Key Takeaways
- Fundamental analysis examines financial statements, industry, and economic factors to determine intrinsic value.
- Technical analysis studies price patterns, volume, and charts to predict future price movements.
- Fundamental analysis answers 'WHAT to buy'; technical analysis answers 'WHEN to buy.'
- Dividend Discount Model (DDM): Stock value = present value of all future dividends.
- Gordon Growth Model: Value = D₁ ÷ (r - g), where D₁ is next year's dividend, r is required return, g is growth rate.
- If intrinsic value > market price, the stock is UNDERVALUED (buy signal).
- If intrinsic value < market price, the stock is OVERVALUED (sell signal).
- Growth investors seek capital appreciation; value investors seek undervalued stocks with high dividend yields.
Equity Valuation Methods
Investors use various approaches to determine if a stock is fairly valued, undervalued, or overvalued. The two primary schools of analysis are fundamental analysis and technical analysis.
Fundamental Analysis
Fundamental analysis examines a company's financial health, industry conditions, and economic environment to determine its intrinsic value - what the stock is actually worth based on fundamentals.
Top-Down vs. Bottom-Up Approach
| Approach | Process | Focus |
|---|---|---|
| Top-Down | Economy → Industry → Company | Macro factors first |
| Bottom-Up | Company → Industry → Economy | Company fundamentals first |
Key Areas Examined
| Category | What to Analyze |
|---|---|
| Economic Factors | GDP growth, inflation, interest rates, employment |
| Industry Analysis | Competition, regulation, life cycle stage, barriers to entry |
| Company Financials | Revenue, earnings, cash flow, debt levels |
| Management | Experience, strategy, corporate governance |
Financial Ratios Used
| Ratio | Formula | Interpretation |
|---|---|---|
| P/E Ratio | Price ÷ EPS | Lower may indicate undervalued |
| P/B Ratio | Price ÷ Book Value per Share | <1 may indicate undervalued |
| ROE | Net Income ÷ Shareholders' Equity | Higher is better |
| Debt-to-Equity | Total Debt ÷ Total Equity | Lower generally preferred |
| Current Ratio | Current Assets ÷ Current Liabilities | >1 indicates liquidity |
Intrinsic Value
The intrinsic value is the calculated "true" value of a security based on analysis.
| Comparison | Conclusion | Action |
|---|---|---|
| Intrinsic Value > Market Price | Undervalued | BUY |
| Intrinsic Value < Market Price | Overvalued | SELL |
| Intrinsic Value = Market Price | Fairly valued | HOLD |
Technical Analysis
Technical analysis studies historical price patterns, trading volume, and chart patterns to predict future price movements. Technical analysts (chartists) believe that all information is reflected in the price.
Key Assumptions
- Market price reflects all known information
- Prices move in trends
- History tends to repeat itself
Common Technical Tools
| Tool | Description | Use |
|---|---|---|
| Support Level | Price floor where buying increases | Identify entry points |
| Resistance Level | Price ceiling where selling increases | Identify exit points |
| Moving Averages | Average price over time period | Identify trends |
| Volume | Number of shares traded | Confirm price movements |
| Head and Shoulders | Chart pattern | Predict reversals |
Moving Averages
| Type | Description |
|---|---|
| 50-Day Moving Average | Short-term trend indicator |
| 200-Day Moving Average | Long-term trend indicator |
| Golden Cross | 50-day crosses above 200-day (bullish) |
| Death Cross | 50-day crosses below 200-day (bearish) |
Fundamental vs. Technical Analysis
| Aspect | Fundamental | Technical |
|---|---|---|
| Question | "WHAT should I buy?" | "WHEN should I buy?" |
| Focus | Intrinsic value | Price patterns |
| Time Horizon | Long-term | Short to medium-term |
| Data Used | Financial statements | Charts, volume |
| Belief | Market may misprice stocks | History repeats |
Exam Tip: Fundamental analysis determines WHAT to buy (finding undervalued stocks). Technical analysis determines WHEN to buy or sell (timing the market).
Dividend Discount Model (DDM)
The Dividend Discount Model values a stock based on the present value of all expected future dividends.
Basic DDM Concept
Stock Value = PV of all future dividends
The model assumes that a stock is worth only what it will pay in dividends over its lifetime, discounted back to present value.
Gordon Growth Model (Constant Growth DDM)
For stocks with dividends that grow at a constant rate forever:
Stock Value = D₁ ÷ (r - g)
Where:
- D₁ = Expected dividend NEXT year
- r = Required rate of return (discount rate)
- g = Constant growth rate of dividends
Gordon Model Example
A stock pays a $2.00 dividend that grows 5% annually. Your required return is 12%.
- D₁ = $2.00 × 1.05 = $2.10 (next year's dividend)
- Value = $2.10 ÷ (0.12 - 0.05) = $2.10 ÷ 0.07 = $30.00
| If the stock trades at... | Then it is... | Action |
|---|---|---|
| $25 | Undervalued | BUY |
| $30 | Fairly valued | HOLD |
| $40 | Overvalued | SELL |
DDM Limitations
| Limitation | Issue |
|---|---|
| Non-dividend stocks | Cannot value companies that don't pay dividends |
| Growth assumption | Constant growth rarely holds forever |
| Sensitive to inputs | Small changes in r or g dramatically affect value |
| Required return | Must accurately estimate required return |
Exam Tip: The Gordon Model ONLY works when r > g. If growth rate equals or exceeds required return, the formula doesn't work.
Growth vs. Value Investing
Two primary investment style approaches:
Growth Investing
| Characteristic | Description |
|---|---|
| Goal | Capital appreciation |
| Focus | Earnings growth potential |
| P/E Ratio | Higher (paying for future growth) |
| Dividends | Low or none (reinvested in business) |
| Risk | Higher (if growth doesn't materialize) |
| Examples | Technology companies, emerging industries |
Value Investing
| Characteristic | Description |
|---|---|
| Goal | Find undervalued stocks |
| Focus | Current fundamentals vs. price |
| P/E Ratio | Lower than market average |
| Dividends | Often higher yields |
| Risk | "Value trap" - cheap for a reason |
| Examples | Mature companies, turnaround situations |
Style Comparison
| Factor | Growth | Value |
|---|---|---|
| P/E Ratio | High | Low |
| P/B Ratio | High | Low |
| Dividend Yield | Low | High |
| Earnings Growth | High expected | Moderate |
| Market Phase | Bull markets | Bear market recovery |
Exam Tip: Growth stocks have HIGH P/E ratios and LOW dividend yields. Value stocks have LOW P/E ratios and HIGH dividend yields.
A stock currently pays a $3.00 dividend that is expected to grow 4% annually. If an investor requires a 10% return, what is the intrinsic value using the Gordon Growth Model?
Which of the following would a technical analyst use?
If a stock's calculated intrinsic value is $45 and its current market price is $55, the stock is:
Which statement best describes fundamental analysis versus technical analysis?
3.4 Public Offerings and IPOs
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