CFA Exam: The Cost of capital video

I explain here the cost of capital which is an CFA exam topic.

Basics: Relative Valuation (Price Multiples)

In contrast to the discounted cash flow valuation, relative valuation contends that it is possible to determine the value of a company by comparing with similar companies on the basis of several relative ratios¹. Relative valuation (also called price-multiples) is one of the most widely used valuation tool. Intuition behind the price-multiples is that we cannot judge whether a stock is undervalued, overvalued, or fairly valued without knowing what a share buys in terms of some other measure of valuation such as earning, assets, sales². Price-multiples ratio measures what a share can buy in comparison to other per share value measure such as earnings per share. There are different valuation ratios. I will discuss mostly used price/earnings, price/cash flow, price/book value, and price/sales ratios.

Price-to-earnings ratio is popular in the investment community. Earnings power is the primary determinant of investment value. Price-to-earnings ratio is using earnings per share (EPS)³. Some companies have basic and diluted earnings per share in the income statement. Diluted earnings take account of the possibility that some convertible securities could increase the number of common shares outstanding.⁴ Diluted earnings per share should be used. There are two version of P/E ratio as trailing and leading P/E ratio. The P/E ratio has a disadvantage. Because, earnings are prone to manipulation.

Price to cash flow ratio is generally less prone to manipulation. Cash flows is important to the valuation and critical for credit analysis. EBITDA is typically use as a specific measure of Cash flow. However, depending on the nature of the industry different cash flow measures can be used such as Free Cash Flow. Cash flow per share should be expected for the next period.

Price to book value ratio is a widely used ratio. There is a excess relationship between the P/BV ratios and excess rates of returns⁵. It is necessary to estimate the end-year-book value per share for the next period. This can be derived from the historical growth rate by the sustainable growth formula (g=ROE*retention rate).

Price to sales ratio is relatively volatile in comparison to other ratios. This ratio is suitable for growth companies. A requirement for a growth company is strong consistent sales growth.

References:

1 Investments, brawn, page 388

2 Equity asset valuation, cfa, page 166

3 Equity asset valuation, cfa, page 166

4 How to think like benjamin graham and invest like waren buffet, page 138

5 Eugene Fama, Kenneth French, “The Cross section of expected returns” journal of finance 47, no.2,june 1992

Practice: http://www.decisionpoint.com/tacourse/Fundamentals.html

Basics: Lazy portfolios

What is a lazy porfolio? Lazy portfolios are do-it-yourself porfolios for passive investors. Paul B.Farrel is tracking the performance of the porfolio. Return of the lazy portfolio is higher then the S&P500. You also watch his video.

Performance of the lazy porfolio

Fund	Allocation	1-year return	3-year annu. return	5-year annu. return
Vanguard Total Stock Market Index	60%	11.10%	10.81%	7.50%
Vanguard Total International Stock Index	30%	20.14	20.64	16.56
Vanguard Total Bond Market Index	10%	6.45	3.17	4.87
Total portfolio	100%	13.35	13.00	9.96
S&P 500 Index		11.83	10.06	6.27

Basics: Moving average lines & Put/Call ratio

MOVING AVERAGE LINES
Technical analyst are using the moving average prices of historical stock prices to analyze the long term trends. They are using two techniques first if 50-day moving average is above the 200 day moving average line that is an indicator of the bullish market inverse is true for bearish market. Secondly, if stock prices go above the moving average line accompanied by the volume increas, this is a bullish indicator.

We are using 200 day and 50 day moving average for on a 3 years prices chart. You can use shorter moving average depending on your analysis period.



PUT/CALL RATIO
The chicago board options exchange(CBOE) Put/Call Ratio is used by technicians. A high put/call ratio indicates a bearish indicator for technicians. Barrons.com pubslishes this ratio with additional comment.

Source: Investment Anylsis and portfolio managment, Reilly&Brown,7th edition, page 633, 639

Business cycles and sector rotation

Here are some pictures to identify the business cycles and to analyze the M of the CANSLIM method.



"The chart obviously simplifies a lot of detail but should give you a graphical understanding of the relationships between sectors and the state of the economy. You can also go the other way -- looking at the relative performance of the sectors to see where the economy is heading. You can do this by viewing Smart Money's Market Map or looking at Stock Chart's sector performance charts or StockChart's market view.




S&P has a similar classification.

You can read the regular columns of the sector rotation guru Sam Stavoll at Business Week's online web site.

You might want to check the industry rankings at the http://www.rabbittanalytics.com.

Source:
[1] http://www.heroncapital.com/sectormodel.html
[2] http://www.businessweek.com/investor/list/stovall_toc01.htm

M of CANSLIM

CANSLIM suggests that you should study general market every they. It recommends to study three indicies.

S&P500: consisting of 500 compannies, this index is broader, more modern presentation of market action than the Dow.

Dow Jones industrial average(DJIA):This index consist of 30 widely traded stocks, and while it used to focus primarly on large, cyclical, industrial issues, it has broadened a little in recent years to include companies like coca-cola and home depot. it is a simple but rather out-of-date average to study because it is dominated by established, old-line companies that grow more slowly than today's more modern, enterpreneurial companies. Also its 30 stocks can be more easily manipulated.

The Nasdaq Composite: The more relevant and volatile index in recent years, the Nasdaq is home to the market's younger, more innovative and fast-growing companies. It includes 4000 companies that trade view the Nasdaq network of market makers, and it is more heavily weighted toward the technology sector.
Source: How to make money in stocks, william j.o'neil, page 48