Top Down Approach to Investing

1
Top Down Approach to Investing

• Company Analysis
• Fundamental Analysis

2
Quantitative Analysis

• Later lecture if time

3
Qualitative Analysis

• Later Lecture if time

4
Momentum Investing

• Later Lecture if time

5
Income Investing

• Later Lecture if time

6
GARP Investing

• Later Lecture if time

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Value Investing

• Later Lecture if time

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Growth Investing

• Later Lecture if time

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Determining Value Based on Dividends

• Later Lecture if time

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Determining Value Based on Cash Flow

• Later Lecture if time

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Determining Value Based Upon P/E and EPS Forecasts

• The majority of the time the P/E is calculated
  using EPS from the last four quarters
  
• Called the trailing P/E
• Analysts attempt to estimate EPS for the next
  four quarters
  
• P/E based on estimated EPS are called leading,
  projected, or forecasted P/E

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Price/Earnings Ratios

• Historically, the average P/E ratio in the market
  has been around 15-25.
  
• Fluctuates depending on economic conditions at
  the time
  
• P/E ratios also vary widely between different
  companies and industries

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Price/Earnings Ratios

• Theoretically, a stocks P/E tells us how much
  investors are willing to pay per dollar of
  earnings
  
• For this reason it is also called the multiple
  of a stock
  
• In other words, a P/E ratio of 20 suggests that
  investors in the stock are willing to pay 20 for
  every 1 of earnings the company generates

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Price/Earnings Ratios

• Stock prices reflect what investors think a
  company will be worth and so future growth is
  already accounted for in the stock price
  
• The P/E ratio is actually a reflection of the
  markets optimism concerning a firms growth
  prospects
  

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Price/Earnings Ratios

• A company with a P/E higher than the market or
  industry average means the market is expecting
  big things over the next few months or years
  
• A company with a high P/E ratio will eventually
  have to live up to the high rating by either
  substantially increasing its earnings or the
  stock price will need to drop

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Price/Earnings Ratios

• You cant compare P/E ratios of two totally
  different companies to determine which is a
  better value!

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Price/Earnings Ratios

• Its difficult to say in general whether a
  particular P/E is high or low without taking into
  account two main factors
  
• Company growth rates.
• How fast has the company been growing in the
  past, and are these rates expected to increase
  (or at least continue) into the future?
  
• Something isnt right if the company has only
  grown at 5 in the past and yet has a P/E in the
  stratosphere.
  
• Industry
• Comparing companies is useful only if they are in
  the same industry.
  
• For example, consumer staples typically have low
  multiples because they are low growth, yet stable
  industries.
  
• The technology industry, on the other hand, is
  characterized by screaming growth rates and
  constant change.
  

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Problems Associated with P/E Analysis

• Accounting
• Earnings is an accounting figure that includes
  non-cash items
  
• To make matters more complicated, EPS can be
  twisted and prodded into many different numbers
  depending on how you do the books
  
• It is difficult to know if you are comparing the
  same figures or apples to oranges

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Problems Associated with P/E Analysis

• Inflation
• In times of high inflation, inventory and
  deprecation costs tend to be understated because
  the replacement costs of costs of goods and
  equipment rises with the general level of prices
• Thus, P/E ratios tend to be lower during times of
  high inflation because the market sees earnings
  as artificially distorted upwards
  
• As with all ratios, its more valuable to look at
  the P/E over time in order to determine the
  trend
  
• Inflation makes this difficult, as past
  information is less useful today

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Problems Associated with P/E Analysis

• Many interpretations
• A low P/E does not necessarily mean that a
  company is undervalued
  
• Rather, it could mean that the market believes
  the company will be in trouble in the short
  future
  
• Stocks that go down usually do so for a reason
• It may be that a company has warned that earnings
  will come in lower than expected
  
• This wouldnt be reflected in a trailing P/E
  ratio until earnings are actually released,
  during which time the company may look undervalued

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Forecasting Earnings Per Share

• Our dilemma
• Our solution
• Three companies specialize in providing forecasts
  of earnings and collecting multiple forecasts
  
• IBES
• Zacks
• First Call

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Forecasting Earnings Per Share

• IBES
• Institutional Brokers Estimate System
• Headquartered in New York City
• Has been in the earnings forecasting business
  since 1971
  
• Gathers financial data on 18,000 companies in 48
  countries
  
• For IBES information, visit Motley Fools
  Website www.fool.com
  

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Forecasting Earnings Per Share

• Zacks Investment Research
• Headquartered in Chicago
• Business for more than a decade
• Compiles data from thousands of firms
• http//my.zacks.com or http//biz.yahoo.com/zacks/
  extreme.html

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Forecasting Earnings Per Share

• First Call
• Financial research subsidiary of the Carson
  Group
  
• New York City
• www.firstcall.com

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Forecasting Earnings Per Share

• IBES and Zacks employee make periodic phone calls
  to professional securities analysts, financial
  analysts, and investors at mutual funds, banks,
  and brokerage houses around the world and solicit
  their forecasts of corporations earnings per
  share for 4 quarters of future earnings and up to
  5 years of annual earnings.
• They analyze these earnings forecast and publish
  the high, low, average, and median earnings the
  experts forecast for each firm and each future
  time period
• The data is updated frequently so that it
  represents current estimates of the continuously
  changing consensus forecast
  
• They also provide an annual earnings growth rate
  for each corporation

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Cautions about EPS estimates

• Forecasters ten to overstimate earnings per
  share
  
• Forecasters tend to revise their forecasts
  downward to improve their accuracy as the
  earnings announcements date draws near
  
• Forecasters seem to be reluctant to say negative
  things about security issuers
  
• Forecasters issue many more buy than sell
  recommendations
  
• May want to use whisper numbers

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Using P/E Ratios to Determine Value

• Lets value APP using P/E ratios, earnings
  forecasts, and historical growth rates.
  
• Go to http//finance.yahoo.com
• Type in APPX for symbol
• Click on Analyst Estimates

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Using P/E Ratios to Determine Value
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Using P/E Ratios to Determine Value

• Here is where the judgment call comes in
• I am going to use the highest P/E ratio for two
  reasons
  
• APPX has historically had a high P/E
• Their growth rate is well above P/E
• I am going to use the average and lowest estimate
  of EPS for two reasons
  
• Drug has not been approved
• Still 6 months from year end

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Using P/E Ratios to Determine Value

• Given these judgment calls, my range for APPX
  is
  
• 46.905 to 54.28
• Currently it is selling for 31.50

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PEG Ratio

• The relationship between the P/E ratio and
  earnings growth tells a much more complete story
  than the P/E on its own
  
• The number used for annual growth rate can vary
• It can be forward (predicted growth) or trailing
• Looking for a number less than or equal to 1

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PEG Ratio

• PEG Ratio for APPX is .82
• APPX is a BUY using P/E, PEG, and some technical
  indicators