1
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1
Contents
-
I
External Environment
Financial System
Financial sector
The mechanics of moving resources
Economic forces
Industry factors
Internal Environment
Inputs, Operations, Outputs and supporting activities
The various departments
Corporate governance and agency problems
Company risk and return
The Future
Forecasted cash flows
Forecasted growth rates
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2
Contents II
Types of Financial Analysis
Fundamental Analysis
Profit Maximization.
ROE (Du Pont) Analysis
Factors That Affect Stock Value
Fundamental Valuation Models
Technical Analysis
Use of Exotics in Financial Analysis and valuation
Use of Mathematics in Financial Analysis
Forecasting in financial Analysis
PE and PB Rations in Depth Analysis
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3
Review
-
What is Financial
Analysis
Financial analysis:
To evaluate and valuate.
Evaluate determinants of financial
performance
Determine and put a value to
performance parameters
Make a decision
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4
Review of the First Session
Introduction to the financial system including an
explanation of the financial sector, participants in the
financial system and interest and money as the driver
and lubricants of the economy.
Reviewed the external and internal environment and
their effects as determinants of forecasting and
drivers of value.
Reviewed the basics of financial analysis like its
scope and content and some new trends in financial
analysis that are becoming the new tools that are
increasingly used especially in valuation of financial
derivatives and other structured financial
instruments.
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5
Manager
–
Shareholder
Agents
--
managers with a fiduciary duty to act in the best interests of owners
Agency problem
--
managers maximize their own self
-
interests at the expense
of owners
High salaries of CEOs
Emphasis on short
-
term performance at expense of long
-
term performance
Empire building for status
perquisites
The burden is to align the interests of the manager with those of the
shareholders
This puts a
DRAIN
on the performance and value of the firm.
Tactics used to align interest:
Manager part owner
Stock options
Bonuses
Cash dividends
Debt
Monitoring
Corporate control markets
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6
Shareholder
–
Debt holder
The conflict of interest arises here when the firm is
over indebted.
Shareholders will get into high risk
–
high return
investments, if such investments materialize,
shareholders will reap most of the benefit (debt
holders are paid a fixed percentage and the residual
goes to the shareholders), if not most of the loss will
be on the side of the debt holders.
The solution is covenants
The financial analyst needs to assess such situation
in the process of determining a risk premium among
other things.
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7
Shareholder
-
Shareholder
A rises in companies with subsidiaries and
affiliates
The interests of the subsidiary shareholders
are not in line with those of the shareholders
of the parent companies
Appears in capital budgeting decisions
especially when the parent and the subsidiary
are in two different tax and regulatory
regimes
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8
Auditors
Auditors are prone to be lenient in auditing
financial statements and in valuing business
because they are paid by the very same party
they are auditing or do not want to lose
future business opportunities.
Such considerations need to be taken into
account when financially analyzing a firm.
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9
Regulators
The regulators interests may be
different from those of the company
being analyzed
The regulator may enact regulations
that hurt the company for the public
good; levying taxes is an example.
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10
The Market for Corporate Control
Participants in the financial markets are
monitoring each other to capitalize on
opportunities of buying an undervalued firm.
Firms that have corporate governance
problems are prone to incur higher rate of
return due to the risk premium added from
such problems
.
The financial analyst needs to incorporate
such factors in estimating and forecasting
required rates of return and future cash
flows.
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11
Company Risk and Return
The analyst needs to incorporate specific analysis of the
riskness of the company to reflect that on the required rate of
return on investing sums of money in such company.
Many measures of risk, the most important ones are the most
simple ones, because they are the ones used most in industry
practice.
Beta
Sigma
VaR
Many more like: down side risk, coefficient of variation,
regressions, time series, FF two factor model, FF multi factor
models, Merton intertemporal model, stochastic models, stress
tests under various distributions …..
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12
Types of Financial Analysis
Fundamental: use of all relevant information
and to predict value
–
assumes markets
efficiency.
Technical: use of past price, trading volume
and people behavior to predict value
–
assumes market inefficiency.
Naïve: Financial ratios and some calculated
indicators
–
limited usefulness.
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13
Fundamental Analysis
The value of an asset is equal to the present
value of all of its future net cash flow.
Need to take previous factors into account
when forecasting cash flows, growth rates
and required rates of return.
