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Applied Equity Analysis and Portfolio Management Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States With offices in North America, Europe, Australia and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation and financial instrument analysis, as well as much more For a list of available titles, visit our Web site at www.WileyFinance.com Applied Equity Analysis and Portfolio Management Tools to Analyze and Manage Your Stock Portfolio ROBERT A WEIGAND, PhD Cover Design: Wiley Cover Image: © iStockphoto.com/simon2579 Copyright © 2014 by Robert A Weigand, PhD All rights reserved Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose No warranty may be created or extended by sales representatives or written sales materials The advice and strategies contained herein may not be suitable for your situation You should consult with a professional where appropriate Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002 Wiley publishes in a variety of print and electronic formats and by print-on-demand Some material included with standard print versions of this book may not be included in e-books or in print-on-demand If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com For more information about Wiley products, visit www.wiley.com ISBN 9781118630914 (Paperback) ISBN 9781118819180 (ePDF) ISBN 9781118819203 (ePub) Printed in the United States of America 10 9 8 7 6 5 4 3 2 Contents Prefaceix Acknowledgmentsxv Chapter Perspectives on Active and Passive Money Management Terminology: Investors, Investment Vehicles, Risk, and Return The Top-Down Fundamental Analysis Process The Record of Professional Money Managers Market Efficiency, Behavioral Finance, and Adaptive Expectations 10 Additional Perspectives on Investing 18 Professional Investment Policy Statements 26 Summary30 Questions30 Answers to Selected Questions 32 References33 Notes34 Chapter Analyzing the Macro-Finance Environment 35 Economic Analysis: The First Step of a Top-Down Fundamental Process 35 Data Considerations: Nominal and Real-Time Series 41 National Income, Corporate Profits, and Job Creation 41 Leading Economic Indicators 43 Coincident Economic Indicators 54 Lagging Economic Indicators 58 Supplemental Economic Indicators 64 Summary67 Questions67 References69 Notes69 Chapter Valuation, Expected Returns, and the Dividend Discount Model Finance Principle 1: Valuation Finance Principle 2: Value and Expected Returns 71 71 77 v vi Contents Summary88 Questions and Problems 88 Answers to Selected Questions and Problems 93 Reference96 Note96 Chapter Historical Performance Analysis 97 Getting Started 98 Historical Stock Returns 100 Growth in Revenues, Profits, and Dividends 101 Gross, Operating, and Net Profit Margins 108 Relative Valuation 111 Liquidity and Debt 115 Profitability: ROA and ROE 118 NOPAT, Total Invested Capital, Free Cash Flow, and ROIC 122 Value Creation: Cost of Capital, EVA, MVA, and Intrinsic Value 127 Using Diffusion Indexes to Summarize Performance Analysis 134 Summary: Historical Performance Analysis 136 Appendix: United Technologies’ Financial Statement Highlights, 2009–2012136 Questions138 Answers to Selected Questions 139 References142 Notes142 Chapter Financial Statement Forecasting, Financial Analysis, and Valuation 143 The Income Statement Forecast Worksheet 144 The Percent-of-Sales Forecasting Method 144 Forecasting MCD’s Income Statement 145 Forecasting MCD’s Balance Sheet 153 Pro Forma Analysis: MCD 159 Intrinsic Value Modeling 164 Financial Fitness and Probability of Bankruptcy Scorecards 170 Summary171 Case Study 5.1: Two Perspectives on Valuation Analysis: The Curious Case of Amazon, Inc. 172 Questions175 References208 Notes208 Chapter Analyzing Company Strategy and Identifying Catalysts Sources of Information Unique Capabilities Lead to