expected c ash flows are a functi on of the attractiveness of a company ’ s product and services , its cost of doing business and competition in its industry . – : ” value investing ” (Warren Buffett specializes in this kind o f analysis) • T he extent investors value the expected cash flows of a com pany de pend s on alternat ive investment opportun ities in the market . The discount rate is a measure of the average return a vailable f rom alternative investments, adjusted f or risk . It is a functio n of economy wide and industry factors • “Growth options” provide potential for future growth in profits. o “growth options” valuable only if the company can capture profits o Usua lly difficult to estimate cash flows from “growth options”. Option valuation method used rather than DCF ( subject of a future lecture) ***************************************************************************************** FINA3324 Investment Analysis Professor Raymond da Silva Rosa ([email protected]) Page 3 of 5 The framework abo ve lists some of th e principal factors that influen ce the cash flows to a com pany. • Changes in tech nolo gy influenc e the value of company • Less widely appreciated b ut equally import ant , changes in regulatory environment affect the viabi lity of a compa ny ’ s business (as illustrated in the lecture) • S o me changes , e.g., broa d shifts in consumer ta stes , demographic tr ends, in creased concern about com pan ies ’ environmental impact , tightening or loosening of regulations , have a great er impact on some companies. The ris e of exchange traded funds (ETFs) allows retail investors to get more exposure to thes e tr ends (as illustrated in the lecture) • A feature of mode rn econ omi es is the dominance of large com panies is increasing . A number of factors, inc luding the regulatory e nvir onment , favour large com panies . 1 Growth options • Growth options may be developed via investments that provide the compa ny with a competitive advantage in earning profits in the future • When high economic growth expected, investors value companies developing growth options (provided the companies ’ shareholders capture that profit) • The re ’ s o ften a tension between management’s and investors’ view of future - Management may think investors are too focuse d on short - term and crippling growth options by demanding distribution of profits - Investors may think managers are excessively optimistic and/or want to “empire build” at their expense. • In recession, investors prefer profits to be distributed to them rather than retained by the company for further investment • Key ques: is the company better placed to make those investments than shareholders? 1 Research by Kathleen Kahle and Rene Stulz shows that in 1975, the biggest 100 public companies in the US accounted for about 49% of all earnings of all public companies. In 2015 that percentage had increased to 2015 FINA3324 Investment Analysis Professor Raymond da Silva Rosa ([email protected]) Page 4 of 5 • The present economic perio d is un usual i n that companies a ren ’ t investing 2 but the share marke t is doing well and the re seems to be a boo m in I POs. 3 • It ’ s a puzzle because if companies are under - investing relative to historic a l levels one would normally think that IPOs wou ld not be well rece ived. What explains the ph enomenon of a boo m in IPOs and weak overall b usiness investment? • A plausible conjecture is that the IP Os ar e raising money for new businesses that are likely to dominate or disrupt their sector. E xi sting bu sinesses do no t have th e same opportunities as the new entrants. This is only a conject ure . We will discuss th is point further in th e lecture on real options . Economic growth and expected return, E[R] • E[R] = risk - free rate plus risk premium • When investors’ risk aversion increases so does risk premium • Risk is relative. Less risky assets gain value when risk aversion increases, while riskier assets lose value. What is the relationship between economic growth and shareholder value ? S hare prices reflect present value of expected profits so if share market indices (e.g., ASX200) rise (fall) that implies good (bad) economic times ahead, no? Oddly: the answer is “no”. The relationship between economic growth and value of shares is not straightforward, for reasons that are useful to understand. 2 “ Reserve Bank governor Philip Lowe has raised concern about weak business investment potentially hampering Australia’s economic recovery and warned that regulators will act if lending stand ards deteriorate again ”. Source: ." RBA concerned about weak business investment by Sean Smith The West Australian 10 March 2021 Weak b usiness investment is also a feature of the US econom y: “ "U.S. capital investment spending has faltered since the dot - com speculative bubble which burst in early 2000. It has not kept pace with the economic growth, pro fits, cash flows or virtually any other metric one could use to benchmark investment spending. In 2014, real GDP was 8.7 percent above its level in the fourth quarter of 2007, the peak quarter prior to the Great Recession. Gross private domestic investment over the same period was just 3.9 percent higher. The trend in investment spending net of the depreciation which occurred is far worse. Net private investment totaled $860 billion in 2006; by 2013 it totaled just $524 billion ” Source: “ Why i s c apital i nvestment c onsist ently w eak in the 21st c entury U.S. e conomy? ” (2015) b y Thomas J. Duesterberg and Donald Norman The Apen Ins titute . 3 "The 29 companies about to join the ASX are tapping into a booming market – with about $2.5 billion raised in recent weeks – during what has been one of the most intense periods for IPOs in Australia in years" Source: "It’s raini ng IPOs at the ASX as year - end nears" Brad Thompson Australian Financial Review Nov 28, 2020. “ The market for new stocks is experiencing a moment of exuberance not seen in roughly 20 years. So far this year, 302 U.S. initial public offerings have raised $1 02.3 billion as of March 10, according to Dealogic. That is up 763% from the 35 offerings, valued at $11 billion, for the same period in 2020. For all of 2020, there were 457 IPOs, collecting $167.8 billion. Before that, the high - water mark for IPOs came d uring the dot - com bubble of 1999 when 547 offerings raised about $108 billion. Source: "The booming IPO market shows no signs of slowing" By Luisa Beltran Barr on's magazine March 15, 2021 FINA3324 Investment Analysis Professor Raymond da Silva Rosa ([email protected]) Page 5 of 5 (1) If economic growth stalls or overheats then the Central Bank (e.g., Reserve Bank of Austr alia) may take action by lowering interest rates to stimulate growth or increasing interest rates to reduce inflationary pressures o We are presently in a curious period where economic growth in the developed economies is weak but interest rates are close to zero so the main weapon of central banks to combat weak economic growth is ineffective. We are in a “liquidity trap” where many investors prefer to hold cash rather than invest (i.e., monetary policy is ineffective in stimulating demand) (2) Economic growth may not benefit existing companies if low barriers to entry in an industry allows new entrants to share in the profits and/or if labour costs increase and/or consumers gain all the benefits via lower prices and higher quality products. Read (in the recommended readings section for week 5): “ Economic grow th an d equity returns ” by Jay Ritter and “ Does the share market really matter ? ” by Ray da Silva Rosa. In addit ion t o the lecture slides on Quantitative Easing, r ead “ What is qua n tit ative easing? ” by t h e Bank of England (a vailable in recommended rea dings for week 5).

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