Chapter 20: Company Analysis and Stock SelectionDocument Transcript
CHAPTER 20: COMPANY ANALYSIS AND STOCK SELECTION
• After our sojourn into bonds, we return to stocks for the remainder of the course.
• Unlike all the previous chapters, this is a chapter that teaches the techniques of
analysis that can make you one a good stock-picker. These are some good, sound
techniques that can help us understand a company in the context of its industry and
• Will the knowledge of these techniques make you an ace stock-picker overnight?
Most probably not. There are two reasons for this:
- First, like any art or science, stock picking is learned by experience. Many, many
years have to be spent before one becomes an ace at anything.
- All these techniques are fairly standard and everyone on Wall Street knows them.
It is unlikely then, that they will be any source of competitive advantage.
However, they are a necessary prerequisite for any analysis of stocks, and we
shall consider some of these techniques.
• I shall follow the text very closely in this chapter.
• Different types of companies and stocks
- Growth Companies are those that have consistently experienced above-average
increases in sales and earnings. Growth Stocks need not be stocks in growth
companies. Any stock that has a higher rate of return compares or other stocks of
similar risk is a growth stock. A company might be a great growth company, but
as long as it is not selling cheaper relative to its intrinsic value, it does not
represent the potential to be a growth stock.
- Defensive Companies are those, whose future earnings are most likely to
withstand an economic downturn. Examples are utilities or grocery chains, in the
business of providing basic necessities. A defensive stock is any stock whose
value declines by less than one-for-one compared to a market decline. i.e. a stock
with a low or negative systematic risk, or beta can be called defensive.
- A cyclical company is one whose earnings will more or less move with the
level of economic activity. Classic examples are autos, and heavy
manufacturing industry, which are right now at a low point. A cyclical stock,
on the other hand is any high-beta stock, which means it follows the overall
stock market quite closely.
- A speculative company is one whose business involves great risk, with the
possibility of great return. A good example is oil exploration. A speculative stock,
is any stock, which has a possibility of very negative returns.
• The top-down method of investment analysis
The traditional approach to investing consists of three levels.
1) Economic analysis: Analysis of the macroeconomic trends that affect every
industry and company. This involves taking a view about prospects for the
economy, interest rates etc.
2) Industry analysis: Analysis of specific industries, and how prospects for
profitability for each look in the short run and in the long run.
3) Company analysis: This is the final step in this approach. Having decided on the
economy, and the industry for investment, one needs to analyze specific
companies and evaluate the prospects for investment. This is the step we will
learn in this chapter.
• Company Analysis
In analyzing a company, we first need to understand the strategic aspects of the
company. For this, we need a framework to understand the context within which a
firm operates. It is useful to describe two frameworks here.
Porter’s five forces model
This model is presented in Figure 19.8 of your text. Prof. Michael Porter of Harvard
University came up it, in describing the forces influencing competitive rivalry within
an industry. According to Porter, the five basic forces influencing industry structure
1) Competitive structure within an industry.
2) Threat of potential entrants
3) Threat of substitute products or services
4) Bargaining power of suppliers
5) Bargaining power of buyers
SWOT stands for Strengths, Weaknesses, Opportunities, and Threats analysis. The
SW are internal components of the analysis, where a firm identifies its own strengths
and weaknesses. The OT are external components of the analysis, the opportunities
and threats to the company; opportunities to be exploited and threats to be avoided.
Such is the stuff of strategic analysis of firms. But, that’s not our principal focus. We
shall concentrate on the financial aspects of company analysis. The financing
approach to investment consists of the following steps:
1. Compute the intrinsic value of the stock.
2. If the current market price of the stock is less than the intrinsic value, the stock is
underpriced i.e. it is selling at a bargain price, and one should buy the stock. If the
converse is true, i.e. if the current market price of the stock is greater than the
intrinsic value, then the stock is overpriced, meaning it is too expensive relative to
what we think it should be selling for. We would sell this stock.
This approach is straightforward, but the problem clearly is to try and find the
intrinsic value of the stock.
We shall discuss several ways to do this next.
• Estimating intrinsic value
I shall follow the Walgreen example presented in your text. The idea is to find the
intrinsic value of Walgreen stock in the year 1999. The market price of Walgreen at
the time was around $30. Be sure to read these notes along with the tables etc. from
Chapter 20 pertaining to Walgreen, in your text.
Method 1: Present Value of Cash Flows
This method says that investors can calculate the intrinsic value of any stock by
estimating future cash flows and discounting them at appropriate discount rates.
