Moving into part two of equity analysis, the material introduces more calculations than part one.   Candidates will see a number of formulas that are commonly applied when valuing stocks.  It is important not only to know the formulas, but also to able to interpret them and understand their respective strengths and weaknesses.  Building on the foundation of part one, part two illustrates methods for intrinsic and relative valuation of stocks.

Beyond the increase in formulas, part two of equity also continues to examine the qualitative aspects of stock analysis.  Concepts concerning industry analysis (including Porter’s Five Competitive Forces), the business cycle, country analysis, and additional considerations for emerging market equities.

This tutorial aligns with Study Session 11 material in the Level II CFA Program Curriculum ©.
<h3><strong>NOTES:</strong></h3>
r<sub>ce</sub> = common notation for required return on common equity (or required return on equity for short).

r<sub>rf</sub> = common notation for return on a risk free asset; the standard risk free asset is government debt, such as U.S. Treasuries

b = common notation for a company’s earnings retention ratio

k = common notation for a company’s dividend payout ratio

β = beta; used in applications involving the Capital Asset Pricing Model

Subscript <sub>0</sub> vs. Subscript <sub>1</sub>: a “0” in the subscript represents the current period, while a “1” in the subscript indicates the value is the next future period
<h3><strong>Material:</strong></h3>
I.          Porter’s Five Competitive Forces

II.        Industry Analysis

III.       Emerging Markets Valuation

V.        Discounted Dividend Valuation

<strong> </strong><strong> </strong>

Equity Analysis Part 2 - Introduction

A firm’s profitability is heavily influenced by the overall strength of its industry. One approach for evaluating an industry structure is Porter’s Five Competitive Forces:

<img class="aligncenter size-full wp-image-5833" title="porter" src="https://financetrain.com/wp-content/uploads/porter.gif" alt="" />
<h3>Force 1: Threat of New Entrants</h3>
The easier it is to enter an industry, the more competitive that industry becomes.  Increased competition tends to depress profit margins.

If the industry is already highly competitive, prices and profit margins may already be sufficiently low enough to discourage would be new entrants as their capital can be more attractively deployed elsewhere.

Barriers that can discourage new entrants are: large start-up capital requirements, strong brand identification with existing businesses, government restrictions, patented product technology of existing companies, and the threat of strong retaliation by existing companies.
<h3>Force 2: Bargaining Power of Suppliers</h3>
When suppliers to an industry have strong bargaining power, they can reduce the industry’s profits.

Conditions that increase supplier power include: relatively large supplier size, low buyer importance to supplier, high switching costs for buyers, supplier cartel, and shortage of supplier’s product.
<h3>Force 3: Bargaining Power of Buyers</h3>
Buyers of an industry’s product also influence the industry’s profit.

Conditions that increase buyer power are: high buyer importance to seller, high buyer knowledge of seller, and high buyer ability to influence end market users.
<h3>Force 4: Threat of Substitute Products</h3>
The existence of closely related products to that of the industry in question tangentially increases competition, lowering industry profitability.

When looking at substitute products, the analyst should consider how easy it would be for consumers to switch to a similar product.
<h3>Force 5: Intensity of Rivalry</h3>
An industry with an intense rivalry among firms will tend to have low profitability.

Symptoms of an intense rivalry include: high number of competitors, slow industry growth, low product differentiation, high product storage cost, and low relative strength among competitors.

Porter’s Five Competitive Forces

This article will describe elements of industry analysis beyond Porter’s Five Competitive Forces.
<h2>Sample Steps for an Industry Analysis</h2>
<img class="aligncenter size-full wp-image-5833" title="Industry Analysis Steps" src="https://financetrain.com/wp-content/uploads/industry-steps.gif" alt="" />
<h2>Industry Life Cycle</h2>
Industries tend to follow a natural progression which can be outlined as follows:

<img class="aligncenter size-full wp-image-5833" title="Industry Life Cycle" src="https://financetrain.com/wp-content/uploads/life_cycle.gif" alt="" />

1)    <strong>Pioneer Stage:</strong> a high degree of uncertainty at this point.  The product is unproven and cash flow is most likely negative, but future growth prospects are high.  Investors face a high risk/high reward situation with companies in the Pioneer Stage.