Depends on all relevant information
Believes in Semi strong form market
efficiency.
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14
Is stock price maximization the same as profit
maximization?
No, despite a generally high correlation
amongst stock price, EPS, and cash flow.
Current stock price relies upon current
earnings, as well as future earnings and
cash flow.
Some actions may cause an increase in
earnings, yet cause the stock price to
decrease (and vice versa).
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15
Profit Maximization
Example:
Equity = 10 million shares @
DHS
1 a share book
value, no RE, no PIC and no reserves.
Profits =
DHS
10 million
CEO and CFO claim that they can maximize
profits by increasing them to
DHS
10.5 million if
they company would issue 1 million new
shares.
In this case profits are maximized however
profitability is lowered
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16
Profit Maximization
Well, what happened to profitability?
# shares
Value per share
Profits
Case 1
10
10
10
Case 2
11
11
10.5
Profits are maximized (a handsome increase of 0.5 million)
# shares
Value per share
Profits
EPS
Case 1
10
10
10
1
Case 2
11
11
10.5
0.955
Profits are maximized (a handsom increase of 0.5 million)
However, profitability declined!
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17
Profit and Profitability Maximization
Example:
Equity =
1
million shares @
DHS
1
a share book
value, no RE, no PIC and no reserves.
Profits =
DHS
1
million
CEO and CFO claim that they can maximize
profits by increasing them to
DHS
1.5
million if
they company would retain all of last year’s
earnings, i.e.
DHS
1
million .
In this case profits and profitability are
maximized
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18
Profit and Profitability Maximization
# shares
Value per share
RE
Value of equity
Profits
EPS
ROE
Case 1
1
1
0
1
1
1
100%
Case 2
1
1
1
2
1.5
1.5
75%
Profits are maximized (a handsom increase of 0.5 million)
EPS maximized (from 1 to 1.5 per share)
However, return on equity is lowered from 100% to 75%
# shares
Value per share
RE
Profits
EPS
Case 1
1
1
0
1
1
Case 2
1
1
1
1.5
1.5
Profits are maximized (a handsom increase of 0.5 million)
EPS maximized (from 1 to 1.5 per share)
How would this affect return on equity?
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19
Maximizing Profits, Profitability
and Return on Equity!
Use leverage to increase the return on equity
However this will increase the riskness of the firm
Increasing risk lowers the price.
Furthermore, the return on total assets will decline
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20
Maximizing Profits, Profitability
and Return on Equity!
Example
same as last example, but instead of
retaining earnings, finance growth
operations and profits by borrowing
from the bank at
10
%.
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21
What would happen to the Return on total assets?
# shares
Value per share
Value of equity
Debt
Profits
EPS
ROE
Case 1
1
1
1
0
1
1
100%
Case 2
1
1
1
1
1.4
1.4
140%
Cost of debt is 10% (i.e. 0.1 million)
Profits = 1.5 - 0.1 = 1.4)
Profits , EPS and ROE are all maximized
Maximizing Profits, Profitability
and Return on Equity!
# shares
Value per share
Value of equity
Debt
Total Assets
Profits
EPS
ROE
ROA
Case 1
1
1
1
0
1
1
1
100%
100%
Case 2
1
1
1
1
2
1.4
1.4
140%
70%
Cost of debt is 10% (i.e. 0.1 million)
Profits = 1.5 - 0.1 = 1.4)
Profits , EPS and ROE are all maximized
Return on assets is minimized + you have increased the riskness of the firm
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22
ROE Analysis
Assets
Total
Income
Net
ROA
Assets
Total
Sales
Turnover
Asset
Total
Sales
Income
Net
Margin
Profit
1
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23
ROE Analysis
Turnover
Asset
Total
Margin
Profit
ROA
Assets
Total
Sales
Sales
Income
Net
ROA
1
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24
ROE Analysis
Multiplier
Equity
ROA
Equity
Common
Assets
Total
Assets
Total
Income
Net
ROE
Equity
Common
Total
Income
Net
ROE
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25
ROE Analysis
Multiplier
Equity
Turnover
Asset
Total
Margin
Profit
ROE
Equity
Common
Assets
Total
Assets
Total
Sales
Sales
Income
Net
ROE
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26
Factors that affect stock price
Projected cash flows to shareholders
Timing of the cash flow stream
Riskiness of the cash flows
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27
Basic Valuation Model
To estimate an asset’s value, one estimates the
cash flow for each period t (CF
t
), the life of the
asset (n), and the appropriate discount rate (k)
n
1
t
t
t
n
n
2
2
1
1
.