Sustainable Competitive Advantage Getting Started: Analyzing Strategy and Competitive Advantage Porter’s Five Forces Model 209 212 212 216 223 Contents vii SWOT Analysis 229 Catalysts232 Summary232 Questions233 Answers to Selected Questions 233 References234 Chapter Portfolio Risk and Performance Attribution 235 Appendix The Time Value of Money and the Basics of Valuation 281 About the Online Video Course 309 About the Author 311 Foundations: Risk and Expected Return 236 Statistical Representations of Macroeconomic and Firm-Specific Risk 240 Extending the Mean-Variance Framework: Beta 249 Performance Attribution: Sector Weights, Dividend Yield, Beta, and Style 255 Multifactor Models 262 Summary266 Questions and Problems 267 Answers to Selected Questions and Problems 271 References279 Notes279 Basic Terminology 282 The Basic Future Value Tool 282 The Basic Present Value Tool 285 Perpetuities292 Calculating Average Annual Compound Rates of Return 293 Integrated Problems Featuring Multiple TVM Tools 293 Solving for the Number of Periods 294 More on the EAR-to-APR Conversion 295 Arithmetic versus Geometric Averages 296 Questions and Problems 298 Answers to Selected Questions and Problems 302 Index313 305 The Time Value of Money and the Basics of Valuation b Set up the present value annuity expression and solve for the payment: 1− $PMT (1.06)25 = $1, 249, 766.40 06 The present value annuity factor for percent and 25 years (term in brackets) equals 12.783356 Divide both sides of the equation by this number to solve for the $PMT: PMT = 1, 249, 766.40 = $97, 765.12 12.783356 If the account earns percent per year, you will receive payments of $97,765.12 per year for 25 years 12 m 0.2999 APR − = 1 + 21 EAR = 1 + 12 m 34475 = 34.48% − = 0.3 23 The present value of your stream of monthly car payments plus your down payment should be less than or equal to the maximum price you’re willing to pay for the car Taking the present value of the stream at the quoted APR of percent: 1 − + 06 $399.25 × 12 06 12 ( ) × 12 = $17, 000 The present value of your payments at an APR of percent equals $17,000 Adding your down payment of $1,000, you would be paying exactly $18,000 for the car, $1,000 more than you intended, so their offer is not fair 25 In this case, set up the present value annuity expression and solve for the payment to see if it’s less than the maximum amount of $299 If you’re paying $15,112 for the truck, and have $2,000 to put down, you need to finance $13,112: 1 − + 0.045 $PMT × 12 045 12 ( ) × 12 = $13,112 The present value annuity factor for an APR of 4.5 percent and 48 monthly payments (term in brackets) equals 43.85294 Dividing both sides of the equation by this number solves for the monthly payment: $PMT = 13,112 = $298.99 43.85294 The monthly payment is $1 lower than the maximum specified by your bank, so at a price of $15,112, you can afford the truck 306 27 Applied Equity Analysis and Portfolio Management 2500 = $41, 666.67 0.06 29 This solution is slightly tricky It’s helpful to remember one characteristic of present value annuity and perpetuity formulas—they discount the cash flow stream back one period before the first cash flow Therefore, when we apply the present value of a growing perpetuity formula: PVGrowing Perpetuity = CF(1 + g) 5000(1.03) = = 85, 833.33 i−g 09 − 03 We’re taking the present value of all the cash flows from periods through infinity Since there is also a payment at time period zero, we also have to add that in to calculate the full value of the contractual cash flows: $85,833.33 + 5,000 = $90,833.33 A single lump-sum payment of $90,833.33 at time zero is therefore economically equivalent to the growing perpetuity described by the legal judgment 31 Whenever you’re given beginning and ending wealth levels in a sequence and asked to calculate the average annual compound