2)    <strong>Growth Stage:</strong> now sales and profits are increasing.  The product is gaining acceptance, but total market size potential is still not fully known.  Star equity analysts discover growth industries ahead of the herd.

3)    <strong>Mature Stage:</strong> the industry has become saturated and growth rate will slow to the rate of general economic growth.  Growth companies can still be found within mature industries, as they may be improving the product’s quality or acquiring competitors.

4)    <strong>Decline Stage:</strong> demand for the industry’s product is contracting and the surviving firms fight for market share.  Profit margins will shrink and some firms will fail or leave the industry.  Stronger firms may anticipate product decline and diversify their operations.
<h2>Industry Classifications and Business Cycle Reactions</h2>
While industries can be classified by their lifecycle phase, they must also be considered within the context of how they react to the business cycle.

The table below describes industries by business cycle:
<table class="mytable">
<tbody>
<tr>
<th scope="colspan">INDUSTRY TYPE</th>
<th scope="colspan">BUSINESS CYCLE TRAITS</th>
<th scope="colspan">LIFECYCLE TRAITS</th>
</tr>
<tr>
<th class="spec" scope="row">Growth Industry</th>
<td>Grows regardless of business cycle phase.</td>
<td>Moving from pioneer phase to growth phase; products commonly employ new technology.</td>
</tr>
<tr>
<th class="specalt" scope="row">Defensive Industry</th>
<td class="alt">Perform in a stable manner throughout the business cycle, with growth during economic expansion, but small hurts to profitability in a recession.</td>
<td class="alt">Defensive firms commonly come from mature industries. Healthcare is considered by some to be a defensive industry.</td>
</tr>
<tr>
<th class="spec" scope="row">Cyclical Industry</th>
<td>Company profits will fluctuate with the business cycle.</td>
<td></td>
</tr>
</tbody>
</table>
<h2>External Factors</h2>
Factors outside the industry and its companies can influence behavior and profitability. External factors include:
<ul>
	<li><strong>Technology</strong>: this can be a positive or negative as technology can provide an industry or company with a protective moat when it is difficult to replace or a competitive threat when a mature industry’s technology is subject to replacement by new innovation.</li>
</ul>
<ul>
	<li><strong>Government Involvement</strong>: like technology, government behavior can protect or hinder industry performance.</li>
<ul>
	<li>Regulations for health and safety can increase industry operating costs, which hurts profitability.  Alternatively, these same regulations may lead to the development of new industries as a new supplier need is created, which did not previously exist.</li>
	<li>Taxes and subsidies can be deployed to force companies to offset negative externalities created by their products (ex. pollution) or to support domestic companies in the face of international competition.</li>
</ul>
</ul>
<ul>
	<li><strong>Foreign Factors</strong>: when a key component in an industry’s supply chain comes from overseas, the industry is susceptible to foreign influence.  This creates risk within the industry that might not be easy to mitigate.</li>
</ul>
<ul>
	<li><strong>Demographic Changes</strong>: demand for an industry’s product can be affected by changes in the age and income distribution of the industry’s target geographic market.  For example, as the U.S. population continues to age, new opportunities for firms in the healthcare industry will emerge.</li>
</ul>
<ul>
	<li><strong>Social Changes</strong>: lifestyle preferences evolve over time and the changes impact industries.  Some social changes take long period of time to occur, while changes in fashion are more short term and unpredictable.</li>
</ul>
 