k)
(1
CF
k)
(1
CF
k)
(1
CF
k)
(1
CF
Value
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28
Dividend Discount Models
Constant growth
Two growth
Multi growth
Stochastic
Additive w and w/o bankruptcy
Geometric w and w/o bankruptcy
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29
Residual Income Valuation
g
k
g
ROE
BV
)
(
*
Value
0
1
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30
Multipliers
PE
PB
V/EBIT
P/S
P/CF
1
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31
Technical analysis
Depends on past prices and trading
volumes to predict price and
performance
Markets are inefficient
Prices are trendy
Can be very mathematical
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32
Technical Charts
Point and figure
Candlesticks
OHLC
Price lines
Moving averages
……
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33
Technical Indicators
Candlesticks: hammer, bullish engulfing,
morning star, bearish engulfing, hanging
man, harami, Marubozu, three white soldiers,
…. Many more.
Technical indicators: moving averages,
exponential moving averages, Bollinger
bands, slow stochastic, fast stochastic, Trin,
Trix, Money flow index, RSI, Average
directional index, Williams %R, Price rate of
change, Oscillators, …. Many more.
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34
Exotic Financial Analysis
Stochastic models in forecasting items
and future interest rates and discount
rates, and the previously mentioned
stochastic dividend discount models.
Real Options
Abandonment Options
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35
Use of Mathematics
Towards the end of this program and as
an introduction to future programs we
will look into the mathematics of
financial analysis and their numerical
solutions especially for derivatives and
their use in equity and other securities
financial analyses.
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36
Forecasting Example
Cash & sec.
$
20
Accts. pay. &
accruals
$
100
Accounts rec.
240
Notes payable
100
Inventories
240
Total CL
$
200
Total CA
$
500
L
-
T debt
100
Common stock
500
Net fixed
Retained
assets
500
earnings
200
Total assets
$
1
,
000
Total claims
$
1
,
000
Balance sheet, in millions of dollars
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37
Sales
$2,000.00
Less:
Var. costs (60%)
1,200.00
Fixed costs
700.00
EBIT
$ 100.00
Interest
16.00
EBT
$ 84.00
Taxes (40%)
33.60
Net income
$ 50.40
Dividends (30%)
$15.12
Add’n to RE
$35.28
Income statement, in millions of dollars
Forecasting Example
1
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38
Key assumptions
Operating at full capacity in
2006
.
Each type of asset grows proportionally with
sales.
Payables and accruals grow proportionally
with sales.
2006
profit margin (
2.52
%) and payout
(
30
%) will be maintained.
Sales are expected to increase by $
500
million. (%GS =
25
%)
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39
Determining additional funds needed AFN
AFN
= (A*/S
0
)
Δ
S
–
(L*/S
0
)
Δ
S
–
M(S
1
)(RR)
= ($
1
,
000
/$
2
,
000
)($
500
)
–
($
100
/$
2
,
000
)($
500
)
–
0.0252
($
2
,
500
)(
0.7
)
= $
180.9
million.
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40
How shall AFN be raised?
The payout ratio will remain at
30
percent
(d =
30
%; RR =
70
%).
No new common stock will be issued.
Any external funds needed will be raised as
debt,
50
% notes payable and
50
% L
-
T
debt.
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41
Forecasted Income Statement
Sales
$
2
,
000
1.25
$
2
,
500
Less:
VC
1
,
200
0.60
1
,
500
FC
700
0.35
875
EBIT
$
100
$
125
Interest
16
16
EBT
$
84
$
109
Taxes (
40
%)
34
44
Net income
$
50
$
65
Div. (
30
%)
$
15
$
19
Add’n to RE
$
35
$
46
Forecast
Basis
2007
Forecast
2006
1
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42
2007
1
st
Pass
Forecasted Balance Sheet (
2007
)
-
Assets
2006
Forecast
Basis
Cash
$
20
0.01
$
25
Accts. rec.
