Company Analysis


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Company Analysis

  1. 1. Company Analysis and Stock Valuation  After analyzing the economy and stock markets for several countries, you have decided to invest some portion of your portfolio in common stocks  After analyzing various industries, you have identified those industries that appear to offer above-average risk-adjusted performance over your investment horizon  Which are the best companies?  Are they overpriced? Dr. Jitendra Mahakud 1
  2. 2. Company Analysis and Stock Valuation  Good companies are not necessarily good investments  Compare the intrinsic value of a stock to its market value  Stock of a great company may be overpriced  Stock of a growth company may not be growth stock Dr. Jitendra Mahakud 2
  3. 3. Growth Companies  Growth companies have historically been defined as companies that consistently experience above-average increases in sales and earnings  Financial theorists define a growth company as one with management and opportunities that yield rates of return greater than the firm’s required rate of return Dr. Jitendra Mahakud 3
  4. 4. Growth Stocks  Growth stocks are not necessarily shares in growth companies  A growth stock has a higher rate of return than other stocks with similar risk  Superior risk-adjusted rate of return occurs because of market undervaluation compared to other stocks Dr. Jitendra Mahakud 4
  5. 5. Defensive Companies and Stocks  Defensive companies’ future earnings are more likely to withstand an economic downturn  Low business risk  Not excessive financial risk  Stocks with low systematic risk Dr. Jitendra Mahakud 5
  6. 6. Cyclical Companies and Stocks  Cyclical companies are those whose sales and earnings will be heavily influenced by aggregate business activity  Cyclical stocks are those that will experience changes in their rates of return greater than changes in overall market rates of return Dr. Jitendra Mahakud 6
  7. 7. Speculative Companies and Stocks  Speculative companies are those whose assets involve great risk but those that also have a possibility of great gain  Speculative stocks possess a high probability of low or negative rates of return and a low probability of normal or high rates of return Dr. Jitendra Mahakud 7
  8. 8. Value versus Growth Investing  Growth stocks will have positive earnings surprises and above- average risk adjusted rates of return because the stocks are undervalued  Value stocks appear to be undervalued for reasons besides earnings growth potential  Value stocks usually have low P/E ratio or low ratios of price to book Dr. Jitendra Mahakud 8
  9. 9. Economic, Industry, and Structural Links to Company Analysis  Company analysis is the final step in the top-down approach to investing  Macroeconomic analysis identifies industries expected to offer attractive returns in the expected future environment  Analysis of firms in selected industries concentrates on a stock’s intrinsic value Dr. Jitendra Mahakud 9
  10. 10. Economic and Industry Influences  If trends are favorable for an industry, the company analysis should focus on firms in that industry that are positioned to benefit from the economic trends  Firms with sales or earnings particularly sensitive to macroeconomic variables should also be considered  Research analysts need to be familiar with the cash flow and risk of the firms Dr. Jitendra Mahakud 10
  11. 11. Structural Influences  Social trends, technology, political, and regulatory influences can have significant influence on firms  Early stages in an industry’s life cycle see changes in technology which followers may imitate and benefit from  Politics and regulatory events can create opportunities even when economic influences are weak Dr. Jitendra Mahakud 11
  12. 12. Company Analysis  Industry competitive environment  SWOT analysis  Present value of cash flows  Relative valuation ratio techniques Dr. Jitendra Mahakud 12
  13. 13. Firm Competitive Strategies  Current rivalry  Threat of new entrants  Potential substitutes  Bargaining power of suppliers  Bargaining power of buyers Dr. Jitendra Mahakud 13
  14. 14. Firm Competitive Strategies  Defensive strategy involves positioning firm so that its capabilities provide the best means to deflect the effect of competitive forces in the industry  Offensive strategy involves using the company’s strength to affect the competitive industry forces, thus improving the firm’s relative industry position  Porter suggests two major strategies: low- cost leadership and differentiation Dr. Jitendra Mahakud 14
  15. 15. Porter's Competitive Strategies  Low-Cost Strategy  The firm seeks to be the low-cost producer, and hence the cost leader in its industry  Differentiation Strategy  firm positions itself as unique in the industry Dr. Jitendra Mahakud 15
  16. 16. Focusing a Strategy  Select segments in the industry  Tailor strategy to serve those specific groups  Determine which strategy a firm is pursuing and its success  Evaluate the firm’s competitive strategy over time Dr. Jitendra Mahakud 16
  17. 17. SWOT Analysis  Examination of a firm’s:  Strengths  Weaknesses  Opportunities  Threats Dr. Jitendra Mahakud 17
