Give real-world examples whenever possible. Please show all of your work, including all formulas used, if the question requires calculations.
1. Discuss what the auditor’s report signifies about financial statements.
2. Explain the purpose and implications of a fundamental security analysis.
3. Use the chart below and write the calculations that demonstrate the values requested.
Combining information from the S&P reports and some estimated data, the following calendar-year data, on a per-share basis, are provided:
a. Calculate the D/E, ROE, and TR for 2002, 2003, and 2004. (Use the average of the low and high prices to calculate TRs.)
b. Show that from 2000 through 2004 the per annum growth rate in dividends was 6.9 percent and for earnings was 8.2 percent.
c. Using the current price of $47, with estimated earnings for 2005 of $6.75, show that the P/E would be evaluated as 6.96.
d. On the basis of the annual average P/E ratios shown above and your estimate in Problem c, assume an expected P/E of 7. If an investor expected the earnings of GF for 2005 to be $7.50, show that the intrinsic value would be $52.50.
4.Describe a bar chart and a point-and-figure chart and give the purposes of each.
Investments F04V
Assignment 04,
Analyzing Common Stocks and Well-diversified Portfolios
1. Intrinsic value means what is considered the actual true value of the company when you consider all of the pieces of the business, which contains the tangible (physical assets) and intangible (patents, goodwill etc) that the company owns. It is totally different than the market price (the price investors place on its value on the exchanges) or the book value of the company (an accounting valuation). The valuation of the intangibles, which include trademarks, brand name, copyrights and patents are the important part of intrinsic value which are often hard to get an correct valuation that will be reflected in the market price of the company. To determine intrinsic value the best way is to look at the discounted cash flows associated with the company. You will need to have assumptions based on what you think those cash flow will be, what the growth rate of those flows will be and required rate of return that you need to assume the risk of investing in the company.
2. a. The P/E ratio means the Price to Earnings ratio and can be calculated by dividing the stock price by the earnings for the company. In the case of Hall Dental Supply Company, the Share Price is currently $32 and the estimated 12 month earnings are $4. That would make the P/E Ratio = $32/$4 or 8.
b. If the expected earnings grow by 10%, that would equate to $4.40 per share of estimated earnings (since $4.00 times 10% is $0.40 and this would be added to the previous estimate for a total of $4.40). If the P/E ratio would stay constant at 8, that would mean that the projected share price for the next year would be: 8 × $4.40 = $35.20
c. If the payout ratio for Hall Dental remains the same, that would imply a dividend of $2.20 for next year ($4.40 × 50%).
P = D1/(k-g)
= $2.20/(0.16-0.10)
= $36.67
A price of $35.20 would indicate a required rate of return of 16.25% (since P = $2.20/(0.1625-0.10) = $35.20). So this would be a good buy. The lower the required return the higher the expected price of the stock would be, as it approaches 10%, the stock price would approach infinity.
d. If interest rates are expected to decline, this would likely have an increasing effect on Hall's PE ratio. The Fed model indicates that the fair value of the market PE ratio is the inverse of the 10 year Treasury Bond. So if the 10 year is at 6%, that would lead to a P/E multiple of 16.7, while a decline in interest rates to 5%, would indicate a fair value P/E ratio of 20. Fundamentally, lower interest rates tend to spur economic growth and higher interest rates tend to dampen growth and this would have an impact on all securities.
3. A portfolio of securities contains two types of risk, systematic risk and non-systematic risk. The first systematic risk is also known as market risk which cannot be diversified away. The second non-systematic risk is also known as unique risk which can be diversified away with the right mix of assets in the portfolio. The returns will mirror the direction of the overall market with a well diversified portfolio. If it is up, a well-diversified portfolio should also be up and if it is down, a well-diversified portfolio should also be down. The movement in the market will be amplified by the overall risk that the well-diversified portfolio has relative to the overall market, depending on the level of risk taken. This measurement is known as Beta. A Beta of 1 will follow the market in lock-step. A Beta of greater than 1 will tend to have higher movements in relation to the overall market and a Beta of below 1 will tend to have lower magnitudes of movement than the overall market.
This suggests that it is very important to understand the basic make-up of the investments in a mutual fund in the context of Beta, in order to be able to understand whether the performance is good relative to other funds. It is also necessary to understand the objective and style of the mutual fund in question, since different mutual funds will have different styles (Growth, Value, GARP) and different objectives. We can have a well diversified mutual fund that invests in the Technology or BioTech areas, but will have a much higher overall Beta than a fund that invests in dividend paying utility and telecom stocks.
4. Fundamental Analysis and the tools surrounding Fundamental Analysis are created to assets in the assessment of a company to help to determine the intrinsic value of a security. In order to decide the intrinsic valuation of a company, an analyst will begin with forecasting earnings, determine the level of dividends that are anticipated and the discount rate that is necessary to properly recompense for the risk that the investor is going to take. It is different from Technical Analysis because the technical analyst will look at past market data (including price and trading volume) and then determine and estimate of the future price based on data from the market itself. A fundamental analyst will use specific data around industry analysis, company analysis and economic analysis and try to uncover things that are not priced into the market to determine whether a firm is trading below its real value.
References
Scott Smart, Lawrence Gitman & Michael Joehnk (2014). Fundamentals of Investing (12th Ed.). New Jersey: Pearson.
Edgar Wachenheim (2016). Common Stocks and Common Sense: The Strategies, Analyses, Decisions, and Emotions of a Particularly Successful Value Investor (1st Ed.). New Jersey: Wiley.