rate of growth, the intermediate values can be ignored In this case you can use the formula from section 2.14, where PV = $1.00 and FV = $1.45: FV r = PV n 1.45 −1 = 1.00 − = 0.097342 = 9.73% If, however, you were only given year-by-year growth rates, you could then calculate the average annual compound rate of growth using the geometric return formula: n + i j ) ∏ j =1 ( n −1 The year-by-year growth rates are: 1.08 − = 0.080000 = 8.000%, 1.00 1.21 − = 0.12037 = 12.037%, 1.08 1.34 1.45 − = 0.107438 = 10.744%, − = 0.082089 = 8.209% 1.21 1.34 Plugging into the geometric return formula gives: [(1.08000)(1.12037)(1.10744)(1.08209) − = 0.09734 = 9.73% 307 The Time Value of Money and the Basics of Valuation 33 Net Present Value (NPV) of the investment = PV of the cash benefits – PV costs 900, 000 900, 000 900, 000 900, 000 + + + 1.12 (1.12)2 (1.12)3 (1.12)4 + 1, 000, 000 − 2,100, 000 = $1, 201, 041.27 (1.12)5 Did you see that the project’s cash flows in years through could be discounted using the PV annuity formula? 1− 1, 000, 000 900, 000 (1.12)4 + − 2,100, 000 = $1, 201, 041.27 (1.12)5 12 The present value of the project’s cash benefits is significantly larger than the present value of the project’s costs (the project has positive NPV); the investment should therefore be made 35 (Study the solutions until you fully understand why both ways of solving the problem are equivalent.) The value of the cash flow stream equals the present value of the expected future cash flows We need to take the present value of the stream to determine what single payment at time zero is equivalent to receiving the payments at the end of periods 2, 4, 6, 8, and 10 There are five payments total; the easiest solution is to simply discount each cash flow back to the present manually: PV = 10, 000 10, 000 10, 000 10, 000 10, 000 + + + + = $26, 651.995 (1.12)2 (1.12)4 (1.12)6 (1.12)8 (1.12)10 Notice that the five payments of $10,000 also meet the definition of an annuity: all the cash flows are equal, the time periods between the cash flows are equal, and the first payment occurs one period from now—provided you define a “period” as two years instead of the customary one year To use the annuity formula, you need to first convert the APR of 12 percent into a twoyear rate: (1.12)2 − = 0.2544 = 25.44% You can now take the present value of the five payments of $10,000 using the TVM annuity formula, using 25.44 percent as the interest rate: 1− PVA = $10, 000 × (1.2544)5 0.2544 = $26, 651.995 308 Applied Equity Analysis and Portfolio Management 1− 37 $2, 000, 000 × (1.12)12 = $12, 388, 748 12 1− $2, 750, 000 × (1.12)6 = $11, 306, 370 12 The first athlete’s contract is more valuable at a discount rate of 12 percent 1− 12 = $7 , 450, 244 $2, 000, 000 × (1.25) 25 1− = $8,116, 416 $2, 750, 000 × (1.25) 25 The second athlete’s contract is more valuable at a discount rate of 25 percent The relative value of the contracts changes as the discount rate rises because of the magnitude and timing of the cash flows The first contract features smaller payments spread over a longer period, while the second contract features higher payments spread over a shorter period When the cost of waiting is relatively low—12 percent—the longer time it takes to collect the higher nominal payments from the first contract is not that “expensive”; therefore, the contract’s value holds up well When the cost of waiting is relatively more expensive, however—25 percent—the last few payments in the first contract undergo a large amount of “discounting” because they take so long to receive This contract therefore loses a lot more value The second contract’s payments not lose as much value because they are received sooner; the second contract therefore holds more value as the discount rate rises About the Online Video Course T his book is accompanied by a 50- to 