BIG Intro Session

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BIG Intro Session

• MDW
• 2/14/07

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Where Investments Come From

• Consider a steakhouse with about 80 restaurants
  located in the Southwest. It know it would be
  successful in nearby towns, but needs funds to
  build new restaurants. It does not have the cash
  it needs on hand. It can take on debt to raise
  the money it needs.

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Bonds

• The company could issue debt to build the new
  restaurants. This would be OK, but the owners
  arent sure whether theyll be able to make their
  interest payments in a volatile restaurant
  business.

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Bonds 2

• Bonds promise a fixed schedule of payments.
  Should a company go bankrupt, bondholders are
  paid before stockholders.

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What is Equity/Stock

• The company could also sell ownership to stakes
  to investors to raise money.
• Stock represents an ownership share in the
  corporation. You are given residual cash flows,
  or whats left after paying the companys debtors
  and reinvesting profits into growing the company.
• One buys stocks to get access to those profits.

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Evaluating Stocks

• Some Fundamental Questions
• How much are they earning now? How much do I have
  to get access to those earnings?
• How much are they likely to earn in the future?

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Some Accounting Things

• Income Statement
• Total Revenue how much you sold in a given
  period
• Cost Of Revenue how much the items you sold
  cost you
• Gross Profit Total Revenue minus Cost of
  Revenue
• Operating Expenses- Things you have to pay,
  regardless of how much you sell. Includes
  Research Development
• Operating Income Gross Profit minus Operating
  Income
• Interest Expense- The cost of any debt you may
  have outstanding over the given period
• Tax Expense The Cost of Taxes over a given
  perod
• Net Income (Earnings)- How much you made over a
  given period. This is a key number.

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Earnings Per Share

• If in buying stocks, youre paying for access to
  what is left over from earnings, youd want to
  know how much in earnings you are actually
  buying. You can compute this by taking total
  earnings (Net Income) and divide by number of
  shares.
• Earnings/( of Shares)Earnings per Share (EPS)

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Some Key Income Statement Ratios

• Revenue Growth- Computes how fast the company is
  growing. Current Revenue/Past Revenue
• Earnings Growth- Computes how fast the earnings
  of the company are growing. Earnings/Past
  Earnings
• Price/Earnings Ratio- (Price/Share)/(EPS)

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Price/Earnings (P/E Ratio)

• P/E states how much youre paying for a dollar of
  earnings in the current period.
• If you expect earnings to grow quickly, P/E will
  be higher, as youll be expecting high future
  earnings.
• Usually P/E is measured using the last 12 months
  of earning. You can compute it using earnings
  projections for the next year. Doing so is called
  the forward P/E.

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Abercrombie Fitch Example

• Abercrombies P/E is 19.60. Their forward P/E is
  15.65. The current price is 82.64. This implies
  current EPS of 82.64/19.6 4.22
• It implies future earnings of 82.64/15.655.28.
• This implies a growth rate of 25
• If growth expectations continue for next year,
  and P/E stays at 19, then the price move to about
  100.
• 25 is a pretty great return!

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What about risk?

• We say that ANF has an expected return of 25.
• There are a whole bunch of things that could
  cause errors in Abercrombies products bad
  design, recalls, etc.
• But imagine we owned a bunch of clothing
  retailers. Then what would be important?

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Beta

• So ignore the business risk how should we
  evaluate risk as a whole?
• The Capital Asset Pricing Model states that our
  expected return should greater if we are more
  correlated with the market that is, higher
  expected return is more tied to the market.

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What?

• You can get right now about 5 returns completely
  risk free, by buying Treasury Bills from the US
  government.
• If you bought a stock, youd expect a greater
  return, as its more risky.
• If you invested in a number of stocks
  representing proportionally most of the value in
  the stock market, the difference between the risk
  free rate and the markets return is the risk
  premium.

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Thanks to http//geoffreyzheng.files.wordpress.co
m/2005/12/capm_eq1.gif and google image search
for the equation.
Beta

• Beta is a stocks correlation to the market as a
  whole. Stocks with a beta of 1 should move about
  with the market. The CAPM offers a simple way to
  calculate expected returns Add the risk free
  rate to the market correlation multiplied by the
  risk premium.

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Beta

• Abercrombies beta is around 2. If you know that
  the risk free rate is 5, and you expect that the
  market will do about 15 in the next year, then
  the risk premium is 10. 510225, which is
  what we calculated earlier.
• It makes intuitive sense that Abercrombie would
  be sensitive to changes in the market.

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Market Indexes

• As you might want to know how risky your
  portfolio is or how it is performing relative to
  the market, it is helpful to have benchmarks
  against which to compare. Market indexes fill
  this function.

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DJIA

• The Dow Jones Industrial Average is an index of
  30 of the largest companies, weighted by their
  prices, representing broad sectors of the market.
• Examples Alcoa, AIG, American Express, Boeing,
  Citigroup, Caterpillar, DuPont, Walt Disney,
  General Electric, GM, Home Depot, etc.

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SP 500

• The SP 500 is an index of 500 large-cap stocks.
  It is weighted by market cap (i.e. the larger
  stocks are more important to the index)
• 10 Largest Companies Exxon, GE, Citigroup,
  Microsoft, BofA, ATT, ProctorGamble,
  JohnsonJohnson, Pfizer, AIG

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Nasdaq Composite

• Is a market-cap weighted index of all of the
  companies in the Nasdaq stock market- which tend
  to be technology and rapidly growing stocks.
• Top 10 Holdings Microsoft, Intel, Cisco, Dell,
  Amgen, Oracle, Qualcomm, eBay, Comcast, Applied
  Materials
• Thanks to http//www.beaconequityresearch.com/res
  ource-ind_nasdaq-comp.php

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What is Market Capitalization

• Market Capitalization is the total market value
  of all of a companys shares. It is simply Shares
  OutstandingCurrent Price. Its also a good rule
  of thumb regarding how large (financially) a
  corporation is.
• Definitions vary, but Investopedia uses these
• Mega Cap Market cap of 200 billion and greater
  Big/Large Cap 10 billion to 200 billion Mid
  Cap 2 billion to 10 billion Small Cap 300
  million to 2 billion Micro Cap 50 million to
  300 million

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Investing Strategies

• Growth Investing companies in good markets
  whose earnings are may grow beyond what the
  market predicts.
• Value Investing companies in which the price of
  access to the stream of present and future
  earnings looks cheap relative to the market.
• Income Investing Investing in relatively stable
  companies with stable cash payments.

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Growth Investing

• The Key- Right product in the right market by the
  right company at the right time. Its Amazon in
  98, Google in 2004, Coach Bags in 2002, Armor
  Holdings in 2003, etc.
• These companies generally dont pay dividends, as
  they invest all of their profits. They also tend
  to have high RD costs, or be tech companies.
• Tend to have high betas.

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Value Investing

• Uses Quantitative techniques to evaluate generate
  a fair value for a stock. When the stock is below
  its fair value, they buy, and wait for the market
  to correct to the fair price.
• Often believe the market overreacts to news,
  sending good stocks down excessively on bad news.
• Evidence Low P/E strategies tend to outperform
  the market in the long term.

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Pfizer - Torcetrapib
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Income Investing

• Generally incorporates many bonds, due to their
  predictable schedule of payments, but can include
  high dividend stocks.
• Often utilities, because of their slow revenue
  growth, pay dividends to increase shareholder
  value.
• Income stocks always must have very low betas.