Industry Analysis

<h2>Supply Analysis</h2>
<ul>
 	<li>Commonly demand analysis is the greater concern when analyzing and industry, but supply analysis is not without its useful insights.</li>
</ul>
<ul>
 	<li>The story of supply is largely told by knowing an industry’s capacity and the degree to which it is over or under-utilized.</li>
</ul>
<ul>
 	<li>If the analyst knows that capacity is being highly utilized, then it may signal high profitability.  Alternatively, when there is significant excess capacity, profit margins may be declining; firms may offer price discounts in order to induce buying and increase capacity utilization.</li>
</ul>
<ul>
 	<li>In industries with only a few firms or with significant capital costs to increase capacity, analysts may find it easy to estimate capacity utilization.  However, in industries with many firms or low expansion costs, capacity utilization can be much more difficult to estimate.</li>
</ul>
<h2>Demand Analysis</h2>
<ul>
 	<li>Understanding industry demand trends is critical for equity analysts; this receives more attention than supply analysis.</li>
</ul>
<ul>
 	<li>Historical data will be useful, but the ability to spot industry turning points can separate good analysts from great ones.</li>
</ul>
<ul>
 	<li>In order to understand demand, analysts will need to study an industry’s customer base and their needs.</li>
</ul>
<ul>
 	<li>In the case where an industry provides an intermediate good, product demand is a derived demand.</li>
</ul>
<ul>
 	<li>One technique for analyzing intermediate good demand is called input/output analysis.</li>
</ul>
<h2>Pricing Practices Analysis</h2>
<ul>
 	<li>The ability of a company to retain some degree of pricing flexibility can have a significant impact on its profit margins.</li>
</ul>
<ul>
 	<li>Many inferences can be made about an industry’s pricing practices through the lens of Porter’s Five Competitive Forces; product segmentation also provides insights into industry pricing.</li>
</ul>
<ul>
 	<li>Product segmentation can be seen in the form of branding and service levels.  In segmenting products, companies can create some pricing flexibility.</li>
</ul>
<ul>
 	<li>For example, a large clothing designer might create a middle market <a href="https://popgear.com/" target="_blank" rel="noopener noreferrer">clothing line</a> to appeal to middle class consumers, but also have an upscale brand distributed only in luxury boutiques.</li>
</ul>

Supply and Demand Analysis

<strong>Introduction</strong>

Emerging markets present tremendous opportunities to investors as their growth prospects are much higher than mature economies.

However, emerging markets also present valuation challenges to analysts as their stock markets may have lower liquidity, financial disclosure requirements can be low, and political situations can be unstable.

<strong>Making Nominal and Real Financial Projections in Emerging Markets</strong>

Financial projections in emerging markets can be quite challenging for analysts because exchange rates, inflation, and interest rate changes can all move significantly in short time periods.

<strong>Examples:</strong>
<ul>
	<li>Inflation can cause analysts to over-estimate real revenue growth.</li>
	<li>Interest rate and inflation movements can cause distort solvency ratios because debt may be at current costs but assets are likely shown at historical costs.</li>
</ul>
The following steps can be taken to make financial projections for emerging market firms:

<img class="aligncenter size-full wp-image-5833" title="Financial Projections" src="https://financetrain.com/wp-content/uploads/projections-steps.gif" alt="" />

Financial Projections in Emerging Markets

<h2><strong>Cost of Equity</strong></h2>
CAPM can be used to estimate the cost of equity capital for an emerging market.

Note however, if the country is not very well integrated into the global capital market system, then <a title="The Capital Asset Pricing Model" href="https://financetrain.com/the-capital-asset-pricing-model/">CAPM</a> may be an unsuitable technique, so be mindful of this qualifier when reading the item set.

Start by creating a risk free rate estimate for the foreign country:
<div class="formula1">RF<sub>foreign</sub> = RF<sub>US</sub> + (Inflation<sub>foreign</sub> – Inflation<sub>US</sub>)</div>
Next estimate a market risk premium to add on to the foreign risk free rate.