70-minute video for each of the seven chapters and the appendix The entire text is covered in the video lectures As you read or watch the lectures, you can follow along in the companion Excel spreadsheets (for Chapters through 7) To get the URL and access code for your online video course, please refer to the instructions at the back of this book If you purchased an e-book, you can find instructions for verifying your purchase and obtaining an access code at the end of the e-book 309 About the Author R obert A Weigand, PhD, is professor of finance and holder of the Brenneman Professorship in Business Strategy at Washburn University in Topeka, Kansas Dr Weigand has also been a faculty member at Texas A&M, the University of Colorado, and the University of South Florida As the author of more than 40 scholarly articles and book chapters, Dr Weigand’s research has supported a variety of innovations in asset management, including Russell Investments’ CrossVol™ volatility indexes Dr Weigand serves on the Harvard Business Review Advisory Council and as a panel member for McKinsey Quarterly His blog, Financial Market Commentary, is syndicated by financial media outlets such as Wall Street Cheat Sheet, and has been recognized by Bisk Education’s CPA Review as a Top Accounting Education Resource and by Future Advisor as a Top Unbiased Blog Dr Weigand is a recipient of the Ned Fleming Award for Excellence in Teaching (2011), the A Roy Myers Award for Excellence in Research (2010), the John and Betty Dicus Excellence in Teaching Award (2010), the Kaw Valley Bank Excellence in Research Award (2009), and the Student Life Achieving Excellence Award (2009) Dr Weigand holds a BS and a PhD in Financial Economics from the University of Arizona 311 Index Absolute return vehicles, Active investors, definition, Active money management See Money management, active and passive Adaptive markets hypothesis (AMH), 11, 17–18 Alpha, Altman Probability of Bankruptcy Z-Score, 136, 171 Amazon, 13–15, 172–208, 217–223, 225–232, 265–266 SWOT analysis, 230–231 valuation analysis, 172–208 American Railcar Industries (ARII), 265 Animal spirits, 26 Annual percentage rate (APR), 290–292, 295–296 car payment example, 291 EAR-to-APR conversion, 295–296 mortgage loan payments, calculating, 291–292 Apple, 214 Asymmetry, 213 Balance sheet forecasting, 153–158 Behavioral finance, 11, 16–17 Beta, 2–3, 249–255 drivers of, 252–254 estimating, 250–252 historical and pro forma, 128 low, 254–255 Bogle, John, 18, 19 Bond valuation, 73–74 Bristol-Myers (BMY), 5, 210–211 Bubbles, 26 Buffett, Warren, Business cycle, 36 Capital asset pricing model (CAPM), 81–87, 128, 164, 166, 249 Catalysts, 232 Chevron Corporation (CVX), 84–86, 236–237, 239, 242, 244–248, 253, 265 annual returns, 236 Citigroup, 6–8 Cognitive consonance, 17 Cognitive dissonance, 17 Coincident economic indicators, 37–39, 54–58 employees on nonagricultural payrolls, 55–56 index of industrial production, 57–58, 68–69 nominal and real total retail sales, 54 personal income less transfer payments, 56–57 Competitive and strategic positioning, 209–234 analyzing, 216–223 competitive advantage and performance, 217–223 intended vs realized strategies, 216–217 catalysts, 232 Porter’s Five Forces model, 223–229 extent of rivalry among existing firms in an industry, 227–228 power of buyers to negotiate better terms, 227 power of suppliers to charge higher prices for critical inputs, 226–227 synthesis of Porter’s analysis, 228 threat of new competitors, 224–225 threat of substitute products and services, 225–226 SWOT analysis, 229–231 Amazon, 230–231 sources of information, 212 sustainable competitive advantage, 212–216 achieving, 214–215 core competency and socially complex resources, 215–216 Conference Board, 37, 39, 54–58 coincident economic indicators, 54–58 See also Coincident economic