Module 6: Equity Securities
(BUSFIN 4221 – Investments)
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| Instructor: | Andrei S. Gonçalves |
| E-mail: | Andrei_Goncalves@kenan-flagler.unc.edu |
| Website: | andreigoncalves.com/BUSFIN4221 |
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Welcome to Module 6!
Download the class slides here and the “to print” version here.
The Efficient Market Hypothesis in Module 4 states that “prices correctly incorporate all relevant information available to investors”. However, for this to be the case, investors need to know how to incorporate information into prices. You have a general idea of how this is done through the Fundamental Valuation Equation, but we may gain new insights by being more specific.
In this module, we study Equity Markets and how equity contracts are priced in financial markets. We will see that two key elements are relevant for equity valuation: (i) expected dividend growth and (ii) discount rates.
We have spent some time thinking about how to estimate discount rates (mostly in the “Factor Models” module). However, we have not spent any time discussing how to think about dividend growth. Module 6 will, therefore, focus on that and is divided into the following sections:
1) Macroeconomic and Industry Analysis
Before we even consider the valuation of any equity security, we need to decide how much of our portfolio should be allocated to equities and to any particular industry (this is called “asset allocation decision”). This depends heavily on how well you think equities (or an industry) will perform relative to alternative asset classes.
Since the performance of equities is related to economic growth, our asset allocation decision relies on evaluating and predicting economic conditions. This section focus on that. It details what type of information/government policy is likely to improve/deteriorate economic conditions going forward. It then explains what type of industries should benefit the most from any given change in economic conditions.
If we are able to perform better macroeconomic/industry analysis than other market participants, then we can profit from proper asset allocation.
2) Equity Valuation
Once asset allocation decisions are made, we need to select specific stocks. Even if markets are fully efficient it is possible that your required rate of return deviates from the market required rate of return. In this case, understanding which stocks offer the most attractive opportunities to you is extremely important. Equity valuation helps in this regard.
The idea is simple: if you have good estimates of expected growth and the rate of return you should require, then you can find the fair price of any given stock and use that information to decide whether to invest in that stock or not.
I will argue that a similar (but slightly different) approach might be more useful. If you have a good growth estimate, then observing market price is enough to figure out what is the expected return of any given stock under any given equity valuation approach. Then you can decide whether that expected return is enough compensation for you to hold that specific stock. Obviously, this method also relies heavily on equity valuation.
3) Financial Statement Analysis
While section 1 helps us on asset allocation decisions, section 2 helps us to decide in which stock to invest. However, section 2 relies on investor’s ability to estimate future dividend growth. How can investors do that? In this section, I demonstrate that dividend growth is intrinsically related to firm profitability. More specifically, under some conditions, future dividend growth is proportional to future Return on Equity (which is a profitability measure). In this module, we will use basic financial statement analysis to better understand Return on Equity as an attempt to improve our ability to estimate expected dividend growth.