240
0.12
300
Inventories
240
0.12
300
Total CA
$
500
$
625
Net FA
500
0.25
625
Total assets
$
1
,
000
$
1
,
250
1
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43
2007
1
st
Pass
2006
Forecast
Basis
Forecasted Balance Sheet (
2007
)
-
Liabilities and Equity
AP/accruals
$
100
0.05
$
125
Notes payable
100
100
Total CL
$
200
$
225
L
-
T debt
100
100
Common stk.
500
500
Ret.earnings
200
+
46
*
246
Total claims
$
1
,
000
$
1
,
071
* From income statement.
1
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44
What is the additional financing needed
(AFN)?
Required increase in assets
= $
250
Spontaneous increase in liab.
= $
25
Increase in retained earnings
=
$
46
Total AFN
= $
179
The company must have the assets to generate
forecasted sales. The balance sheet must balance,
so we must raise $
179
million externally.
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45
How will the AFN be financed?
Additional N/P
0.5
($
179
) = $
89.50
Additional L
-
T debt
0.5
($
179
) = $
89.50
But this financing will add to interest
expense, which will lower NI and retained
earnings. This will lower equity financing and
increase debt financing, and so on. We will
generally ignore financing feedbacks.
1
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46
2007
2
nd
Pass
2007
1
st
Pass
AFN
Forecasted Balance Sheet (
2007
)
-
Assets
Cash
$
25
-
$
25
Accts. rec.
300
-
300
Inventories
300
-
300
Total CA
$
625
$
625
Net FA
625
-
625
Total assets
$
1
,
250
$
1
,
250
1
-
47
2007
2
nd
Pass
2007
1
st
Pass
AFN
Forecasted Balance Sheet (
2007
)
-
Liabilities
and Equity
AP/accruals
$
125
-
$
125
Notes payable
100
+
89.5
190
Total CL
$
225
$
315
L
-
T debt
100
+
89.5
189
Common stk.
500
-
500
Ret.earnings
246
-
246
Total claims
$
1
,
071
$
1
,
250
1
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48
Advanced Forecasting
Use of regressions for each item
Use of iterations in finding interest
income and expense
Forecasting with stock dividends, stock
repurchase, stock issuance, stock splits,
….
1
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49
Analyzing PE and PB and its Usages
Case I
:
لاح يف ريعستلا
ومن دوجو مدع
=
ومنلا
0%
ةيدقن تاعرزوت لكش ىلع حابرلأا ةفاك عفدت
=
عيزوتلا
100%
)
اهدوجو مدع وأ ةفاضم ةيداصتقا ةميق دوجو
(
همدع وأ ةيدايتعا ريغ حابرا دوجو
=
بولطملا دئاعلا
10%
هنم ربكأ وأ بولطملا دئاعلا يواسي ققحتملا دئاعلا نا يأ
قوس يأ وأ راكتحا وأ ةسفانم قوس
بولطملا دئاعلا لدعم
/
مهسلا ةيحبر
=
رعسلا
1
-
50
Analyzing PE and PB and its Usages
Case I
ةسفانم
راكتحأ
ةيرتفدلا ةميقلا
10
10
10
بولطملا دئاعلا
10%
10%
10%
يلكلا حبرلا
1
2
3
يداعلا حبرلا
1
1
1
يداع ريغلا حبرلا
0
1
2
ققحتملا دئاعلا
10%
20%
30%
عيزوتلا
1
2
3
ةيرتفدلا ةميقلا
10
10
10
يقوسلا رعسلا
10
20
30
ةيرتفدلا ةميقلا فعاضم ةيرتفدلا ةميقلا ىلا ةيقوسلا ةميقلا
