Investment Analysis & Financial Market Dynamics
Simulation & Investment Decisions
Sensitivity Analysis
Sensitivity analysis considers changes in variables, with only one change in each simulation. It provides a tool to answer “what if” questions (key variables: units sold, selling price). By comparing changes in different variables, we can assess project risks and make decisions accordingly.
Scenario Analysis
Scenario analysis considers changes in two or more variables simultaneously. It allows us to consider the best and worst-case scenarios. It requires a large number of simulations. By comparing different scenarios, we can assess project risks.
Break-Even Analysis
The break-even point is the level of sales that offsets all costs. It can be calculated in terms of profit or cash flow. It must assume a certain sales mix if the product contributions are different.
Monte Carlo Simulation
Monte Carlo simulation is a statistical technique that considers all possible combinations of variables. Therefore, the results of the simulation consider all possible outcomes, allowing assessment of the risks assumed in the investment project. It’s based on selecting random numbers for each variable. The model must include the relations between the variables and an estimate of the probability of each variable. Random numbers are generated by the computer, and the process is repeated many times, obtaining different outcomes.
Decision Trees
Normally, investment projects are subject to change during their life due to certain “milestones.” The different outcomes of certain milestones in the project may condition the decisions taken and, therefore, change the result, affecting the project cash flows and its present value.
Efficiencies of Financial Markets
Perfect Market
A perfect market is frictionless. In perfect competition, in securities markets, all participants are “price takers.” Information is costless and received simultaneously by all individuals. All individuals are rational and maximize their expected utility.
Efficient Market
In an efficient market, prices fully and instantaneously reflect all available relevant information. If the market is totally efficient, there can be no positive NPV transactions.
Requirements:
- Prices reflect all information contained in the record of past prices.
- Prices reflect not only past prices but all other public information.
- Prices are always fair, and no investor would be able to make consistently superior forecasts of stock prices.
Asset Valuation
Asset valuation is used to decide if we should buy or sell the asset, and for Initial Public Offerings. It is also used to decide if building a real estate development is worth more than construction costs.
Static Methods
Static methods do not take into account either the future perspectives of the company or the time value of money. It is quite basic and simply adjusts the book value to the market value of assets and liabilities. Adjustments may include taking into account the real value of property or other fixed assets and other costs.
Valuation by Multiples
Valuation by multiples uses basic ratios that give an idea of the company’s perspectives. The most important is the Price Earnings ratio (PER), which is defined as the Market Price of the Share divided by the Earnings per share. It indicates how “valuable” the company’s earnings are.
Dividend Discount Model
The value of a stock is the NPV of its expected dividends. Providing that we are able to forecast the growth rate for the dividend, the discounted value of a dividend in perpetuity is: V= D/(r-g).
Free Cash Flow
Free cash flow indicates the amount of money generated by the company to pay the different sources of financing. It is calculated as follows: EBIT *(1-Tax rate) + Depreciation and Amortization – Capital Expenditure +/- Changes in Working Capital.
Valuation Analysis for Companies
Valuation of companies implies many factors, which makes finding a unique value for the company quite complex. These factors include:
- Financial performance of the company, key parameters, industry perspectives, competitors, etc.
- WACC applicable to the company. This requires advancing market situations and values like market interest rates.
Financial Markets
Concept
Financial markets are “places” where both investors and “borrowers” negotiate financial assets. A big stake of the funds that are negotiated in the markets is done by institutional investors. By being tradeable in this secondary market, shares, bonds, and other financial assets get liquidity, increasing their value and making them more attractive to investors.
Financial Market Transactions
Transactions in the stock market are done by matching buying and selling bids. A buyer places an order to buy a certain amount of stock at a certain maximum price; a seller places an order to sell x shares at a minimum price. Financial markets operate with transparency, and prices. They also provide liquidity, making it easier to turn the investment into cash and vice versa.
Primary Markets
Financial markets must first be issued and then “listed.” New securities may come from capital increases of companies that are already listed or when a company starts being traded for the first time. The objective of a capital increase is normally to reinforce the company’s equity structure. An IPO may have a double objective: to provide liquidity to existing shareholders and to get new funds for the company.
Stock Market Indexes
A stock market price index is done by averaging the prices of the companies. Other indexes also take into account market capitalization. NASDAQ is also a very relevant index in the US since it includes a large number of technology firms. In Europe, the most relevant index is the Euro Stoxx 50, which includes the 50 largest companies by market capitalization in the Eurozone.
Fundamental Analysis
Fundamental analysis is a security valuation method based on the economic situation and future prospects. It’s a business valuation method. Also, the sharp decrease in interest rates and the cost of capital increases the number of “relevant” years in terms of cash flow, which by itself increases uncertainty.
Technical analysis tries to anticipate future trends by studying historical data, basically using prices and volumes traded. Note that technical analysis doesn’t take into account the company’s financial data. This technique assumes that the market prices include all the available information. It also considers that stock prices move following trends due to the behavior of the different actors in the market.
Bull and Bear Markets
A market is in a “bull” trend when it goes up. On the other hand, a ”bear” market has a downward trend. Making money in a bear market is much more complicated; while the market goes down, you cannot make money by buying shares.