Factors Influencing Price/Earnings Multiple
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1 Learning Objectives Foundation of Research Forecasting Methods Factors Influencing Price/Earnings Multiple Passive & Active Asset Management Investment in Foreign Markets
2 Introduction In the investment decision making, analysis of economy, industry and company is a total exercise; and it is called investment or equity research. The latest techniques of research include the econometric models, linear programming, and unique dedicated software. The research is carried by expert staff of financial institutes & fund managers and its objective is to identify undervalued shares for purchase and over valued for sale.
3 Foundation of Research The basis for research is data and information. This data is internal to the company it relates to working operations, results, plans, and financial statements of the company. This data is also external to the company it relates to industry, economy, markets, social & political developments, several government publications and reports from research analysts of financial institutes.
4 Foundation of Research Techniques of Analysis Investment Research firms adopt many techniques & methods for collecting and collating data for analysis. Collection from the daily press. Cuttings collected & filed into company and industry profiles. Survey / Questionnaire Techniques. Data is collected from surveys conducted by Universities and trade associations or by sending questionnaires to them.
5 Foundation of Research Techniques of Analysis Factory & Plant Visits. Data is collected by site visits to firms and direct talks with the management. Direct inputs are gathered on material supply, labour relations, locational advantages, plans for productivity improvement etc. Desk Study of Financial Statements. Data available from published accounts and reports of the companies are studied in the office using different analytical techniques.
6 Forecasting Methods We considered traditional approaches of forecasting earnings through estimation of sales net present value of future dividend flows earnings per share price earnings multiple. These methods had a major drawback as they focused on returns and ignored risks which are equally important under modern portfolio analysis.
7 Forecasting Methods Hence we now we discuss more scientific approaches Regression & Correlation analysis Trend Analysis Decision Tree Analysis Econometric Models
8 Forecasting Methods Regression & Correlation analysis Simple relationship of two variables can be expressed and studied through simple linear regression equation. This is represented Y y = a + b(x) As y = f(x) or y = a+ b(x) shown in the graph. The data on x & y can be rate b slope of growth or absolute a values. O Y
9 Forecasting Methods Trend Analysis In trend analysis, regression technique is used and the dependent variable [sales] is regressed over time [months or years]. E Y A company D R company C N company B I company A N G s O Years X
10 Forecasting Methods Decision Tree Analysis Regression and Trend analyses require certainty of events for estimation; they quantify the qualitative aspects and use statistical tools & economic rationale. Major subjective factors are not quantifiable and it is only in Decision Tree analysis that estimates can be made with probabilities varying with occurrence of intermediate events and in the sequence of events or in the process of sequencing.
11 Present Value Approach For estimating the share valuation, it is good to start with a holding period yield [HPY]. HPY is calculated by adding dividend received in the period to capital appreciation and dividing the total by price at the beginning. Thus if share of Rs. 50/- was sold at Rs. 65 after a year & Rs. Five received as dividend HPY = [65 50]+ 5 / 50 = 40%
12 Present Value Approach Thus present value of a share P o based on future flows of dividends D 1 and future price P 1 is calculated by D 1 P 1 P o = + where r is required 1+r 1+r rate of return If the dividend payouts are growing and the periods are many years this equation changes to P o = D / (r-g) where g is annual growth rate. This formula can be used as a rough of ready method to derive a price of a share.
13 Normal P/E Ratio & Proper P/E Ratio Market price of a share = EPS multiplied by P/E ratio. For proper P/E ratio can we use closing price, or average daily [ monthly or yearly] price? can we use half yearly earnings & annualize them or average of a few past years? With each assumption, the data will change significantly. Hence many rules of thumb are used or recourse is taken to BSE P/E ratios.
14 Factors Influencing P/E Multiple [a] Expected sales growth. [b] Expected earnings growth. [c] Projected dividend payout. [d] Stability of the sales growth and consistency in retention ratio or dividend payout ratio. [e] Variability of any of the above influencing the EPS. [f] Variations in capital structure or debt/equity ratio. [g] Nature of the product, market and demand, company s management policy etc.
15 Industry & Company Analysis In the selection of equity stocks, at one stage of investment analysis, it becomes necessary to put the industry study along with the company study together & in a comparative fashion. Industries in the growth stage or sunshine industries are chosen for investment. Or industry with P/E above the market P/E is favored.
16 Investment Decision Equity investment strategy yield results like scrips which are under priced and good for buy orders. scrips which are over priced and good for sell orders, with the necessary margin of profit or capital appreciation. scrips which are becoming sick and have to be disposed off immediately. scrips which have uncertain trend & have to be held with neither buy or sell orders.
17 Passive & Active Asset Management Under passive asset management, investor selects diversified portfolio from the BSE or NSE index scrips. At regular interval [month] a specific quantity of selected scrips is purchased, irrespective of the ruling prices. Market averages out and provides the investor with market return. Under this alternative investor makes steady investment with objective of earning steady returns over a long term.
18 Passive & Active Asset Management Under active asset management, investor has different methodology not only for selection of scrips but also for timing. His choice of scrips is spread over Blue Chip Companies. Emerging Blue Chips. Small Size Companies Defensive stocks Timing is equally important. Golden rule is to buy in a rising market and sell in declining one; And no trades based on hearsay, rumors or in unlisted companies.
19 Investments in Foreign Markets Individuals cannot directly invest in foreign markets. But Mutual Funds Companies & banks can invest within permissible limits fixed by RBI. If foreign markets were to open up for investors they should - diversify risks among countries - plan for larger average returns after considering loss/gain on the exchange of currencies.
20 Investments in Foreign Markets Investments in foreign markets has its own additional risks Sovereign risks - events specific to a country - political, economic, natural calamity etc. Foreign Exchange Risks exchange rates may fluctuate to the investor s disadvantage. Difficulties in comparison, as accounts are in different currency. Absence of reliable research, market depth, desired degree of liquidity.
21 In conclusion Internal & external data is required for investment research. Regression & Correlation; Trend and Decision Tree Analysis and Econometric models are used in scientific research. Investment decisions are taken by passive as well as active capital asset management. Investment in foreign markets has its own returns and risks. Next Chapter Nine Security Pricing
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