1
2
3
)
ةيحبرلا فعاضم
(
ةيحبرلا ىلا ةيقوسلا ةميقلا
10
10
10
لا مأ ةفاضم ةميق دوجو نع رظنلا ضغب اتباث ةيحبرلا فعاضم ىقبيو ةيرتفدلا ةميقلا فعاضم ريغتي
1
-
51
Analyzing PE and PB and its Usages
Case II
:
لاح يف ريعستلا
ومن دوجو
رخلآا اهفصن زجحيو ةيدقن تاعيزوت لكش ىلع حابرلأا فصن عفدي ومنلا ليومتل
=
ومنلا
0.05
)
ةفاضم ةيداصتقا ةميق دوجو مدع
(
ةيدايتعا ريغ حابرا دوجو مدع
=
عيزوتلا
0.5
عقوتم وه امم رثكأ سيلو طقف بولطملا دئاعلا يواسي ققحتملا دئاعلا نا يأ
=
بولطملا دئاعلا
0.1
ةكرشلا مجح ةدايزل رامثتساو ةسفانم قوس
=
ققحتملا دئاعلا
0.1
)
ومنلا لدعم
-
بولطملا دئاعلا لدعم
(/)
ومنلا لدعم
+
1
(*
تاعيزوتلا
=
رعسلا
1
-
52
Analyzing PE and PB and its Usages
Case II
ةنسلا
1
2
3
4
5
ةيرتفدلا ةميقلا
10
10.5
11.03
11.58
12.16
بولطملا دئاعلا
10%
10%
10%
10%
10%
يلكلا حبرلا
1
1.05
1.103
1.158
1.216
يداعلا حبرلا
1
1.05
1.103
1.158
1.216
يداع ريغلا حبرلا
0
0
0
0
0
ققحتملا دئاعلا
10%
10%
10%
10%
10%
عيزوتلا
0.5
0.525
0.551
0.579
0.608
ةيرتفدلا ةميقلا
10.5
11.03
11.58
12.16
12.76
يقوسلا رعسلا
10.5
11.03
11.58
12.16
12.76
ةيرتفدلا ةميقلا فعاضم ةيرتفدلا ةميقلا ىلا ةيقوسلا ةميقلا
1
1
1
1
1
)
ةيحبرلا فعاضم
(
ةيحبرلا ىلا ةيقوسلا ةميقلا
10.5
10.5
10.5
10.5
10.5
اتباث رمتسا هنكلو ومنلا ببسب ةيحبرلا فعاضم داز
عقوتملا نم ربكأ ومن دجوي لا هنلأ اتباث يقب ةيرتفدلا ةميقلا فعاضم نأ لاإ ةكرشلا يف ومنلا نم مغرلاب
عقوتملا نم ربكأ ومن دجوي لا هنلأ اتباث يقب ةيحبرلا فعاضم نأ لاإ ةكرشلا يف ومنلا نم مغرلاب
1
-
53
Analyzing PE and PB and its Usages
Case III
:
لاح يف ريعستلا
ومن دوجو
رخلآا اهفصن زجحيو ةيدقن تاعيزوت لكش ىلع حابرلأا فصن عفدي ومنلا ليومتل
=
ومنلا
0.05
)
ةفاضم ةيداصتقا ةميق دوجو
(
ةيدايتعا ريغ حابرا دوجو
=
عيزوتلا
0.5
بولطملا دئاعلا نم ربكأ ققحتملا دئاعلا نا يأ
=
بولطملا دئاعلا
0.1
ةكرشلا مجح ةدايزل رامثتساو ةسفانم قوس
=
ققحتملا دئاعلا
0.2
)
ومنلا لدعم
-
بولطملا دئاعلا لدعم
(/
ةيدايتعلاا ريغ حابرلأا
+
ةيرتفدلا ةميقلا
=
رعسلا
1
-
54
Analyzing PE and PB and its Usages
Case III
ةنسلا
1
2
3
4
5
ةيرتفدلا ةميقلا
10
11
12.1
13.31
14.64
بولطملا دئاعلا
10%
10%
10%
10%
10%
يلكلا حبرلا
2
2.2
2.42
2.662
2.928
يداعلا حبرلا
1
1.1
1.21
1.331
1.464
يداع ريغلا حبرلا
1
1.1
1.21
1.331
1.464
ققحتملا دئاعلا
20%
20%
20%
20%
20%
عيزوتلا
1
1.1
1.21
1.331
1.464
ةزوجحملا حابرلأا
1
1.1
1.21
1.331
1.464
ةيرتفدلا ةميقلا
11
12.1
13.31
14.64
16.11
يقوسلا رعسلا
31
34.1
37.51
41.26
45.39
ةيرتفدلا ةميقلا فعاضم ةيرتفدلا ةميقلا ىلا ةيقوسلا ةميقلا
2.818
2.818
2.818
2.818
2.818
)
ةيحبرلا فعاضم
(
ةيحبرلا ىلا ةيقوسلا ةميقلا
15.5
15.5
15.5
15.5
15.5
اتباث رمتسا هنكلو ومنلا ببسب ةيحبرلا فعاضم داز
اتباث ةيرتفدلا ةميقلا فعاضم ىقبي
اتباث يقب ةيحبرلا فعاضم نأ لاإ ةكرشلا يف ومنلا نم مغرلاب
1
-
55
Analyzing PE and PB and its Usages
Case IV
:
لاح يف ريعستلا
ومن دوجو
رخلآا اهفصن زجحيو ةيدقن تاعيزوت لكش ىلع حابرلأا فصن عفدي ومنلا ليومتل
=
ومنلا
0.05
)
ةفاضم ةيداصتقا ةميق دوجو
(