Specifically, we have three methods under this broad framework.
1. PV(Dividends) or Dividend Discount Model (DDM)
Here the idea is that the price of a stock is the present value of all future dividends.
D1 D2 D3 Dn
P0 = + + ++ +
(1 + k) (1 + k) 2
(1 + k) 3
(1 + k) n
The model itself is very intuitive, but in order to use it, we need to estimate all future
dividends. Obviously, it is not possible to estimate all future dividends. A way out is
to make some assumptions regarding dividend growth. For example, the simplest
assumption one might make is that dividends are going to remain a constant number
for the rest of the firm’s life. i.e. we are assuming D1=D2=…=Dn=….= D. According
to this model, the price of a firm’s stock can be found as the present value of a
perpetuity of D dollars per period, which is, given by: P0=D/k. The assumption of
constant, perpetual dividends is great for preferred stock, but not a great one for
common stock. It is typical to assume some growth.
The simplest model with growth is to assume that dividends will grow at a constant
growth rate g forever. i.e. D1=D0(1+g); D2=D1(1+g); …;Dn= Dn-1(1+g) , which means
that dividends under this model are a growing perpetuity. Thus, the price of common
stock today is given by the formula for the PV of a growing perpetuity, which is:
D1 D (1 + g)
P0 = = 0
(k - g) (k - g)
Here, D0 and D1 are the expected dividends now and next year respectively. k is the
rate of return required by investors on this common stock, while g is the constant
growth rate at which dividends are expected to grow forever. D0 is the current
dividend, and is hence known. What about k and g? How do we set about estimating
There are two methods to estimate g the constant growth rate expected in the future.
One is to look at past data regarding the particular stock and calculate a historical
growth rate. If the firm has had a fairly constant growth rate, this is a sensible
method. Let us say we have a series of dividend numbers from the past n periods
(usually years): D0 through Dn. Then, the average growth rate is given by the g that
solves the following: Dn = D0(1+g)n, or g = n − 1 . In the Walgreen example, we
can take a sample of 10 years, from 1988 to 1998. D1988 is $0.04 per share, and D1998
is $0.125 per share (See Table 20.2). The average growth rate is:
g = 10 − 1 = 10 − 1 = 12.068%
Remember, this method works only if the historical growth rate is reasonably
constant. If there were big jumps in between, obviously blind plugging-in is not going
There is another method to estimate the constant growth in dividends. Under this
method, the growth rate g is given by the following formula:
g = Retention ratio × Return on Equity
= (1-dividend payout ratio)× Return on Equity
For Walgreen, the Retention Ratio is given to us as 75%, and the Return on Equity is
19%, which yields a growth rate estimate of g= 0.75 × 19% = 14.25%.
After calculations by both methods, we have two values of g, 12.07% and 14.25%.
So, we now have a range of 12.07% through 14.25%. The authors of your text have
placed more weight on the second method, as they feel (subjectively) that the ROE of
Walgreen is the factor driving the growth; hence they settle on a value of 14.0% for
One can use the good old CAPM to estimate k, the rate of return that investors require
on the firm’s stock. You will recall (from Chapter 10) that the CAPM relates the
expected return and the systematic risk of any asset.
ki = rf+βi[E(rM)-rf]
At the time of this analysis, i.e. at the end of 1998, the risk free rate was 6%. There
are different numbers that analysts plug in for the market risk premium. The actual
historical market risk premium i.e. the excess returns of stocks over risk-free treasury
securities is about 8%. Academics contend that the number to plug in should be a lot
smaller, like 3%. The authors of your text have chosen to be in the middle of the road,
and picked 5%. The beta of Walgreen is found by estimating the characteristic line:
RWAG = αWAG+βWAG.RM +εWAG
You will recall that we plotted a line like this for Coke way back in the course, during
our discussion of the CAPM. Basically, this amounts to fitting a line with the rate of
return on the market (typically, a proxy such as the S&P 500 rate of return on the X-
axis, and the rate of return on Walgreen stock on the Y-axis. The slope of the fitted
line is the estimated beta of Walgreen – 0.90 in the calculation by the authors using a
sample of data for 5 years from 1994-1998.