  18. 18. SWOT Analysis  Examination of a firm’s:  Strengths INTERNAL ANALYSIS  Weaknesses  Opportunities  Threats Dr. Jitendra Mahakud 18
  19. 19. SWOT Analysis  Examination of a firm’s:  Strengths  Weaknesses  Opportunities EXTERNAL ANALYSIS  Threats Dr. Jitendra Mahakud 19
  20. 20. Some Lessons from Peter Lynch Favorable Attributes of Firms 1. Firm’s product should not be faddish 2. Firm should have some long-run comparative advantage over its rivals 3. Firm’s industry or product has market stability 4. Firm can benefit from cost reductions 5. Firms that buy back shares show there are putting money into the firm Dr. Jitendra Mahakud 20
  21. 21. Tenets of Warren Buffet  Business Tenets  Management Tenets  Financial Tenets  Market Tenets Dr. Jitendra Mahakud 21
  22. 22. Business Tenets  Is the business simple and understandable?  Does the business have a consistent operating history?  Does the business have favorable long- term prospects? Dr. Jitendra Mahakud 22
  23. 23. Management Tenets  Is management rational?  Is management candid with its shareholders? Dr. Jitendra Mahakud 23
  24. 24. Financial Tenets  Focus on return on equity, not earnings per share  Calculate “owner earnings”  Look for companies with high profit margins  For every dollar retained, make sure the company has created at least one dollar of market value Dr. Jitendra Mahakud 24
  25. 25. Market Tenets  What is the value of the business?  Can the business be purchased at a significant discount to its fundamental intrinsic value? Dr. Jitendra Mahakud 25
  26. 26. Estimating Intrinsic Value A. Present value of cash flows (PVCF)  1. Present value of dividends (DDM)  2. Present value of free cash flow to equity (FCFE)  3. Present value of free cash flow (FCFF) B. Relative valuation techniques  1. Price earnings ratio (P/E)  2. Price cash flow ratios (P/CF)  3. Price book value ratios (P/BV)  4. Price sales ratio (P/S) Mahakud Dr. Jitendra 26
  27. 27. Analysis of Growth Companies  Generating rates of return greater than the firm’s cost of capital is considered to be temporary  Earnings higher than the required rate of return are pure profits  How long can they earn these excess profits?  Is the stock properly valued? Dr. Jitendra Mahakud 27
  28. 28. Negative Growth Model  Firm retains earnings, but reinvestment returns are below the firm’s cost of capital  Since growth will be positive, but slower than it should be, the value will decline when the investors discount the reinvestment stream at the cost of capital Dr. Jitendra Mahakud 28
  29. 29. Measures of Value-Added  Economic Value-Added (EVA)  Compare net operating profit less adjusted taxes (NOPLAT) to the firm’s total cost of capital in dollar terms, including the cost of equity  EVA return on capital EVA/Capital  Alternative measure of EVA  Compare return Jitendracapital to cost of capital Dr. on Mahakud 29
  30. 30. Measures of Value-Added  Market Value-Added (MVA)  Measure of external performance  How the market has evaluated the firm’s performance in terms of market value of debt and market value of equity compared to the capital invested in the firm  Relationships between EVA and MVA  mixed results Dr. Jitendra Mahakud 30
  31. 31. Measures of Value-Added  The Franchise Factor  Breaks P/E into two components  P/E based on ongoing business (base P/E)  Franchise P/E the market assigns to the expected value of new and profitable business opportunities Franchise P/E = Observed P/E - Base P/E Incremental Franchise P/E = Franchise Factor X Growth Factor Rk  G rk Dr. Jitendra Mahakud 31
  32. 32. Intra-Industry Analysis  Directly compare two firms in the same industry  Factors to consider  A major difference in the risk involved  Inaccurate growth estimates  Stock with a low P/E relative to its growth rate is undervalued  Stock with high P/E and a low growth rate is overvalued Dr. Jitendra Mahakud 32
  33. 33. Site Visits and the Art of the Interview  Focus on management’s plans, strategies, and concerns  Restrictions on nonpublic information  “What if” questions can help gauge sensitivity of revenues, costs, and earnings  Management may indicate appropriateness of earnings estimates  Discuss the industry’s major issues  Review the planning process  Talk to more than just the top managers Dr. Jitendra Mahakud 33
  34. 34. When to Sell  Holding a stock too long may lead to lower returns than expected  If stocks decline right after purchase, is that a further buying opportunity or an indication of incorrect analysis?  Continuously monitor key assumptions  Evaluate closely when market value approaches estimated intrinsic value  Know why you bought it and watch for that to change Dr. Jitendra Mahakud 34
  35. 35. Efficient Markets  Opportunities are mostly among less well- known companies  To outperform the market you must find disparities between stock values and market prices - and you must be correct  Concentrate on identifying what is wrong with the market consensus and what earning surprises may exist Dr. Jitendra Mahakud 35
  36. 36. Global Company and Stock Analysis Factors to Consider:  Availability of Data  Differential Accounting Conventions  Currency Differences (Exchange Rate Risk)  Political (Country) Risk  Transaction Costs  Valuation Differences Dr. Jitendra Mahakud 36