ةيدايتعا ريغ حابرا دوجو
=
عيزوتلا
0.5
بولطملا دئاعلا نم ربكأ ققحتملا دئاعلا نا يأ
=
بولطملا دئاعلا
0.1
ةيدايتعلاا ريغ حابرلأا يف ومن
=
ققحتملا دئاعلا
0.2
ةكرشلا مجح ةدايزل رامثتساو ةسفانم قوس
=
ةيدايتعلا ريغ حابرلأا ومن
0.05
)
ومنلا لدعم
-
بولطملا دئاعلا لدعم
(/
ةيدايتعلاا ريغ حابرلأا
+
ةيرتفدلا ةميقلا
=
رعسلا
1
-
56
Analyzing PE and PB and its Usages
Case IV
ةنسلا
1
2
3
4
5
ةيرتفدلا ةميقلا
10
11
12.16
13.5
15.06
بولطملا دئاعلا
10%
10%
10%
10%
10%
يلكلا حبرلا
2
2.31
2.68
3.124
3.66
يداعلا حبرلا
1
1.1
1.216
1.35
1.506
يداع ريغلا حبرلا
1
1.271
1.538
1.864
2.262
ققحتملا دئاعلا
20%
21%
22%
23%
24%
عيزوتلا
1
1.155
1.34
1.562
1.83
ةزوجحملا حابرلأا
1
1.155
1.34
1.562
1.83
ةيرتفدلا ةميقلا
11
12.16
13.5
15.06
16.89
يقوسلا رعسلا
31
37.68
44.45
52.63
62.57
ةيرتفدلا ةميقلا فعاضم ةيرتفدلا ةميقلا ىلا ةيقوسلا ةميقلا
2.818
3.1
3.294
3.495
3.705
)
ةيحبرلا فعاضم
(
ةيحبرلا ىلا ةيقوسلا ةميقلا
15.5
16.31
16.59
16.85
17.09
ةيدايتعلاا ريغ حابرلأا يف ومنلا عم ةدرطم ةدايزبو ومنلا ببسب ةيحبرلا فعاضم داز
ةيدايتعلاا ريغ حابرلأا يف ومنلا عم ةدرطم ةدايزبو ومنلا ببسب ةيرتفدلا ةميقلا فعاضم داز
ةيدايتعلاا ريغ حابرلاا يف ومنلا عم نيفعاضملا دادزي
1
-
57
Analyzing PE and PB and its Usages
Conclusions
Reinvestment of free cash flow at rates of
return in excess of capital costs creates
growth in abnormal earnings, resulting in
valuation multiple expansion.
The PE is a function of the prospective
growth in future abnormal earnings.
Usages of PE in any other case will result in
mispricing and arbitrage opportunities.
This huge limitation should be considered
among many other ones.
1
-
58
Analyzing PE and PB and its Usages
Conclusions
Which PE to use the historical average
of the same firm’s PE’s, OR
The PE of similar firms, OR
The PE of the industry
How are PE’s used for companies that
have more than one division
1
-
59
Analyzing PE and PB and its Usages
Conclusions
PE does take risk into account indirectly (i.e. through
the used pricing model’s discount rate)
.
PE gives the dollar amount (Price) the investor is
willing to pay for one dollar of continued earnings. PE
is the reciprocal of the required rate if return.
Empirical studies show that the required rate of
return (calculated using other return models like the
market model or CAPM) is usually different from the
one calculated by PE ratios.
Only sustainable earnings are used, transitory or non
recurring earnings
must
be excluded.
1
-
60
Analyzing PE and PB and its Usages
Recommendations
Use PE ratios with maximum caution
Know when it is used and what it
means
PB is also problematic some times, it is
used when there are abnormal returns
regardless whether they grow or not.
1
-
61
Tools of Financial Analysis
See you all in December
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