When using CAPM, then the beta for a company or industry should be calculated against a global market index and the market risk premium should reflect a global risk premium and not the local market risk premium.
<div class="formula1">r<sub>ce</sub> = RF<sub>foreign</sub> + β * (Market Risk Premium <sub>global</sub>)</div>
<h2><strong>Cost of Debt</strong></h2>
The cost of debt is equal to the foreign risk free rate calculated above plus an additional premium for the systemic portion of credit risk.

The cost of debt will not include a country risk premium; more to come on this below.
<div class="formula1">r<sub>debt</sub> = RF<sub>US</sub> + (Inflation<sub>foreign</sub> – Inflation<sub>US</sub>) + Credit Spread<sub>systemic</sub></div>
<h2><strong>WACC</strong></h2>
One the analyst has his/her cost of equity and cost of debt for the emerging market company or industry a standard <a title="Weighted Average Cost of Capital (WACC)" href="https://financetrain.com/weighted-average-cost-of-capital-wacc/">WACC</a> calculation can be made.

Do not forget to apply the company’s appropriate tax rate shield to the cost of debt when calculating WACC.
<div class="formula1">WACC = ((1-tax rate)* r<sub>debt </sub>* Weight debt) + (r<sub>ce </sub>* Weight ce)</div>
The weights represent the percent of debt or equity as part of the total capital structure.
<h2><strong>Interpreting Country Risk Premium</strong></h2>
An emerging market country will have its own unique risks, such as political instability.

In order to account for these, the analyst can add a country risk premium to the discount rate used in valuation.

Once WACC is calculated, then a country risk can be applied.

Sometimes the sovereign debt spread between the emerging country’s sovereign interest rate and a developed country’s sovereign interest rate can be used to create a country risk premium, but this is only when the cash flows of the company correlate with the payments on government bonds.

Country risk premiums can be calculated in other ways and no consensus exists.  The analyst must carefully understand the assumptions used to derive the country risk premium used in a valuation.

Cost of Capital in Emerging Markets

When calculating the present value of a company, an analyst can choose between dividends, free cash flows, and residual income to derive the stock’s intrinsic price.  Each of these cash flows has advantages and drawbacks.
<h2>Dividends</h2>
These direct cash payments are a key component of an investor’s returns.

<strong>Dividend Advantages:</strong> Typically more stable than earnings; small individual shareholders cannot influence dividends, so dividend based valuation may be most appropriate from their perspective.

<strong>Dividend Disadvantages:</strong> A lot of companies do not pay dividends, but opt to reinvest 100% of earnings; different countries have different dividend cultures and dividend tax policies, so dividend valuation presents some inconsistencies in an international context.
<h2>Free Cash Flows</h2>
CFA focuses on two types of free cash flows for valuation – free cash flow to the firm and free cash flow to equity.

Free cash flows are appropriate when the company pays no dividend, pays an unsustainable dividend, cash flows track company profits, and/or the investor is large and wants the perspective of a controlling interest.
<h2>Residual Income (RI)</h2>
RI attempts to capture the extra value that an investor can receive beyond opportunity cost.
<div class="formula1">RI = Net Income – (r<sub>ce</sub> * Book Value of Equity <sub>beginning of period</sub>)</div>

Cash Flows: Dividends vs. Free Cash Flows vs. Residual Income

<ul>
<li>If James Brown is the “Godfather of Soul”, then the dividend discount model could be considered the “Godfather of Equity Valuation”.  Many of the approaches used today can trace their roots to DDM.</li>
	<li>The basic thesis of the DDM is that the value of a common stock to an investor is the present value of expected future dividend payments.</li>
	<li><b>DDM Single Holding Period</b></li>
	
	<div class="formula1">
	V<sub>0</sub> = (Div<sub>1</sub> + P<sub>1</sub>) /(1 + r<sub>ce</sub>)
		<ul class="list2">
			<li>V<sub>0</sub> = present value</li>
			<li>Div<sub>1</sub> = dividend expected over the next year</li>
			<li>P<sub>1</sub> = share price expected when stock is sold in one year</li>
			<li>Note: for simplicity sake, this assumes the single holding period is equal to one year.</li>
		</ul>
	If the analyst believes that his/her inputs into the single period DDM are accurate, then he/she will compare the calculated value to the market price in order to determine the investment recommendation.
	</div>
	<li><b>DDM Multiple Holding Periods</b></li>
	