Plugging in these inputs, we can estimate the expected rate of return on Walgreen
stock as: kWAG = 6% + 0.90(5%) = 10.5%
Now, let us try plugging these inputs into our DDM formula, with D1 = $0.16:
P0 = =
(k - g) (10.5% - 14.0%)
Wait! Something is wrong here. The denominator is a negative number, which
implies a negative price for Walgreen stock, which cannot be true at all. What
The answer is: The numbers are telling us that this is not an appropriate method to
use. The company is growing way too fast for it to maintain the same growth rate
forever. Thus, we need to improve upon this method. One method, known as the non-
constant growth dividend discount model, is as follows:
Pick a time period during which one expects abnormal or above-normal growth of
14% in dividends. Here, let’s pick the above-normal growth rate period as extending
from 2000 through 2004. Then, assume that the growth rate tapers off over the next
few years, until the growth steadies in 2010 to 8% forever. The following presents the
dividends of Walgreen with these assumptions.
Walgreen Company PV @
Year Growth Dividends 10.50%
1999 - 0.140
High growth period
2000 14% 0.160 $0.144
2001 14% 0.182 $0.149
2002 14% 0.207 $0.154
2003 14% 0.236 $0.159
2004 14% 0.270 $0.164
Declining growth period
2005 13% 0.305 $0.167
2006 12% 0.341 $0.170
2007 11% 0.379 $0.170
2008 10% 0.417 $0.170
2009 9% 0.454 $0.167
Steady growth period
2010 8% 0.490
Price at the end of 2009 19.614 $7.227
Total present value- Price per stock $8.840
Starting with a 1999 value of $0.14 per share, we have dividends growing at 14%
until 2004, for five years. The present value of the first five dividends during this
above-normal phase is $0.769. From 2005 through 2009, the growth rate declines
until it reaches 9% in 2009. As can be seen from the above table, the present value of
dividends during this phase is $0.844. Finally, from 2010 onwards, the dividends
grow at 8% forever. That is, dividends are a growing perpetuity from 2010 onwards.
This is shown as below:
0.49 0.49(1.08) 0.49(1.082) 0.49(1.083)
2009 2010 2011 2012 2013 ….
The present value of this series can be found by the growing perpetuity formula,
which means that the P2009 is estimated to be:
D 2010 0.49
P2009 = = = $19.614 . The present value of this is estimated as:
(k - g) (10.5% - 8.0%)
= $7.227 .
(1 + .105) 9
Thus, the total price of Walgreen stock is found as: $(0.769+0.844+7.227) = $8.84
Notice that this method results in a price of $8.84, compared to the then market price
of about $30. This method says that Walgreen stock is very much overpriced
compared to its intrinsic value.
What about a company that does not pay any dividends, e.g. Microsoft? Obviously,
the DDM is not going to work. We need another method to deal with this and other
such tricky cases.
2. PV(FCFE): PV(Free Cash Flow to Equity) method
Here the idea is that the total value of a company’s equity is the present value of all
the free cash flows that are expected to flow to equity holders (shareholders) of the
FCFE1 FCFE 2 FCFE 3 FCFE n
Market value of equity = + + ++ +
(1 + k) (1 + k) 2
(1 + k) 3
(1 + k) n
The definition of FCFE is:
FCFE = Net Income + Depreciation Expense – Capital Expenditures
-∆ in working capital – Principal repayments on debt +New debt issues
Let us apply a non-constant growth model to FCFE. Again, the algorithm is similar to
that for dividends. Pick a time period during which one expects abnormal or above-
normal growth in FCFE. If one looks at Table 20.2, we can see that FCFE has had a
growth of about 20 percent over the 15-year period, but this growth is highly volatile.
So, the authors decided on 16% as a conservative value for the above normal growth.
Again, let’s pick the above-normal growth rate period as extending from 2000
through 2004. Then, assume that the growth rate tapers off over the next few years,
until the growth steadies in 2012 to 8% forever. The following presents the FCFE and
the valuation of Walgreen with these assumptions.
Walgreen Company PV @
Year Growth FCFE ($ M) 10.50%
1999 - 204
High growth period
2000 16% 237 214
2001 16% 275 225
2002 16% 318 236
2003 16% 369 248
2004 16% 428 260
Declining growth period
2005 15% 493 271
2006 14% 562 279
2007 13% 635 286
2008 12% 711 289
2009 11% 789 291
2010 10% 868 289
2011 9% 946 286
Steady growth period
2012 8% 1022
Value at the end of 2011 40874 12,334
Total present value of FCFE 15,507
Number of shares 1,003
Value per share 15.46
This method results in a price of $15.46, compared to the then market price of about
$30. This method again says that Walgreen stock is very much overpriced compared
to its intrinsic value.