indicators lagging economic indicators, 58–64 See also Lagging economic indicators leading economic indicators, 43–54 See also Leading economic indicators Confirmation errors, 17 Corporate profits, 41–43 Corporate projects, valuing, 74–75, 94 Covariance, 241–242 Current ratio, 115–116 Days sales outstanding, 116–117 Debt-to-assets ratio, 117–118 Debt-to-equity ratio, 117–118 313 314 Deere, 268, 269, 275–276, 278 Diffusion indexes, 134–136 Altman Probability of Bankruptcy Z-Score, 136 Piotroski’s Financial Fitness Scorecard, 134–136 Diversification, 242–247 Dividend discount model (DDM), 75–77, 80, 94, 166–167 Chevron Corporation (CVX), 84–86 expected returns and, 80 ExxonMobil Corporation (XOM), 85–86 Johnson & Johnson (JNJ), 81–84 McDonald’s (MCD), 166–167 Pepsico (PEP), 92 with variable growth, 76–77 Verizon Communications (VZ), 86–88 Earnings and dividend yields, 113–114 Eavis, Peter 14–15 eBay, 111 EBIT/EBITDA, 105 Economic analysis, 35–41 sector rotation, 36–39 writing guidelines, 39–41 Economic equivalence, 286–287 Economic value-added (EVA), 128–129 Effective annual rate (EAR), 290–291, 295–296 EAR-to-APR conversion, 295–296 Efficient markets hypothesis (EMH), 10–11, 15 Ellis, Charles, 18, 19–21 “Levels of the Game” (2000), 19–20 “The Winner’s Game” (2003), 20–21 Equity expected returns, 80–81 capital asset pricing model (CAPM), 81 Exchange-traded funds (ETFs), Expected returns, 77–88 dividend discount model, 80, 81–88 Chevron Corporation (CVX), 84–86 ExxonMobil Corporation (XOM), 85–86 Johnson & Johnson (JNJ), 81–84 Verizon Communications (VZ), 86–88 equity expected returns, 80–81 internal rate of return (IRR), 79–80 loans, 79 yield to maturity (YTM), 79 Extrapolation errors, 17, 22 ExxonMobil Corporation (XOM), 85–86 Federal Reserve Economic Data (FRED) database, 37–38, 63 Finance theory, Financial Analysis & Valuation worksheet, 159–160 Financial cycle, 36 Five Forces model See Porter’s Five Forces model Free cash flow (FCF), 125–126 Index General Theory of Employment, Interest and Money, Chapter 12 (Keynes), 21–26 Gross domestic product (GDP), 41–42 Gross and operating profit margins, 108–109 Heuristics, 16 Hindsight errors, 17 Historical performance analysis, 97–142 diffusion indexes, 134–136 Altman Probability of Bankruptcy Z-Score, 136 Piotroski’s Financial Fitness Scorecard, 134–136 economic value-added (EVA), 128–129 free cash flow (FCF), 125–126 getting started, 98–100 chapter method and companion spreadsheets, 99–100 comparing to industry averages vs one key competitor, 99 large-cap analysis, 98 quality vs quantity, 98 gross and operating profit margins, 108–109 growth in revenues, profits, and dividends, 101–107 earnings and dividends per share, 105–107 EBITDA and EBIT, 105 growth rates, 102–103 total revenue, 103–104 historical stock returns, 100–101 liquidity and debt, 115–118 current and quick ratios, 115–116 days sales outstanding and inventory turnover, 116–117 market value-added, 130–134 intrinsic value, 131–134 net operating profit after tax (NOPAT), 122–123 net profit and free cash flow margin, 109–110 relative valuation, 111–114 earnings and dividend yields, 113–114 multiples, 111 price-to-earnings multiple, 112–113 total debt-to-assets and long-term debt-to-equity, 117–118 yield metrics, 112 return on assets (ROA) and return on equity (ROE), 118–121 differences in, 119–121 return on invested capital (ROIC), 125 total invested capital, 123–124 United Technologies’ financial statement highlights (2009–2012), 136–137 weighted average cost of capital (WACC), 127–128 Hulbert, Mark, Hulbert Financial Digest, Index 315 Income statement forecasting, 145–152 analysts’ consensus forecasts, 149–150 drivers, 147–148 growth in common shares and dividends, 152 plausibility, 148–149 professional research reports, 150–151 profit margins, 151–152 Income Statement Forecasting