	<div class="formula1">V<sub>0</sub> = (Div<sub>1</sub> / (1 + r<sub>ce</sub>)) + (Div<sub>2</sub> / (1 + r<sub>ce</sub>)<sup>2</sup>) + ... + (Div<sub>n</sub> + P<sub>n</sub>) /(1 + r<sub>ce</sub>)<sup>n</sup> </div>	
</ul>


Dividend Discount Model (DDM)

<ul>
<li>The GGM is a variation on the standard DDM that allows the analyst to assume that dividends will grow in perpetuity at a constant rate.</li>
	<div class="formula1">
		V<sub>0</sub> = Div<sub>1</sub> /(r<sub>ce</sub> - g<sub>div</sub>)
		
		<ul class="list2">
			<li>Div<sub>1</sub> = D<sub>0</sub> * (1 + g<sub>div</sub>) = future period dividend payment</li>
			<li>r<sub>ce</sub> = by now you should know this!
			<br><br>
			In an exam problem CFA might make you derive the required return on common equity via CAPM.
			</li>
			<li>g<sub>div</sub> = growth rate of the dividend</li>
			<li>Note that in order for GGM to "work", the required return on common equity must be greater than the expected growth rate of the dividend.</li>
					
		</ul>
	
	
	</div>
<li>GGM can also be used to value preferred stocks, whose dividend payments are fixed.</li>
	<div class="formula1">
		Preferred Stock V<sub>0</sub> = Pref Div /r <sub>preferred stock</sub>
	</div>
<li>GGM can be appropriate when:</li>
	<ul class="list2">
		<li>The analyst is looking at broad equity indexes.</li>
		<li>The analyst is valuing steadily growing companies that pay dividends.</li>
	</ul>
<li>GGM has drawbacks of:</li>
	<ul class="list2">
		<li>Being incredibly sensitive to small changes in the model inputs.</li>
		<li>An inability to value companies that do not pay dividends.</li>
		<li>An inability to value companies whose growth is not stable.</li>
	</ul>
</ul>


Gordon Growth Model (GGM)

<ul>
	<li>A stock's valuation can be heavily influenced by future growth expectations.</li>
	<li>As a company generates positive earnings and retains these earnings, its book value of equity increases; however, in order for the positive retained earnings to create wealth for investors, the company's return on equity must exceed its cost of equity.</li>
	<li>In theory, when a company sees no attractive growth opportunities, it should payout all earnings as dividends (yeah right, like corporate executives are going to do that!).</li>
	<li>PVGO allows analysts to calculate how much growth opportunities contribute to a company's current share price.</li>
	<div class="formula1">PVGO = Price<sub>0</sub> - (Earnings <sub>current period</sub> /  r<sub>ce</sub>)
	
	<br><br>
	If a company has a stock price of $75 and the PVGO calculation is $50, then growth opportunities contributes 2/3rds of the share valuation.</div>
	
</ul>


Present Value of Growth Opportunities (PVGO)

<ul>
	<li>The principles of GGM can be applied to derive Leading and Trailing price to earnings ratios.</li>
	<li><b>Leading P/E Model:</b> Based on future earnings.</li>
	<div class="formula1">P<sub>0</sub>/E<sub>1</sub> = (Div<sub>1</sub>/Earning<sub>1</sub>)/(r<sub>ce</sub> - g) = k/(r<sub>ce</sub> - g)
	
	<br><br>
	Where k is the dividend payout ratio and g assumes that earnings growth and dividend growth are equal rates.
	</div>
	<li><b>Trailing P/E Model:</b> Slight variation based on current dividend and current earnings.</li>
	<div class="formula1">
	P<sub>0</sub>/E<sub>0</sub> = (Div<sub>0</sub> &times; (1+g) / Earning<sub>0</sub>)/(r<sub>ce</sub> - g) = (k&times;(1+g))/ (r<sub>ce</sub> - g)
	</div>
</ul>