3. PV(FCFF): PV(Free Cash Flow to Firm) method
Here the idea is that to find the entire firm, and then subtract from that value, the
value of debt, to arrive at the value of equity. The total value of a company’s equity is
the present value of all the free cash flows that are expected to flow to the firm (note:
the firm, not just the shareholders of the firm).
FCFF1 FCFF2 FCFF3 FCFFn
Market value of firm = + + ++ +
(1 + WACC) (1 + WACC) 2
(1 + WACC) 3
(1 + WACC) n
The definition of FCFF is:
FCFF = EBIT(1-Tax rate) + Depreciation Expense – Capital Expenditures
-∆ in working capital – ∆ in other assets
Notice that the above formula says we should discount the FCFFs at not k, but the
WACC. This is the Weighted Average Cost of Capital, and is the appropriate rate to
discount cash flows to the firm. You should have seen the WACC in a corporate
finance course. The definition of WACC is:
WACC = wE.ke+wD.kd(1-t), i.e. the WACC is a weighted average of
the costs of equity and debt, with the weights being the proportions of debt and equity
in the firm’s capital structure. Think of this as a rate of return on a portfolio (firm)
with two assets (debt and equity) in its portfolio. The weights on the two assets have
to add up to 1.
Calculation of WACC: The WACC calculation needs wE and wD, the proportions of
debt and equity in the firm’s capital. It is important that we realize that these
proportions must be based on the market values of debt and equity, not the book
values from the accounting statements. In your text, it is given that wE=0.90, and
wD=0.10, based on market values. This means that Walgreen uses very little debt.
It is also given that kd(1-t) = 7%(1-0.39) =4.3%. Earlier, we estimated ke=10.5%.
Let’s plug these values into the WACC equation:
WACC = wE.ke+wD.kd(1-t) = 0.90.(10.5%)+0.10.(7%).(1-0.39)=9.88%
We should use this rate now to discount the free cash flows to the firm, or the FCFF.
Again, we shall use a non-constant growth model to value the FCFFs. Once again, the
algorithm is identical. Let’s pick a time period during which one expects abnormal or
above-normal growth in FCFF. The authors decided on 14% as a value for the above
normal growth, during the period from 2000 through 2004. Then, assume that the
growth rate tapers off over the next few years, until the growth steadies in 2011 to 7%
forever. The following presents the FCFF and the valuation of Walgreen with these
Walgreen Company PV @
Year Growth FCFF ($ M) 9.88%
1999 - 202
High growth period
2000 14% 230 210
2001 14% 263 217
2002 14% 299 226
2003 14% 341 234
2004 14% 389 243
Declining growth period
2005 13% 439 250
2006 12% 492 255
2007 11% 546 257
2008 10% 601 257
2009 9% 655 255
2010 8% 708 251
Steady growth period
2011 7% 757
Value at the end of 2011 26286 9,324
Total present value of FCFF 11,979
Minus: Value of debt 4250
Value of equity 7,729
Number of common shares 1003
Value per share 7.71
This method results in a price of $7.71, that is once again substantially lower than the
market price of about $30. Again, our analysis suggests that Walgreen stock is very
much overpriced compared to its intrinsic value.
Method 2: Relative Valuation ratio Techniques
Here, we try to estimate the earnings of a company, and multiply that by the
appropriate Price/Earnings (P/E) ratio for the company, and arrive at a stock price.
The various steps of this method are explained below for Walgreen.
Step 1: Forecasting Sales for Walgreen
Here, the analyst tries to get at a “best guess” forecast of sales based on several
factors. On alternative is to use some measure of consumer spending and relate it to
the company in hand. After all, consumers have to buy the products that this company
offers. As we know, Walgreen is primarily a pharmacy, hence personal spending on
medical care might be especially important. Table 20.5 tries to compare Walgreen
sales over the past 20 years (1977-1998) to various measures. Figure 20.2 plots the
relationship between Walgreen sales and the Personal Consumption Expenditure –
Medical (PCE-Medical), and finds a strong relationship between the two. This
suggests that is we know how PCE-Medical is going to grow, we can try to get an
estimate for Walgreen sales.
Economists are forecasting the PCE will grow at 6.3% in 1999 which will result in a
dollar figure for PCE of $6,177 billion. Of this, 15.3% is expected to be expenditure
on medical care, which says that PCE-Medical care will be about (15.3%
×6,177)=$945 billion, which is a growth rate of 6.5% from 1998. Using the
relationship between PCE-Medical care and Walgreen Sales, such as the one in
Figure 20.2, we can forecast Walgreen sales growth in 1999 as 11%.