worksheet, 144 Installment credit, 73 Institute for Supply Management New Manufacturing Orders Index, 45, 67–68 Intel, 268, 269, 275–276, 278 Internal rate of return (IRR), 79–80 Intrinsic value, 10, 72, 93, 131–134 Intrinsic value modeling, 164–170 dividend discount model (DDM), 166–167 estimating target prices using relative valuation multiples, 167–170 Financial Fitness and Probability of Bankruptcy Scorecards, 170–171 Inventory turnover, 116–117 Leading Economic Index (LEI), 43–45 Leading economic indicators, 37–39, 43–54 average length of manufacturing workweek, 43–45 average weekly claims for unemployment insurance, 52–53 building permits, new private housing units, 53–54 Chicago Federal Reserve’s National Credit Conditions Index, 49–51 Institute for Supply Management New Manufacturing Orders Index, 45, 67–68 interest rate spread, 10-year Treasury yield minus Fed Funds rate, 47–49 manufacturers’ new orders, nondefense capital goods, 52 manufacturers’ new orders for consumer goods and materials, 49 stock prices, S&P 500 index, 51 University of Michigan Consumer Sentiment Index, 45–46 January effect, 16 Johnson & Johnson (JNJ), 6, 81–84, 236–237, 239, 242, 244–245, 247–248, 251–253 annual returns, 236 dividend discount model (DDM), 81–84 Job creation, 41–43 Macro-finance, 35–69 coincident economic indicators, 37–39, 54–58 employees on nonagricultural payrolls, 55–56 index of industrial production, 57–58, 68–69 nominal and real total retail sales, 54 personal income less transfer payments, 56–57 economic analysis, 35–41 sector rotation, 36–39 writing guidelines, 39–41 lagging economic indicators, 58–64 average duration of unemployment, 63–64 average prime rate, 58–60 commercial and industrial loans, 62–63 consumer price index for services, 61 inventory to sales ratio, manufacturing and trade, 61–62 ratio of consumer installment credit/personal income, 60–61 unit labor cost, manufacturing, 63 leading economic indicators, 43–54 average length of manufacturing workweek, 43–45 average weekly claims for unemployment insurance, 52–53 building permits, new private housing units, 53–54 Chicago Federal Reserve’s National Credit Conditions Index, 49–51 Institute for Supply Management New Manufacturing Orders Index, 45, 67–68 Kahneman, Daniel, 16 Keynes, John Maynard, 21–26 General Theory of Employment, Interest and Money (Chapter 12), 21–26 animal spirits, 26 beauty contest analogy, 24–25 bubbles, 26 excessive volatility, 23 fundamental investors, reduced role of, 25 investment professionals and market efficiency, 23–24 long-term expectations, 22–23 long-term investors, warning for, 25 market valuations, 23 professional investors, 24 Lagging Economic Index (LAG), 58–59 Lagging economic indicators, 37–39, 58–64 average duration of unemployment, 63–64 average prime rate, 58–60 commercial and industrial loans, 62–63 consumer price index for services, 61 inventory to sales ratio, manufacturing and trade, 61–62 ratio of consumer installment credit/personal income, 60–61 unit labor cost, manufacturing, 63 316 Macro-finance (continued) interest rate spread, 10-year Treasury yield minus Fed Funds rate, 47–49 manufacturers’ new orders, nondefense capital goods, 52 manufacturers’ new orders for consumer goods and materials, 49 stock prices, S&P 500 index, 51 University of Michigan Consumer Sentiment Index, 45–46 nominal and real time series, 41 national income, corporate profits, and job creation, 41–43 supplemental economic indicators, 64–66 inflation, 64–65 oil and gas prices, 65–66 total U.S federal debt and U.S debt/GDP ratio unemployment rate and U6 unemployment plus underemployment rate, 64 Market efficiency, 11–16 analysts, 13–15 anomalies, 15–16 behavior of securities prices in efficient market, 12–13 securities prices in efficient market, 11–12 Market value-added, 130–134 intrinsic value, 131–134 