Lecture 40: Top Down 3

Introduction to Market Analysis

Overview

• Investment Analysis - Top-Down Approach: Examines macroeconomic indicators (GDP, unemployment, inflation) before identifying specific investment opportunities. Critical to understanding overall market health, influencing sector performances and company valuations.

Microvaluation Analysis

• Objective: Estimate market value of investments or companies through various techniques:

  • FCFE Model: Evaluates cash availability for equity shareholders post expenses and debt.

  • Relative Valuation: Compares a company's metrics with similar firms.

  • CAPE Ratio: Uses average inflation-adjusted earnings over 10 years for smoother profit trend analysis.

FCFE Analysis

• Requirements:

  • Next year’s cash flow estimates are crucial.

  • Determine an appropriate discount rate for present value calculation.

Cash Flow Calculation Steps

1. Convert to Free Cash Flow from consensus EPS (e.g., S&P 500).

2. Estimate growth and retention rates to find the Payout Ratio.

3. Use two-stage models for forecasting and market value estimation.

Organic Model for FCFE

• Focuses on grassroots estimates instead of consensus. Key variables include:

  • Growth Rate of Sales

  • Operating Margin

  • Interest Expense and Tax Rate.

Interest Expense and Tax Considerations

• Interest Expense: Deduct from operating profit for accurate net income.

• Tax Rate: Influenced by political factors, necessitating integration in models.

Discount Rate in FCFE Model

• Determine cost of equity; higher rates lower present value.

Terminal Value Estimation

• Use constant growth model: Terminal Value = FCFE * (1 + growth rate) / (cost of equity - growth rate).

P/E and CAPE Ratio Analysis

• Simplified P/E multiple analysis requires key inputs to reflect market conditions.

• CAPE approach smooths out earnings, reducing volatility effects, but should be used with other valuation metrics for accuracy.