GGM, Leading P/E Ratio, and Trailing P/E Ratio

<ul>
	<li>Unlike the Multiple Holding Period DDM previously described, the Multi-Stage Dividend Discount Model allows for multiple growth rates in calculating a stock value.</li>
	<li>The allowance of multiple growth rates is more realistic, companies commonly experience a growth phase, a transitional phase (as new competition enters the market driving down returns), and a mature phase.</li>
		<ul class="list2">
			<li>Naturally this implies that a Three Stage DDM could be tested; see the official curriculum for a detailed example.</li>
		</ul>
	<li>The Multi-Stage DDM presents the analyst an opportunity to account for the different growth rates that a company may experience in these different growth phases.</li>
	<li><u>The Two Stage High Growth followed by Stable Growth DDM:</u> </li>
		<ul class="list2">
			<li>The formula for a High Growth followed by Stable Growth Two Stage DDM may look daunting at first, but its components are logical and build upon the foundation of the basic DDM principles.</li>
		</ul>		
</ul>


Multi-Stage Dividend Discount Models

<ul>

	<li>The H-Model is a modification of the Two Stage DDM. Unlike other two-stage models where the growth rate is assumed to be a constant, the H-Model assumes that the growth starts at a higher rate, and then gradually declines till it becomes normal stable growth rate.</li>
	<li>"H" represents half-life of the high growth period.</li>

<div class="formula1">V<sub>0</sub> = ((Div<sub>0</sub> × (1+g<sub>mature</sub>)/(r<sub>ce</sub> - g<sub>mature</sub>)) + ((Div<sub>0</sub> × H × (g<sub>high</sub> - g<sub>mature</sub>)/(r<sub>ce</sub> - g<sub>mature</sub>))
<ul><li>H = one half of the growth period</li>
<li>g<sub>mature</sub> = company’s growth rate in its mature phase</li>
<li>g<sub>high</sub> = company’s growth rate in its high growth phase</li>
</ul></div>
	<li>This model works well for companies that have an initial high growth rate but the growth is expected to decline as the firm becomes bigger, loses its advantage, or other factors.</li>
	<li>A flaw in the H-Model is that in order for it to work, the company in question must keep a constant payout ratio through all periods and this is a bit unrealistic.</li>
</ul>

H-Model for Valuing Growth

When referencing a company's sustainable growth rate, an analyst is discussing the growth in earnings and dividends that can be maintained given a company's ROE and its existing capital structure.
<div class="formula1">
<b>g<sub>sustainable</sub> = b &times; ROE</b>
	<ul>
	<li>b = earnings retention rate = (1 - dividend payout rate)</li>
	<li>CFA may present candidates with a problem that requires a growth rate value, but fail to provide that growth rate value.  However, it may provide ROE and either the retention rate or payout rate.  If that is the case, then use the above formula to derive the growth rate and solve the problem.</li>
	</ul>

</div>

<ul>
<li>The DuPont method for ROE can also be used to derive a company's sustainable growth rate - hopefully by now you have picked up that the DuPont ROE is a concept that CFAI is likely to test on the exam.</li>
<div class="formula1">
g = (Net Inc. / Sales) &times; ((Net Inc. - Div.) / Net Inc.) &times; (Net Revenue / Avg. Total Assets) &times; (Avg. Total Assets / Avg. Shareholders Equity)
<br><br>
g = Net Profit Margin &times; Retention Ratio &times; Asset Turnover &times; Financial Leverage

</div>
<li>Note this formula references average values; if the test question only provides you with one value (as two is required to create an average) simply use what is provided.</li>
</ul>


Sustainable Growth Rate

Equity Analysis Part 2

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Equity Analysis Part 2

Lessons

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