Markowitz, Harry, 236, 245, 249, 250 McDonald’s (MCD) balance sheet forecasting, 153–158 historical performance analysis, 100–136 income statement forecasting, 145–152 analysts’ consensus forecasts, 149–150 drivers, 147–148 growth in common shares and dividends, 152 plausibility, 148–149 professional research reports, 150–151 profit margins, 151–152 intrinsic value modeling, 164–170 dividend discount model (DDM), 166–167 estimating target prices using relative valuation multiples, 167–170 Financial Fitness and Probability of Bankruptcy Scorecards, 170–171 pro forma analysis, 159–164 Financial Analysis & Valuation worksheet, 159–160 metrics and forecasting assumptions, 160–164 Money management, active and passive, 1–34 alpha and beta, 2–3 market efficiency, behavioral finance, and adaptive expectations, 10–18 analysts, 13–15 Index anomalies, 15–16 behavior of securities prices in efficient market, 12–13 securities prices in efficient market, 11–12 three levels of market efficiency, 12 perspectives on investing, 18–26 Bogle, John, 18, 19 Ellis, Charles, 18, 19–21 Keynes, John Maynard, 21–26 “Why Do People Trade?” (Dorn, Dorn, & Sengmueller, 2008), 21 professional investment policy statements, 26–30 Morgan Stanley Focus Growth Strategy Profile, 26–28 professional money managers, 8–10 underperformance of active managers, 9–10 relative vs absolute return investing, terminology, 1–3 top-down fundamental analysis process, 3–8 stocks with solid fundamentals, 4–8 Morgan Stanley Focus Growth Strategy Profile, 26–28 investment philosophy, 26–27 investment process, 27 sample investment policy, 28–30 Mortgage loan payments, calculating, 291–292 Multifactor models, 262–266 based on macro factors, 263–264 based on style factors, 264–266 managing a portfolio using, 266 National income, 41–43 Net operating profit after tax (NOPAT), 103, 122–123 Net operating working capital (NOWC), 123 Net profit and free cash flow margin, 109–110 Passive investors, definition, Passive money management See Money management, active and passive Percent-of-sales forecasting method, 144–145 Pfizer, 268, 269, 276, 278 Piotroski’s Financial Fitness Scorecard, 134–136, 170–171 Porter’s Five Forces model, 223–229 extent of rivalry among existing firms in an industry, 227–228 power of buyers to negotiate better terms, 227 power of suppliers to charge higher prices for critical inputs, 226–227 synthesis of Porter’s analysis, 228 threat of new competitors, 224–225 threat of substitute products and services, 225–226 317 Index Portfolio risk and performance attribution, 235–279 beta, 249–255 drivers of, 252–254 estimating, 250–252 low, 254–255 macroeconomic and firm-specific risk, statistical representations of, 240–249 diversification, 242–247 three-stock portfolio, risk and expected return of, 247–249 multifactor models, 262–266 based on macro factors, 263–264 based on style factors, 264–266 managing a portfolio using, 266 risk and expected return, 236 expected value and, 236–237 standard deviation of returns, 237 volatility, components of, 239–240 sector weights, dividend yield, beta, and style, 255–262 dividend yield by sector, 258 portfolio alpha and beta, 259–261 returns by sector, 257 sector betas and Treynor ratio, 261–262 sector over- and underweights, 256–257 Practitioner Perspective, 11 Price-to-earnings multiple, 112–113 Pro forma analysis, 159–164 Financial Analysis & Valuation worksheet, 159–160 metrics and forecasting assumptions, 160–164 Prospect theory, 16 Quick ratio, 115–116 Randomness, misunderstanding Relative vs absolute return investing, Relative return vehicles, Relative valuation, 111–114 earnings and dividend yields, 113–114 multiples, 111 price-to-earnings multiple, 112–113 yield metrics, 112 Return on invested capital (ROIC), 125 S&P 500 Index, 6–8 Sector overweights and underweights, Sharpe, William, 246, 