Another way to get at the same quantity, i.e. Walgreen sales growth is based on total
square footage in all Walgreen stores in the country. This is a common measure in
retail sales. As shelf space in retail stores is very valuable, one tries to forecast the
sales per square footage, and multiply that with the total square footage. For
Walgreen, the authors assume a growth in total square footage of 1.5 million sq. ft,
which, added to the 1998 number of about 26 million sq. ft. (see Table 20.6 for this)
yields a total of about 27.5 million sq. ft. Sales per thousand sq. ft. has been steadily
climbing, as can be seen from Table 20.6, which is a good sign. The 1998 number
was $588.19 per 1000 sq. ft. Assuming a slight increase to $600 per 1000 sq. ft. ,
results in a total sales estimate of (600×17.5 million) =$16.50 billion, which is an
increase of about 10.8% over the 1998 sales of $15.31 billion.
Yet another way could be to use the number of stores and multiply that by the sales
per store. Assuming a net increase of 160 stores during 1999 (200 new stores less 40
store closings), we can get from 2549 stores in 1998 to about 2700 stores in 1999.
Sales per store were $6.01 million in 1998. If we assume a modest increase to $6.25
million in 1999, we end up with a total 1999 sales estimate of (2700×6.25 million) =
$16.88 billion, which is an increase of about 10% from 1998.
Given these three estimates, the authors settle on the higher number in view of the
positive economic outlook (in 1998/99), and use 11% as their estimate of sales
growth, which results in an estimated 1999 total sales of about $17 billion. The point
of all these calculations is to tell you that there is no one magic formula that will give
the “right” answer. The idea is to try as many approaches as possible, so one can hope
to triangulate to a sensible number. That is the job of an analyst.
Step 2: Estimating profit margin for Walgreen
Figure 20.3 shows the relation between Walgreen’s Net Profit Margin and that of the
retail drugstore industry as a whole. It can be seen that industry margins have been
declining over the past two years, but Walgreen has steadily been increasing its
margins. The reason, if one dug a little deeper, is aggressive price cutting in the retail
drugstore industry. But Walgreen has been consistently improving its position by
adding more and more high-margin items on its shelves. This leads us to believe that
Walgreen is strongly positioned to increase net profit margin. The authors assume a
modest increase here of 3.50%.
Estimated net profits of Walgreen = (Estimated Net Profit Margin)×(Estimated Sales)
= (3.50%)× $17 billion = $595 million
Assuming there are 1003 million common shares outstanding, we can arrive at an
estimate of the Earnings per Share (EPS) as follows:
Estimated EPS = Estimated net profits/No. of common shares
= 595/1003 = $0.59 per share
Step 3: Estimating the P/E ratio for Walgreen
From Figure 20.4, we can see that Walgreen’s P/E ratio follows closely that of the
retail drug industry, as well as that of the S&P 400 index, especially since 1992.
Considering that Walgreen has been growing at a faster clip than the industry, one
can conjecture that Walgreen will, in future, have a multiple a little higher than the
industry. Assuming a multiplier of about 22 for the retail drugstore industry, we can
use some higher numbers such as 24, 26 or 28 for Walgreen. (There is nothing
sacrosanct about these numbers, we could have use 23 or 25. As it is, this is a game of
“best guesses”.) Using the three multiples, we have the following intrinsic values
implied for Walgreen:
Estimated intrinsic value = Estimated Multiplier (P/E ratio) × Estimated EPS
24 × $0.59 = $14.16
26 × $0.59 = $15.34
28 × $0.59 = $16.52
Making the Decision
The following are the values we obtained for Walgreen, from all the methods.
Three stage DDM $8.84
Three stage FCFE $15.46
Three stage FCFF $7.71
Relative Valuation: P/E=24 $14.16
Relative Valuation: P/E=26 $15.34
Relative Valuation: P/E=28 $16.52
All our analysis and every method we have used us is telling us that Walgreen has a
value of less than the prevailing market price of $30 or so. Thus, we must conclude
that Walgreen is overpriced relative to its value. If you own it, we would recommend
a sell, if you don’t own it, we would not recommend a buy.
Obviously, Walgreen is a growth company, but not a growth stock at this time.
That’s all I wanted to cover in “Company Analysis and Stock Selection”. In
particular, I want you to look at and appreciate the various kinds of data that have
been used in the analysis. Everything from economic forecasts to company data is
extensively used. This will hopefully have given you a flavor of “real-world”
analysis, where data is plenty, good information is scarce, answers are not obtained
by textbook formulas, and the analyst’s job is to guess better than the next best guess.