249 Sharpe ratio, 246–247, 275–277 Standard deviation of returns, 237 Stock valuation, 75–76 Student Investment Fund (SIF), 255–262, 263–266 active portfolio weights, 256 beta by sector, 261 dividend yield by sector, 258 portfolio, 255 regression of returns on various macro factors, 263 returns vs S&P 500, 259–260 returns by sector, 257 style factor regressions, 265 Treynor ratio by sector, 262 Supplemental economic indicators, 64–66 inflation, 64–65 oil and gas prices, 65–66 total U.S federal debt and U.S debt/GDP ratio unemployment rate and U6 unemployment plus underemployment rate, 64 SWOT analysis, 229–231 Amazon, 230–231 Time value of money (TVM), 72, 281–308 arithmetic vs geometric averages, 296–298 average annual compound rates of return, calculating, 293 basic future value tool, 282–285 basic present value tool, 285–292 economic equivalence, 286–287 present value of an annuity, 288–292 valuing contracts, 287–288 EAR-to-APR conversion, 295–296 future value of an annuity, 284–285 with more frequent compounding, 285 savings example, 284–285 future value with more frequent compounding, 283–284 integrated problems featuring multiple TVM tools, 293–294 perpetuities, 292–293 solving for number of periods, 294–295 terminology, 282 Top-down fundamental analysis process, 3–8 stocks with solid fundamentals, 4–8 Total invested capital, 123–124 Treasury yield curve, 47–49 Treynor ratio, 261–262, 278 Truth-in-Lending Act, 290–291 Tversky, Amos, 16 University of Michigan Consumer Sentiment Index, 45–46 United Technologies’ financial statement highlights (2009–2012), 136–137 Valuation, 71–77, 172–175 See also Time value of money (TVM) Amazon case study, 172–208 bond valuation, 73–74 corporate projects, 74–75 dividend discount model (DDM) with variable growth, 76–77 318 Valuation (continued) installment credit, 73 stock valuation, 75–76 time value of money applications, 72 Value chain, 213 Value and expected returns, 77–88 dividend discount model, 80, 81–88 Chevron Corporation (CVX), 84–86 ExxonMobil Corporation (XOM), 85–86 Johnson & Johnson (JNJ), 81–84 Verizon Communications (VZ), 86–88 equity expected returns, 80–81 internal rate of return (IRR), 79–80 loans, 79 yield to maturity (YTM), 79 Verizon Communications (VZ), 86–88, 210–211 Vividness bias, 17 Volatility, 2, 239–240 components of, 239–240 Index Wal-Mart, 6–8, 217–222, 225, 226, 228–229 Weighted average cost of capital (WACC), 127–128 “Why Do People Trade?” (Dorn, Dorn, & Sengmueller, 2008), 21 Yahoo! Finance, 149–150 Yield to maturity (YTM), 74, 79 Yield metrics, 112 Yin, Jim, 150–152 YUM! Brands (YUM), 100–101, 103–134, 236–237, 239–240, 244–248, 253 historical performance analysis, 100–101, 103–134 annual returns, 236 Zero interest rate policy (ZIRP), 60 Your purchase of Applied Equity Analysis and Portfolio Management by Robert A Weigand, Ph.D includes access to an Online Video Course and companion spreadsheets If you have purchased an electronic version of this book, please visit www.wiley.com/go/weigandebook to request an access code For technical support, please visit www.wiley.com For telephone support, please contact us at: 1-800-762-2974 (U.S.), 1-317-572-3994 (International) ... at step of the top-down process: conducting fundamental 10 Applied Equity Analysis and Portfolio Management analysis to determine which stocks to under- and overweight relative to their weights... highest-conviction stocks receive the highest weight and the lowest-conviction stocks receive the lowest Figure 1.1 The Top-Down Fundamental Analysis Process 4 Applied Equity Analysis and Portfolio Management. .. and financial instrument analysis, as well as much more For a list of available titles, visit our Web site at www.WileyFinance.com Applied Equity Analysis and Portfolio Management Tools to Analyze
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